Santangel's Review Strikes Again!

My friends at Santangel's Review are back at it again. Apparently, aside from working day and night on the upcoming newsletter, they somehow find the time to listen to the interviews recently conducted by the Financial Crisis Inquiry Commission and transcribe them for our reading pleasure. From the guys who brought us the transcript of David Einhorn's testimony, the newest transcription includes the wisdom of none other than the Oracle of Omaha himself. I don't want to spoil it for you, but I think everyone will want to hear what Warren Buffett said about what single act saved the entire financial system during the depths of the crisis. No, it wasn't the bogus bank stress tests or TARP. And is wasn't the FASB relaxing the rules on mark-to-market accounting. Have a read and see if you agree...

I also wanted to get in another shameless plug for Santangel's Review. I have inside knowledge regarding the subject of their soon-to-be-released newsletter. In fact, I expect to have a chance to read a draft this week. As such, for those of you who are high net worth individuals or who work for funds of funds, I highly recommend that you visit the website, read the free issue available there and strongly consider subscribing.

Now, without further ado, here is the transcript:

Transcript of Warren Buffett Interview With FCIC

Introduction to Santangel's Review

Readers,

For those of you who are not yet familiar with Santangel's Review, now is a great time to become acquainted with the site. Santangel's Review is a quarterly newsletter that profiles emerging and undiscovered value investors. But, it is different from Value Investor Insight in that it is not focused on Q&A sessions with managers. Instead, the authors provide a narrative of the history of the firms, the people who run them, and the key investment decisions. In reality, the publication reads much more like a short story than a simple profile. However, since it is written by two security analysts, the descriptions of the investments are robust and very in-depth.

For anyone interested in understanding the investment process of managers who have generated exceptional returns over a long period of time (but who operate under the radar), I highly recommend going to the site and downloading the free copy of the first issue. If you like what you see (and I truly believe that you will), please click on the link provided on the site and think about subscribing to the newsletter.

In addition, aside from the newsletter and subscription materials, the site also has a blog that is now up and running. As such, I wanted to call your attention to a piece that was posted today on the site. The authors have transcribed the presentation to the Financial Crisis Inquiry Commission by David Einhorn of Greenlight Capital. I have not seen this posted anywhere else on the web and it is a fascinating read. Here is the link to the posting if you are interested: http://www.santangelsreview.com/2011/02/28/david-einhorn-financial-crisis-inquiry-commission-interview-transcript/

I suggest bookmarking the site as the authors have a knack for finding material that is not available anywhere else. I also hope that you will consider subscribing. You will not be disappointed.

Enjoy the site,

The Inoculated Investor

(Disclosure: I have a close friendship with the authors of the site. I also have helped in the editing of the newsletter. However, I have no financial stake in the endeavor and truly believe that the publication is like no other investment newsletter I have ever seen.)

Must Read Interview with Alice Schroeder

Readers,

I usually refrain from shameless promotion, but my good friend Miguel Barbosa of the world-class site Simoleonsense just released the first installment of his lengthy interview with Buffett biographer Alice Schroeder. Anyone who has read her book, The Snowball, knows that it provided readers with an intimate depiction of Warren Buffett's relationships that had not been available elsewhere. We had long known Buffett the investor and thanks to Ms. Schroeder, we now better understand Buffett the man, father and husband.

Miguel has promised me that this interview will provide even more insight for those who are interested in what makes the world’s greatest investor tick. Please take this opportunity to read the interview linked below. I personally am looking forward to the rest of the series as well.

http://www.simoleonsense.com/simoleonsense-interviews-warren-buffetts-biographer-alice-schroeder-part-1-the-forging-of-a-skeptic-from-accountant-to-buffetts-voice-on-wall-st/

The Best Links of the Week That Was

Looks like the government piling up all that debt is a problem after all: Who would have thought that endlessly accumulating debt to finance current spending obligations could be a bad thing? Come to think of it, the reminders of the risks associated with excessive leverage are probably the central lessons that have emerged from the credit crisis. Even households are starting to understand that you can’t borrow and spend your way to sustainable prosperity and subsequently have been tightening their purse strings. Unfortunately, this intuition has clearly been lost on the US government. Specifically, the backdrop of the need to stimulate a depressed economy has given the powers that be in the US a remarkably convenient excuse to ignore these lessons and continue to borrow with reckless abandon. Aside from the usual risks like default, debt service as a percentage of total revenue increasing as rates rise and the destruction of the US dollar, authors Carmen Reinhart and Ken Rogoff now find that future growth may also be impacted by unsustainable debt levels:

In a new paper presented Monday at the annual meeting of the American Economic Association, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard study the link between different levels of debt and countries’ economic growth over the last two centuries. One finding: Countries with a gross public debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.

The results are particularly relevant at a time when debt levels in the U.S. and other countries at the center of the financial crisis are rapidly approaching the 90% threshold. Gross government debt in the U.S., for example, stood at 85% of GDP in 2009 and will reach 108% of GDP by 2014, according to IMF projections. The U.K.’s gross government debt stood at 69% of GDP in 2009 and is expected to reach 98% of GDP by 2013.

“If history is any guide,” the rising government debt “is very troubling for the U.S. and other advanced economies,” says Ms. Reinhart.

Left unaddressed, it appears that the US’s debt to GDP ratio will cross the 90% point of no return threshold in the next few years and that event could dampen an already meager growth rate. I don’t think I have to point out that a lot of the budget projections that have come out over the last year have included some particularly rosy estimates of future GDP growth. If the debt and deficit collaborate to stunt that growth then suddenly the US has to borrow more than anticipated even though tax revenues are unlikely to increase without meaningful GDP growth. I don’t know what the technical definition of a debt spiral is, but this situation sure sounds like one.

Would a bonus deferral scheme help solve the compensation problem on Wall Street? James Kwak of The Baseline Scenario recently created an interesting post on the potential way to remedy the misaligned incentives issue that is the plague of the taxpayer and a windfall for Wall Street traders. At just about every firm bonuses are paid on a yearly basis even though it could take years for the success of certain trades to be ascertained. Recent trading “profits” stemming from RMBS and CMBS assets come to mind as those that have looked great for a while but then turned into crippling losses when the housing and commercial real estate markets started to implode. A trader who loaded his company’s balance sheet with MBS probably looked like, and was compensated like, a star when the prices of these securities were going up. But then when some of these securities could not be unloaded without taking gigantic losses a few years later, most firms reluctance to claw back past bonuses meant this trader got to keep his bonus even though his trades endangered the going concern status of the institution. Recently, this dynamic has meant heads the trader wins and tails the taxpayer loses as the government has been forced to bail out the firm in question when its balance sheet caught fire.

There has to be another way right? Let’s review what Kwak’s idea is:

Instead, what about making your 2009 year-end bonus based on your performance in 2006, 2007, and 2008? That is, by the end of 2009 you would have better information about whether the trades placed in those years had turned out well or badly. There are all sorts of variations possible: you could weight the years differently; you could include 2009 (with a low weight because it’s too early to tell); you could do it on a quarterly basis to smooth out the lumps; you could pay out on a quarterly basis; and so on. But the basic principle is that you don’t calculate the bonus until enough time has elapsed to ensure that the employee deserves it. If you wait long enough, you could even just pay it out in cash instead of restricted stock.

The first objection will be that new employees get screwed, since they will get lower bonuses until they have been with the company for a few years. There are a couple possible solutions to that. The one I like less is that for someone who joins on 1/1/2009, his 2009 bonus could have a full-size target and be based on 2009 performance; but his 2010 bonus would be based on two years of results, his 2011 bonus on three years of results, and his 2012 and later bonuses on four years of results.

My preferred solution, though, is that people simply get smaller bonuses (and maybe somewhat higher salaries to compensate) when they switch companies, and only get the big bonuses after they’ve been around a few years. (You can imagine a new equilibrium where bonuses for employees in their first years are lower than today, but bonuses for long-term employees are higher. I’m not saying in this post that total compensation has to go down; that’s a separate issue.) In the technology startup industry, employees get stock options that vest over four years (with a one-year cliff). If you leave after two years, you give up your last two years of options (and unless the company is already public, you have a difficult choice about whether or not to exercise your options). This increases the cost to the employee of switching companies, which is good on two levels. First, as far as the division of the pie is concerned, it benefits employers (shareholders) relative to employees, which would be a good thing for the banking industry (as opposed to, say, the fast food industry). Second, it makes the pie bigger, since companies are more productive if they have more stable workforces. For these reasons, banks should actually want to move to this type of bonus calculation.

Although the exact calculations of yearly weights or how many years to include when determining a bonus need to be worked out, this seems like an infinitely better scenario (for taxpayers) than what we have now. Currently, traders have the incentive to make as much money now as possible with little regard for the future consequences. But, if a big bonus after a particularly profitable year were deferred, a trader’s time horizon would be elongated in a way that reduced the possibility of a future blow up. This would actually be great for the bank and would protect taxpayers a lot better without capping or reducing compensation. I’m sure if such a scheme were ever forced upon members of Wall Street I would be able hear their cries from Los Angeles. But, if the goal is to create a more stable financial system in which individual participants are reluctant to take excessive short-term risks because their own compensation is one the line, then maybe Obama and Congress should ignore those ubiquitous financial lobbyists on this topic.

You don’t always have to use a bazooka: In 2008 former Treasury Secretary Paulson likened the threat to take over Fannie and Freddie to having a bazooka that he hoped not to use. In the end, he eventually did have to use the bazooka but the sentiment of his comment was interesting. He thought that the threat of nationalization or conservatorship would be enough to force Fannie and Freddie to reform their money losing ways. In retrospect, by the time he made that threat it was way too late as it had become abundantly clear that F&F had filled their balance sheets with such toxic waste that the HAZMAT team needed to be summoned.

The truth is that in the past sometimes all government officials or the Fed had to do was hint at taking action in order to change market sentiment or practice. Unfortunately, the financial crisis has diminished the credibility of such threats. When Tim Geithner talks about the US’s commitment to a strong dollar people laugh at him and the markets ignore him. However, the Fed does this type of thing all the time and it appears to still be working. Without any actual action, all the Fed has to do is say that rates will be held low for an “extended” period and the market gets the signal that interest rate hikes are not forthcoming immediately. We will see how long this continues but for now the Fed has the ability to pull out the bazooka but not actually fire.

In his most recent piece, Martin Hutchinson of The Prudent Bear goes through a list of potential actions the government could take to incrementally help solve our myriad problems without actually pulling out the big guns. Think of it as pulling out a pistol as opposed to a rocket launcher. It is now painfully obvious that Congress cannot pass single bills that address all of the issues that need attention and if they do, the bills are 20,000 pages long and contain so much pork that they would make pig farmers blush. That’s why I think it makes sense to take little steps like the ones suggested by Hutchinson. Unfortunately, as he details below, the government could also use its pistols in ways that do not tackle the long term conundrums facing the US and only kick the can down the road at the expensive of future taxpayers:

The Christmas Eve decision by the U.S. Treasury to extend unlimited support to Fannie Mae and Freddie Mac was such a policy, albeit one pointed in a pernicious direction. In reality, it makes very little difference; Fannie and Freddie have such massive political support that no kind of devastation in their home mortgage operations would cause the Obama administration to abandon them. However, the unlimited support line from the Treasury allows them to extend their pernicious operations aggressively, thus diverting yet more U.S. capital into the wasteful housing sector, and increasing the contingent liability on taxpayers still further.

Come the November midterm elections, the Democrats will be able to claim that house prices have recovered substantially on their watch. However, a market that is propped up artificially in this way has a tendency to extract its revenge by requiring still larger and larger subsidies in order to avoid collapsing to its true equilibrium level, perhaps still 15% below current levels. Thus the cost to taxpayers, homeowners who buy houses in 2010 and the U.S. economy in general from this particular "miracle" of Treasury sleight of hand will be substantial.

Turning in the opposite direction, to an action of no direct economic consequence that could cause a genuinely useful miracle, we can consider the effect of a modest increase in the federal funds target rate, perhaps to a trading range of 0.25% to 0.50% from its current 0% to 0.25%.

This would have no immediate economic effect. With inflation already running at 2% to 3% and heading higher, short-term rates would remain heavily negative, so monetary policy would remain hugely "stimulative" as Ben Bernanke and the political class wants it.

However, such a move would have a considerable effect on commodity and energy markets. Currently, the main near-term threat to continuing economic recovery arises from these markets, in which prices are continuing to rise and may at some point get to levels that threaten recovery, by draining purchasing power out of commodity-using Western economies and/or produce a confidence-sapping acceleration of inflation…

The United States could have a similar benign effect by agreeing to raise the eligibility age for Social Security and Medicare entitlement by one month each year from 2026, the year in which the Social Security retirement age reaches 67. Such a change would have no direct economic effect at all for the next 16 years but it would at a stroke eliminate the long-term deficit in the Social Security system and greatly reduce that in the Medicare system.

Further reductions in the Medicare system's deficit certainly require a year or two to allow the whole health-care question to be depoliticized after 2009's battles. Then, some cost-saving measures such as limiting damage awards for medical malpractice are themselves highly political.

However, there is one counterintuitive measure that could be taken which would hugely reduce costs in the system overall even though at first sight it would increase federal funding for health care. That would be for the federal government to fund properly the mandate it imposed on hospitals in 1986 to treat indigent patients in emergency rooms, without regard to their ability to pay. If the federal government reimbursed the costs of this mandate, hospitals would no longer have to load the losses onto the charges for insurance-covered patients or the even higher charges on individuals, nor would they have to employ a large staff chasing deadbeats. Since the unfunded cost of emergency room treatment is estimated at $80 billion annually, transferring that burden to government would save two or three times that amount from the costs to insurance companies and individuals of medical treatment, probably saving 1% of GDP from health-care costs by that reform alone.

Does the US have more criminals on a per person basis than the rest of the world or just laws that are too restrictive? It is hard for me to believe that the average person in the US is more likely to engage in criminal activities than someone in a third world country. But that’s what the data regarding the number of incarcerated Americans relative to the US’s percentage of total world population would seem to imply. In reality, without doing a lot of research on the subject I surmise that the reason for this is that the US just has much more developed policing practices, court systems and jail infrastructure. If another country does not have to resources to catch, prosecute and then incarcerate its criminals then of course it would have fewer people in jail on a relative basis.

The problem now is that our ability to house the criminals that we are so good at catching is diminishing fast. The cost of holding all of these people in jail has begun to cripple state budgets. So, we really need to figure out what to do before states literally are forced to raise taxes on the rest of us just to keep so many people locked up. Either we need to change the laws that define what a criminal is or shorten the time that certain types of lawbreakers are forced to stay in jail. In retrospect it may have been a poor decision to put people in jail for having a minimal amount of pot or when their third strike was jaywalking, for example. Thus, we need to assess the actual threat that nonviolent offenders pose on broader society. I have no problem keeping murders, rapists, child molesters, and drug traffickers in prison. There is no question that isolating those people from the rest of us is necessary to maintain some sort of civilized and functioning society.

I just think it makes sense to try to rehabilitate some people outside of jail by helping them gain skills that allow them to re-enter the workforce. My guess is that in just about any scenario the cost of job training or classes about how to properly function within the mainstream society would be a fraction of what we now spend feeding and monitoring these individuals in jail. Not surprisingly, as this NY Times editorial points out, there is some data that supports at least trying some of these alternative measures:

The United States, which has less than 5 percent of the world’s population, has about one-quarter of its prisoners. But the relentless rise in the nation’s prison population has suddenly slowed as many states discover that it is simply too expensive to overincarcerate.

Between 1987 and 2007 the prison population nearly tripled, from 585,000 to almost 1.6 million. Much of that increase occurred in states — many with falling crime rates — that had adopted overly harsh punishment policies, such as the “three strikes and you’re out” rule and drug laws requiring that nonviolent drug offenders be locked away.

These policies have been hugely costly. According to the Pew Center on the States, state spending from general funds on corrections increased from $10.6 billion in 1987 to more than $44 billion in 2007, a 127 percent increase in inflation-adjusted dollars. In the same period, adjusted spending on higher education increased only 21 percent…

One factor seems to be tight budgets as states decide to release nonviolent offenders early. This can not only save money. If done correctly, it can also be very sound social policy. Many nonviolent offenders can be dealt with more effectively and more cheaply through treatment and jobs programs.

Michigan, which has been hard hit by the recession, has done a particularly good job of releasing people who do not need to be in prison. As the American Civil Liberties Union’s National Prison Project details in a new report, Michigan reduced its prison population by about 8 percent between March 2007 and November 2009 by taking smart steps, notably doing more to get nonviolent drug offenders out, while helping in their transition to a productive, and crime-free, life.

What we don’t know is whether crime also increased in Michigan after the prisoners were let go. A skeptic might argue, “once a criminal, always a criminal.” But it doesn’t appear that states have enough money to incarcerate all the people who they decided were criminals so at some point tough choices must be made. I don’t see the harm in implementing prison reduction programs on a trial basis in states that have the resources to monitor the released individuals and properly assess the ongoing risks they pose to society. You never know. We might be pleasantly surprised by the outcome.

(Picture courtesy of usoge.gov)

Turkey Day Readings

Before we get to today’s links, I want to wish everyone a Happy Thanksgiving. While this has been a tough year for many people it is important to reflect on the positive influences in our lives and things we are thankful for.

Tanks or a slow moving train wreck? In his missive this week, John Hussman compares the coming credit losses in home mortgages as Option ARMs reset and prime borrowers fall even further behind on their payments to tanks slowly rolling over a hill to attack villagers. This is very similar to the slow moving train wreck analogy. I think of the impending commercial real estate (CRE) problem as a slow moving train wreck. Everyone is talking about it. Bernanke, Buffett, Elizabeth Warren; you name it. Honestly, the need to refinance billions of CRE debt over the next few years and the associated difficulty based on plummeting property values is the worst kept secret in America today. The conundrum is that there is no way to quantify the damage it is going to cause. Banks are clearly extending and pretending as much as they can. They are putting up a good face but you know that some of the managers are not sleeping at all at night because they know how exposed they are to CRE. (Well, except for at Goldman because it is easy to sleep when God is clearly on your side.)

There are two reasons why I think the market has not reacted more dramatically to the continuing negative impact dodgy CRE loans will have on bank’s balance sheets and capital levels (as evidenced by the huge run-up in banks stocks and levered REITs trading at ridiculous valuations). First, everyone is hoping that markets will rebound before the refinancings are necessary. If you look at previous periods in which real estate lost a significant portion of its value, it has taken many years for prices to reach their prior peaks and in places like Japan it never happened. I actually wrote a piece on this that I think is very pertinent. So, while lenders and borrowers would be much better off if prices went up and cap rates went down, thus causing the properties to no longer be underwater, based on the data I looked at this scenario does not seem particularly likely. Second, the whole process of the unwinding of CMBS and the need to roll over property debt is sort of nebulous. In aggregate the numbers are gigantic but the pain will probably be spread out over a number of years unless vacancy rates continue to go up and lead to more actual foreclosures.

Now, why am I rambling on about CRE when Hussman’s piece was about residential real estate? Because, in contrast to the well known CRE issue, the fact that housing has not yet bottomed is actually a bit of a secret. There have been plenty of people who have called the bottom in housing and have cheered as the $8,000 homebuyer credit and normal seasonality have propped up housing data. But no matter how many RMBS the Fed buys and how much money the government gives homebuyers in an attempt to re-inflate the housing market, job losses, interest rate reset and underwater mortgages are going to cause even more foreclosures and further declines in prices. Throwing money at potential buyers does not fix the underlying problem that people took on too much debt and/or no longer have a stable flow of income. I’ll let Hussman take it from here:

Now, we face a coupling of those weak employment conditions with a mountain of adjustable resets, on mortgages that have to-date been subject to low teaser rates, interest-only payments, and other optional payment features (hence the “Option” in Option-ARM). These are precisely the mortgages that were written at the height of the housing bubble, and therefore undoubtedly carry the highest loan-to-value ratios.

The inevitability of profound credit losses here is unnervingly similar to the inevitability of profound losses following the dot-com bubble. In that event, it wasn't just that people were excited about dot-com stocks in a way that might or might not have worked out depending on how fast the economy grew. Rather, it was a structural issue that related to the dot-com industry itself – those bubble investments couldn't have worked out in a competitive economy, because market capitalizations were completely out of line with what could possibly be sustained in an industry that had virtually no cost to competitive entry. If you understood how profits evolve in a perfectly competitive market with low product differentiation, you understood that profits would not accrue to the majority of those companies even if the economy and the internet itself grew exponentially.

In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn't a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place…

The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has – aside from the recent collapse – maintained a well-behaved growth channel for the better part of a century.

An interesting proposal on banking reform: Lately there have been a number of political and financial commentators speaking out about the need to return to a Glass-Steagall-influenced banking model in which commercial banks and investment banks are forced to get a divorce. The thinking, as espoused by Paul Volcker and others, is that investment banks should be free to gamble with their own money but should not be allowed to gamble with taxpayer money provided through the FDIC deposit backstop. If that forced people inclined to risk taking to move to hedge funds then so be it. At least hedge funds risk their own capital and aside from LTCM have failed without taking down the entire global economy. Personally, I happen to like the idea of going back to a partnership structure for investment banks in which the partners are always at risk of losing their own capital. That’s a much better situation than the US taxpayer being at risk when the banks lever up and do foolish things.

With the understanding that something should be done (although it looks less and less likely every passing day) to remove the taxpayer from the above equation, I came across this op-ed article in the Wall Street Journal by the deputy director of financial and enterprise affairs at the OECD that makes the case for what are known as NOHCs (as if we needed more acronyms in our lives):

One proposal, which we now submit for consideration, is that banking and financial service groups could be structured under a variant of non-operating holding companies (NOHCs), in all countries.

Under such a structure, the parent would be non-operating, raising capital on the stock exchange and investing it transparently and without any double-gearing in its operating subsidiaries—say a bank and a securities firm that would be separate legal entities with their own governance. The subsidiaries would pay dividends through the parent to shareholders out of profits. The nonoperating parent would have no legal basis to shift capital between affiliates in a crisis, and it would not be able to request "special dividends" in order to do so.

These structures allow separation insofar as prudential risk and the use of capital is concerned without the full divestment required under Glass-Steagall or in response to the recently-expressed concerns of Paul Volcker and Mervyn King—such extreme solutions should remain the proper focus of competition authorities. With an NOHC structure, technology platforms and back office functions would still be shared, permitting synergies and economies of scale and scope. Such a transparent structure would make it easier for regulators and market players to see potential weaknesses. Mark-to-market and fair value accounting would affect those affiliates most associated with securities businesses, while longer-term cost amortization would dominate for commercial banking. It would create a tougher, non-subsidized environment for securities firms, but a safer one for investors.

If a securities firm under this structure had access to limited "siloed" capital and could not share with other subsidiaries, and this were clear to the market, this would be priced into the cost of capital and reflected in margins for derivative transactions. The result would likely be smaller securities firms that are more careful in risk-taking than has been the case under the "double gearing" scenarios seen in mixed or universal bank groups.

Finally, if a securities affiliate were to fail under such a structure, the regulator could shut it down without affecting its commercial banking sister firm in a critical way—obviating the need for "living wills." Resolution mechanisms for smaller, legally separate entities would be more credible than those needed in the recent past for large mixed conglomerates—helping to deal with the "too big to fail" issue. To protect consumers, deposit insurance and other guarantees could apply to the bank without being extended to the legally separate securities firm…

The structure of organizations and how they compete will be critical to future stability. Going forward, the aim must be to keep the "credit culture" and the "equity culture" separate so that government implicit and explicit insurance does not extend to cross-subsidizing high-risk market activity, and so that contagion and counterparty risk can be reduced. The right balance must also be struck between sufficient size conducive to diversification and strong competition to meet consumer needs at reasonable costs.

I’m sure there are some drawbacks and there would be some unintended consequences from implementing this structure, but given the difficult political landscape and the lobbying power of the banks, if we could kill this many birds (too big to fail, too big to unwind, subsidies for being so large, systemic risk) with one stone, we would be in much better shape than we are right now.

The deficit bogeyman: When people are not talking about gold, commercial real estate, the US dollar or the evil being that is Goldman Sachs, they are talking about the US debt and budget deficit. The Republicans are crying about big government. The Democrats are blaming Bush tax cuts, the 2 wars and the recession for the increased borrowing and spending even as tax receipts have fallen off a cliff. The fear is that either bond vigilantes or our foreign creditors will force interest rates up as they stop buying Treasuries, thus causing the nascent recovery (that I happen to believe is a mirage) to be stifled and the cost of servicing the humungous debt burden prohibitive. Are these just scare tactics or are they legitimate concerns?

As many people have written lately, this was what was expected in Japan and never did happen. Now, I am concerned that Japan may finally have run out of time and luck as a result of the current global recession, but that is not the point. The argument is that the US could run huge deficits and without causing a crippling rise in interest rates. For those of you who are convinced that interest rates are going to go straight up as US creditors become less inclined to hold our debt and inflation starts to pick up, I suggest you take a look at this piece from James Kwak of The Baseline Scenario. I personally have no idea how this will all play out. I think two logical people could argue both sides very convincingly. That is why it is always important to understand events that could kill your investment thesis:

One of the curious things about the debt scare that is building in the media is that it is happening at a moment when long-term interest rates are very low. In other words, it’s based on a theory that the market is wrong in its collective assessment of the debt situation. I’ve heard this blamed on “non-economic actors” (that is, foreign governments that buy U.S. Treasuries not as a good investment, but for political reasons), or on a “carry trade” where investors are exploiting the steep yield curve (free short-term money, positive long-term interest rates), as Paul Krugman discusses here.

Menzie Chinn crunches some numbers. He takes a model that he and Jeff Frankel created several years ago to estimate the impact on interest rates of inflation, the future projected national debt, the output gap (economic output relative to potential), and foreign purchases of Treasuries. That last term is important, because the oft-heard fear is that foreign governments will suddenly stop buying our debt.

Using the future growth in the debt projected by the CBO, this model predicts that real interest rates will … go down by 7 basis points over the next year, assuming foreign purchases of debt are constant. The reason the impact of the debt is so small is that it’s already priced in; since the looming debt is no secret, it should already be showing up in the data.

The counterargument is that it hasn’t shown up in the data because of the “flight to safety” and foreign governments’ irrational purchases of Treasuries. So Chinn also looks at what would happen if foreign purchases of U.S. debt fell to zero, nada, zilch (which is an extreme scenario). In that case, interest rates go up by 1.3 percentage points. That’s not nothing, but it still keeps interest rates at reasonable levels by historical standards. In addition, the CBO is already incorporating higher interest rates into their forecasts; they expect the 10-year Treasury bond yield to go from 3.3% in 2009 to 4.1% in 2010, 4.4% in 2011, and 4.8% in 2012-13, and that’s built into their projections of future interest payments.

So I’ll say again: none of this is good. But if we’re going to make important policy decisions based on fear of the debt, we should have a rational way of thinking about the impact of that debt rather than just fear-mongering.

Why did AIG get bailed out and not the monolines? According to Thomas Adams of Paykin Krieg and Adams, LLP (who is a former managing director at Ambac and FGIC), it may have been due to—you guessed it—AIG’s relationship with Goldman Sachs. In this post on Naked Capitalism, Adams carefully goes through the similarities and differences between the situations facing the monoline insurers and AIG. One major difference? Goldman had little exposure to the monolines. Thus, his conclusion is that a major wild card in the decision to save AIG and let the monolines flail was the amount of money AIG owned Goldman for collateral on credit default swaps on those wonderful ABS CDOs (there are those acronyms again). Clearly there is no way to know for sure and the timing of the AIG blowup (right after Lehman went away and the financial markets were on fire) may have influenced the decision. However, after the recent revelations by Neil Barofsky about Tim Geithner’s refusal to force the banks to take haircuts on their CDS positions, I would not be surprised one bit if Goldman’s exposure to AIG was a swaying factor:

As we have been reading the latest coverage on the AIG bailout from the SIGTARP report and the Treasury Secretary Geithner’s Congressional testimony, a nagging question remains unresolved: why did AIG get bailed out but the monoline bond insurers did not?

The business that caused AIG to blow up was the same that caused the bond insurers to blow up – collateralized debt obligations backed by sub-prime mortgage bonds (ABS CDOs). This was actually one of the few business that AIG Financial Products had in common with the monolines. AIG didn’t participate in municipal insurance, MBS or other ABS deals, which were all important for the monolines.

Certainly, AIG was larger than any of the bond insurers, but in aggregate, the bond insurers had a tremendous amount of ABS CDO exposure, which at the peak was probably over $300 billion. Despite AIG’s claims to have withdrawn from subprime at the end of 2005, we have identified particular 2006 deals with substantial subprime content that AIG most assuredly did guarantee…

I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation I can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.

When it became clear that AIG could face bankruptcy, Goldman’s plan to profit by shorting ABS CDOs was threatened. While they had the collateral posted, thanks to the downgrades, this collateral could be tied up or lost if AIG went bankrupt. This was a real crisis for Goldman – they thought they had outsmarted the subprime market with their ABS CDOs and outsmarted all of the other banks by getting collateral posting from AIG when they got downgraded. But if AIG went away, this strategy would have blown up and cost Goldman billions.

In addition, I believe that Goldman and their helpers – including their many connections with the White House and the Fed – pumped up concerns about the systemic risk that the market was facing from a Lehman and AIG failure, so that they could force the government to step in and bail out AIG. This would also explain why Lehman was not bailed out. Lehman didn’t really matter to Goldman. But the fear created by Lehman’s failure served as a good excuse for why they should rescue AIG.

I’m going to keep writing about this until the insanity stops: I have to admit it is a little disconcerting. I have heard ostensibly smart people who work with the financial markets every day argue that stocks could continue to rally because of “money on the sidelines.” Again, last I checked, aside from IPOs and other offerings, for every share of stock bought there is an identifiable seller. So as each dollar comes from the sidelines into the market another dollar leaves the market. Now, of course irrational buyers could pay too much for certain stocks and of course that could drive prices up. However, the argument you hear has to do with liquidity on the sidelines waiting to jump into the markets; not about foolish buying in relation to market valuations. Either I am completely crazy and have lost any and all sense of how markets function or this “truism” is in fact complete hogwash. Please, if you want to buy stocks because you think the valuations are attractive, just say so. I would likely argue that in a lot of cases stocks are discounting returns and margins that are implausible given the economic backdrop, but at least the rationale for buying based on intrinsic value reflects some semblance on investment sanity. If the only reason you are buying is because you think there are other buyers waiting in line (the greater fool theory, maybe?) then I implore you to take a step back and examine the macroeconomic and company specific fundamentals.

Thankfully, I am not alone in my plight. Here is a recent piece from Comstock Funds on this topic (hat tip to The Pragmatic Capitalist):

When making our bearish case for stocks we’re amazed at how often our audience brings up the old “cash on the sidelines” argument as a reason to doubt that the current rally can tank. We have been in this business for a while and don’t remember a time when this fairy tale wasn’t trotted out as a reason to be super bullish. In fact we don’t recall any point where observers ever said that the market was going down because there was not enough cash on the sidelines.

A relatively recent example was the summer of 2007 when a majority of commentators insisted that the availability of huge amounts of global liquidly would never allow the market to retreat. The words were hardly out of their mouths (or word processors) before the ECB and the Fed were forced to pour hundreds of billions of dollars into their banking systems. As we indicated at the time, liquidity is never there when you need it.

The fact is, as John Hussman has so eloquently pointed out, the purchase or sale of a stock is net neutral with regard to cash entering or leaving the market. For every buyer there’s a seller, and for every seller there’s a buyer. When “A” buys stock for $100,000 he/she has $100,000 less cash on hand, but “B”, the seller, receives the $100,000. No net cash has entered or left the market.

The reason stocks go up or down is not a result of cash moving into or out of the market. Stocks go up when prospective purchasers are more anxious to buy than sellers are to sell. If there are more willing buyers than sellers at any given level the market has to go up to equalize demand and supply. In fact, it sometimes doesn’t take any transaction at all to move the market. If Intel reports surprisingly high earnings and Dell reports a disappointment the bid and asked price moves up or down before any transaction even takes place.

Furthermore, if even one anxious buyer of a relatively small number of shares drives up the price, the total capitalization of all the shares of that stock rises. And if the purchases are a result of a real upside earnings surprise in a key bellwether stock, the entire market can rise without a dime of new cash entering the market.

Despite the obvious truth of this case, strategists and the media always bring up the old myth of “cash on the sidelines” to justify their bullish views of the market, particularly when their arguments for the economy and valuation are flawed. If you hear anyone make this case just ignore them—it’s a fallacy. If the market rally continues from here, it will happen as a result of buyers being more anxious to buy than sellers are to sell, not because sideline cash is entering the market. If fundamental and technical conditions deteriorate as we expect, prospective purchasers will become less anxious to buy while sellers will be more willing to sell, and the market will decline by enough to equalize supply and demand.

(Picture courtesy of uvm.edu)