Mr. Bernanke's Broadside

See below OpEd from today's Wall Street Journal, 3/06/08, which only underscores our blog commentary from yesterday calling Ben Bernanke an "anti-capitalist"...

Bernanke's 'Principal'March 6, 2008; Page A14
We've seen some puzzlers over the years, but we'll admit we never expected to see a Federal Reserve Chairman talking down the capital cushion of the nation's banking system.
But there it was on Tuesday, the equivalent of a CEO shorting his own stock, as Ben Bernanke encouraged the nation's bankers to write down the principal on millions of mortgage loans. Voluntary loan modifications aren't doing enough to stop foreclosures, declared the chief steward of the U.S. financial system. "In this environment," he said, "principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure."

Mull over that one for a moment. Mr. Bernanke and the Fed are charged with protecting the soundness of the banking system. The bulwark of such protection is shareholder equity -- capital -- which is generated in part by income-producing assets known as loans. Yet the Fed chief has now advised that, as a matter of public policy, banks should take a chunk of that capital and transfer it to mortgage debtors. How this additional charge -- and new political risk -- against bank earnings will ease the mistrust at the heart of the current credit crisis is a mystery.
This came only a few days after Mr. Bernanke had publicly advised Congress that more banks will fail. And it came on the same day that the Fed's Vice Chairman, Donald Kohn, told Capitol Hill that bank earnings are under increasing pressure. Amid such earnings strain and uncertainty about how far real-estate prices will fall, now seems an especially bad time for a Fed chief to instruct banks to create further losses.

It's not as if bankers don't understand their mortgage predicament, or have no sympathy for borrowers. But how, and whether, to renegotiate their loan contracts is a matter for them to decide. They might choose to lower the interest rate on some mortgages, reduce the principal amount on others, or foreclose and repossess homes on the hopeless cases. If the Fed, in its regulatory role, thinks a bank should be more aggressive in taking asset write-downs, it can order that on a bank by bank basis. Elevating principal write-downs to a general banking principle is regulatory overreach.

Only the day before Mr. Bernanke dropped his bomb, Treasury Secretary Hank Paulson disclosed that "since July more than one million struggling homeowners received a workout -- either a loan modification or a repayment plan that helped them avoid foreclosure." In January alone, there were 167,000 such modifications, with the number of borrowers receiving help rising faster than the number of foreclosures.

Mr. Bernanke's broadside might well hamper these voluntary workouts by signaling to other borrowers that they needn't do anything at all. They can merely sit tight and wait for their banker to tell them they don't owe nearly as much as they thought. Or they'll conclude they can wait for Congress to provide its own mortgage bailout, this time on the backs of taxpayers who decided not to speculate on real estate during the housing bubble, or not to purchase a more expensive home than they could afford.

It's no coincidence that one of the chief advocates of a government mortgage bailout, House Financial Services Chairman Barney Frank, hailed Mr. Bernanke's remarks as an endorsement. Meanwhile, Mr. Paulson had to wonder why Mr. Bernanke was undermining the Treasury Secretary's sensible public opposition, expressed on Monday, to a taxpayer rescue. Do the gentlemen not like each other?

The worst irony here is that the mortgage crisis is in large part the fault of the Fed's own reckless monetary policy. Low real interest rates for too long created a subsidy for debt that spurred the housing and credit bubbles that have now burst. Prices got higher than they should have been, and the first step in any recovery is letting those now-falling prices find a new bottom. Government interference in that price discovery will only prolong the crisis, increasing the chances that the losses are eventually dumped onto taxpayers.

The government is already well down this road with its expansion of the Federal Housing Administration's authority, and its unleashing of an unreformed Fannie Mae and Freddie Mac. Given his ostensible independence, the Fed Chairman is supposed to be a crucial restraint on all of this moral hazard and political panic. If the Fed can't do that, we might as well let Congress run the banking system.

Anti-Capitalist Running The Federal Reserve?

In case you missed it, Ben Bernanke, current Chairman of the United Socialist Soviet Republic Federal Reserve, has recommended that "government and private entities cooperate" in reducing some of the stresses on homeowners whose home equity may have dropped in the mortgage meltdown.

http://www.bloomberg.com/apps/news?pid=20601103&sid=aLPiHQ.ASN48&refer=us

Specifically, Bernanke is asking banks to "forgive" some portion of the mortgages held by the banks so that consumers might have some home equity left, presumably to prevent their walking away from their homes (which would prevent even more foreclosures). However, the most likely effect would be (presuming that these same homeowners arent' great at math) that they would simply tap their remaining lines of credit and buy more TV's, home appliances, and pay off credit card debt.

Let's play the logic game. Who is "government"? Eventually that will end up being you and me, and we will pay to subsidize other people's foolishness. Who are "private entities"? These are the banks who participated in creating mortgage contracts with people to purchase their homes. If the banks were to take Bernanke's idea to heart, credit will freeze up even further, which further exacerbates the crisis! So let's get this straight: consumers who financed high priced homes with adjustable rate mortgages, or negative amortization mortgages, and fudged their documentation using "no doc" loan papers (where they pay a higher rate without income verification, but then take the teaser ARM or Negative Amortization rates), need to be bailed out collectively by those "mean sinister banks" and by those "kind generous smart U.S. citizens" who try to spend less than they earn? No. Way. The quickest and most efficient way out of this mess is to let the market actually "work", which means prices need to fall enough for buyers to buy homes again (note to Bernanke: in economics this is called pricing equilibrium).

As far as I'm concerned, Bernanke is a collectivist anti-capitalist. This idea reeks of desperation, of Fed muddling, of having no policy flexibility, and attacks the banking system even further. This is anti-capitalist, and applies Socialist/collectivist solution sets to problems. These solution sets only give more incentive for consumers in the future to make bad choices, and should be avoided at all costs. But instead of just ripping the band-aid off the wound, Bernanke likes to slowly pull it off, taking off one hair and one skin cell at a time.

Investing in Uncertain Times

Amid the subprime mortgage fallout, the U.S. housing market has seen a marked drop in demand, higher levels of unsold inventory, and an increase in foreclosures. Media coverage of these events seems to emphasize that the fallout is unclear, that conditions may worsen, and that the total impact will not be known for some time.

These are precisely the conditions to engage in contrarian investing. At this point of the investment cycle, the valuations of select companies are very attractive, meaning that their current market valuations are trading below their intrinsic values. Examples abound in the financial sector, pharmaceutical sector, auto sector, and food sector. It's understandable for Clients to wonder whether purchases in these areas are "too early", given the potential for continued deterioration, especially in currently unpopular sectors of the economy. How can we determine fair values for companies when the total impact of such current events may be still unknown?

In difficult times stock prices tend to exaggerate the prevailing uncertainties. Opportunities are created where individual stock prices fall below a rational assessment of business worth. Keep in mind that an assessment of business value is conservative and not precise; intrinsic value estimates are dynamic. Often it is best to describe intrinsic value estimates as a "neighborhood", not as specific address. Reversion to the mean allows us to take advantage of short-term price declines that can create long-term opportunities. When the relative difference between stock price and assessed fair value is great enough, the investment decision is not dependent on precision.

January Was Named for Janus

Janus, a God during Roman times, had two faces looking in two different directions, and boy has he been playing rough this month! Unfortunately the direction of the markets in January has been the down, down, down direction. Again we've seen earnings weak in the financial sector, with more and bigger writedowns from the credit crisis.

The credit crisis that we've seen unfold in the last several months has occurred due to lack of faith in how assets were priced in the mortgage market, collateralized debt obligation market, the collateralized mortgage obligation market, etc. Basically, because the "faith" aspect vanished, the market for these securities vanished with it, and with no one on the buy side of the equation, the banks and investment banks have been forced to "write down" the value of these securities, and *still* the valuations of these securities is questionable.

Our best guess as to what will happen is that there needs to be capitulation by CEO's! Yes, the CEO's, who are embarrassed and fighting for their jobs with the Boards of their companies, will need to *aggressively* write down assets each quarter as they "mark to market" the values of these securities. What will eventually happen is that the writedowns will be so big as to be actually conservative on the down side; in which case all the bad news will be out, the credit market will price this information in, valuations will improve, and then all of a sudden the banks will *re-state* a prioir quarter TO THE UPSIDE. When this happens 2 or 3 times with the banks, that will signal the bottom in the financials.

Big One in 2008

This is from the latest issue of Forbes, and nicely encapsulates the upcoming debate in 2008; namely, which direction will the U.S. go? I have read other editorials which suggest, correctly I think, that the U.S. is in a generational battle between an FDR vision of the world and a Ronald Reagan vision of the world. These are fundamental questions that have huge implications for our future GDP growth rates, taxes, technological advances, and the types of policies we implement to try to solve big problems (Social Security, Medicare, healthcare, etc.)...

Big One in '08Steve Forbes 01.07.08, 12:00 AM ET
by Steve Forbes

The upcoming presidential election will be the most critical one since 1980. Back then Ronald Reagan decidedly defeated incumbent Jimmy Carter, ushering in radical new policies that would successfully set the course of this country for the next quarter-century. Unlike previous administrations, Reagan's dramatically cut taxes (the top income tax rate dropped from 70% to 28%). Reagan pushed government deregulation and reined in nondefense, nonentitlement spending. And, most important, he won the Cold War, an extraordinary victory that few experts had thought possible. We have been living off Reagan's dividends ever since.

What course will the country take now? Will we significantly simplify the tax code and cut tax rates, as Rudy Giuliani and some other GOP contenders advocate? Or will we raise taxes to stagnant, old-Europe levels, as all the Democratic presidential wannabes favor doing? Will we push for consumer control of health care or will we have a de facto socialized system, such as that Hillary Clinton is pushing? Will we turn Social Security from a liability into an asset by allowing people under the age of 50 to have personal accounts that are owned by them, not by Washington politicians--a system that will yield far greater returns than the current Social Security system could possibly do? Or will we go the Democratic way of heavier payroll taxes and reduced benefits?

Regarding foreign policy, will we take a broader, more vigorous approach to combating terrorism, deploying not only our military (which must be beefed up) but also a Reagan-like type of "soft diplomacy," such as far more effective use of radio and Internet broadcasts to troubled parts of the world? Will we push pro-growth economic policies that emphasize sound money, low taxes and property rights for developing countries or the detrimental high-tax, cheap-money policies of the current Treasury Department and the IMF?
Fundamental questions all.

While the mud will fly, there will also be a vigorous debate on where we go from here. How that debate is resolved will determine the course of our economy and the direction of the stock market. If the optimistic example of Ronald Reagan triumphs, we'll have sound, noninflationary growth, and we'll lead the world in technological innovation. The stock market will soar easily to new heights. But if the current Democratic platform wins, we are in for troubled times.
I am an optimist. I believe the spirit of Ronald Reagan still reigns in this land.

Who's Paying the Most Taxes?

Today's WSJ ran an editorial showing recently released IRS data for tax year 2005. Take a look:



This chart shows that more and more people in the U.S. are entering the ranks of the truly affluent. This represent upward mobility in a truly competitive and dynamic system.

The amount of capital gains taxes and dividend income declared has increased by 50% since the cap gains and dividend taxes were lowered to 15%.

Bullets and The Gun

Since the massive liqudity injection post-9/11, I have said (when rates were around 1.5%) that the Fed was going to need to reflate the economy by putting "bullets" back in the "gun". This has occurred over the last 24 months, and this is what needed to happen, since there has simply been too much liquidity in the system, and this has led to excessive risk taking, and low risk premiums. Historically, an environment with low risk premiums fares very poorly, and the recent credit crisis shows why.

So why did I think way back when that the Fed needed to put more bullets in the gun? Because those "bullets" represent Fed flexibililty in the face of another economic emergency. If we had been stuck in the 1.5% range, in the face of another Black Swan event, the Fed wouldn't have much wiggle room to move downward, and we certainly wouldn't want to end up in a Japan-style conundrum of a .5% rate environment. So by ratcheting up rates over the last 24 months, the Fed soaked up some liquidity, which is a good thing, since as Milton Friedman always said "inflation is everywhere and always a monetary phenomenon".

The Fed's decision to lower rates yesterday by .25% (Fed funds and discount rate) was seen as too little too late. The market already expected .25%, and "wanted" a reduction of .5%. Over the next year, the market expects rates to be lower by another 1%, which would greatly help out struggling financials and consumers. So while the Fed has wisely loaded it's Monetary Gun with additional bullets over the last couple of years, it needs to be able to pull the trigger! These gradual reductions will lead to more uncertainty and may lead us to the brink of a recession if not diligently handled.