Fannie and Freddie In Conservatorship. More Moral Hazard Ahead?

Since July 2007, the financial system has been an absolute mess. This of course has led to liquidity concerns among certain banks, and most recently to the virtual collapse of Fannie Mae and Freddie Mac. This is truly unprecedented. We now have two publicly traded companies (Fannie and Freddie) that were both "implicitly" backed by the U.S. Government, and due to the latest round of liquidity concerns and bad loans, the U.S. Government has made it an "explicitly" backed relationship.

While I decry bailouts and moral hazard, I honestly do not see any other options with this. And the lawyers actually made a smart move too, putting Fannie and Freddie into Conservatorship, rather than Receivership. Why is this important? Well, the distinction is that in receivership, a company continues operations until it completely winds down its commitments (i.e. this would have led to a run on the banks, institutions that trade mortgage backed products would have been destroyed, or in other words, the entire system would have frozen up). By putting these entities into Conservatorship, they continue operations with U.S. Government oversight, the Government backs the paper, liquidity continues, and the market for mortgage backed products continues, though sluggishly.

Famed investor Jim Rogers noted that "the U.S. has become more Communist than China". What he means is that we have virtually created a system where Risk has been Socialized for the benefit of wealthy people, and Rewards are still benefiting wealthy people. I absolutely agree with this assessment, and the risk premium is a big factor in investing. If investors and Wall Street types continue to have their risks socialized via de facto government bailouts, what's to stop them from taking even more undue risks in the future? This is just a reward for moral hazard in the system.

Lucky 8's?

In China, the number 8 is a sign of luck, which is why they chose 8/8/08 to begin the Olympics in Beijing. It's supposed to be the luckiest day of the century.

Unfortunately, China has been hammered over the last several weeks and months with unlucky things like devastating earthquakes, terrible weather, tsunami warnings, a huge algae probelm in the ocean (caused by excessive pollution and human waste), air quality that resembles another planet, and pollution so bad that China has ordered many factories to be shut down for the last month. They are even shooting special cannisters into the atmosphere to attempt to clear the air. And certain athletes have been denied travel-visas due to their political points of view.

So China, all I can say is..... Good Luck!

Ben Bernanke, Rock Star?

We've heard it all before-- Too Big To Fail. And honestly, some of these institutions, like Freddie Mac and Fannie Mae, are too big to fail. The problem we face is what to do with them... privatize them, bail them out, put them into conservatorship? How do we prevent even more moral hazard in the financials? There are no do-overs here. And the banks are facing their own pressures.

Two weeks ago, Bernanke and the Fed did nothing, and in so doing, they sent a message to the market that was implicitly "we're too worried about the banks and financial system to tackle inflation". So instead of raising rates by .25% and creating a stock market rally based on inflation fighting, and sending an implicit message that the banks will be fine, the market has lost 1000 points in 2 weeks. Had Bernanke and the Fed raised rates slightly, the entire psychological composition of the market would have changed: we'd be fighting inflation, people would invest in the market, financials would be able to raise capital from investors, liquidity would increase... instead, we are where we are.

Nice going Bernanke-- you're a rock star.

We're In Bear Territory-- Don't Become Bear Meat

The last 6 months has turned by definition into a Bear Market, where we've seen more than a 20% drop in stock market prices over the last 6 months. I have received a few calls asking if we should sell everything. This is where I earn my keep to prevent making a financially disastrous decision, since wholesale selling here is more than likely 5-10% away from the bottom. The question of selling everything and attempting to time the market is folly, with numerous empirical studies highlighting this type of behavior; when do you sell? when do you get back in? Typically small investors sell at the bottom, wait for the market to recover 10%, then they buy back in; in other words, they miss a 10% pop in prices, then they buy into the top of a bear market rally, then sell again at the bottom of that failed rally. This could happen several times, to the point that what was a 20% loss ends up being a 30% or 40% loss due to making emotional decisions.

This is not the market price level to sell into, this is the market price level to buy into. So investors, particularly retired investors, whose portfolios undoubtedly contain some allocation in bonds, this is where we take some of that bond allocation and buy into stock prices when they're low. That is, sell bonds to someone who desperately wants to buy your bonds from you, and buy stocks from someone who desperately wants to sell them to you. This is the level-headed approach, and also the approach that happens to help even out investment returns over the long run. In this market, let the other guys make the mistakes, and capitalize on their mistakes.

What Is The Fed Doing?

Yesterday's decision by the Federal Reserve to "do nothing" has given us a swooning stock market today. Why? Because the Fed's indecision to do the right thing (i.e. raise interest rates) is a signal of lack of will to the financial markets. Not surprisingly, financials held ground yesterday, while industrials dipped, and commodity-related securities rallied in the face of more inflation. Today oil topped $140/barrel due to a weaker dollar, and combining the United States' lack of will to find its own oil reserves, the U.S. market has fallen.

Imagine that the market is a coiled spring that has been wound down to the floor by the heavy weight of negative sentiment, inflation expectation, high oil prices, a weak dollar, a weak economy, and an impending dead-heat Presidential election in which one candidate espouses higher taxes, and the other does not (leading to much market uncertainty). This is all bad, right? Yes, and now it's all baked into the current stock market pricing mechanism. Any improvements on any of these fronts will lead to a higher stock market. In particular, a Fed willing to combat inflation through monetary policy would be welcomed by the market, and we would experience market rallies, even with an added threat to the banking system.

Part of the value of dispensing financial advice is not just about "what to do", but sometimes more often "what not to do". Selling into a weak market is a "no-no". There may be some exceptions to this, but they are rare. Buying into a weak market is a "yes" provided an investor has a long term perspective. So for anyone sitting on the sidelines, it's time to start picking at this market, buying temporarily weak sectors or high-quality out-of-favor companies at low prices.

If you have friends that are paralyzed by this environment, have them give us a call. This type of environment is typically when we receive the most referrals.

Politics As Unusual

Well, here we are. Barack Obama has just killed the Clinton political machine, and is now the presumptive Democratic nominee. The battle is now on for the political "center" between John McCain and Barack Obama. McCain is "experienced"; Obama is "shiny and new".

I usually attempt not to proselytize about my own views, but rather to give a likely view that could have *big* consequences for the U.S. economy, taxes, investments, U.S. entitlement programs, and foreign policy.

This November of 2008 is a tremendous tipping point for our beloved nation. This election gives us an opportunity to actually solve some tremendous structural problems in our country. So when you're listening to speeches, reading papers, and making your decision, look for honest debate and concern for the following topics...

1) Comprehensive Energy Policy which focuses opening the floodgates of America's economy to solve our energy reliance. 30 year depreciation and huge tax incentives would be a good start here, and the government should *not* choose which technology wins. The market needs to figure it out. A true solution will focus on new supplies of oil AND new technologies. It's not an either/or option.

2) Entitlement Reform for Social Security, Medicare, Government Pension Plans. These plans need to be fixed ASAP, since we're running out of time, our greatest ally. Kicking the can down the road only robs us of time. There are many countries that have solved their similar problems, but we can't do it here? Failure to act threatens to continue to browbeat our currency, affect our Treasury markets, and could erode our standard of living over time.

3) Taxes. Marginal Tax Rates which stay low, or introduce a Flat tax. Dividend and Capital Gains taxes need to remain low. Raising taxes is the death knell for growth, innovation, and morale.

4) Foreign Policy. Like it or not, 2008 is yet another referendum on the Bush Doctrine. People forget that we already experienced one of these in 2004.

A Crazy Start to '08

What an ugly start to the year. January was bad, just continuing the bloodshed from the end of 2007. February and March weren't much better. However, we experienced two important psychological bottoms in January and in March, which will help the market re-establish and gain its footing.

The first important bottom occurred the Tuesday after MLK, Jr. day, after a weekend in which all other major markets globally had sold off on Monday (when the U.S. market was closed). So here's this psychological agony going on over the weekend, the overnight futures markets showed the market down 600 in overnight trading, and you know what I was doing?: Licking my chops, and I couldn't wait to get into the office to start buying strong companies at give-away prices; after all, this is my job, right? I get paid to be the calm guy and to buy companies when there's blood in the streets.

The thing I hadn't counted on was the Fed, which decided that nobody is allowed to experience any pain anymore. The Fed aggressively lowered rates, lowered the discount rate, and started printing money, injecting liquidity into the banking system at a clip I've never seen before. The market opened down about 550, and within 30 minutes of the Fed's action, about 350 of that juicy fat-pitch down the middle of the plate disappeared back to the upside. I managed to do some buying that day, but not to the extent that I wished to benefit my Clients. Can't an investment manager be allowed (for just 1 day, please Uncle Ben!) to do his job? Frustrating.

The next psychological bottom came on March 7 (Friday), and March 10 (Monday). This of course was the weekend that Bear Stearns went from a market cap of $2.8 Billion on Friday to being sold for $286 Million on Sunday evening to JP Morgan. The firesale was brought about to effectively "bail out" Bear Stearns, with the Fed's help in guaranteeing certain aspects of the deal. It is thought that a failure of Bear Stearns could have unraveled the financial system. Oh, is that all?! Anyway, it was a sweetheart deal for JP Morgan, which saved the financial system that weekend; interestingly, it was J.P. Morgan himself who bailed out the stock exchange about 100 years ago...

With the Fed in a very generous mood to print money, assuage investors, and stem the panic, the market is getting its legs back. There is still a great deal of uncertainty in the market, and pessimism, but this pessimism is temporal; this is the time to be buying quality companies at low valuations. Investors with appropriately long time frames should enjoy nice returns using this strategy, while the speculators are running scared. The longer term negatives that are concerning: inflation is rising, growth is low or stalled, the dollar is weak, and the Fed can only do so much. In fact, we're at the point now where the Fed has little flexibility to do anything should another shoe drop (financial crisis, terrorism, etc.). Congress needs to do its part and *structurally* add incentives for investors to invest by lowering taxes, and control spending, most importantly on our entitlement programs!