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!

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.