Tuesday, September 30, 2008

Larry, Moe, and Curly-Joe

From the Desk of Joe Rollins

When I was growing up, there weren’t nearly as many television shows to choose from as there are today. We only had two channels, and most of the time there wasn’t anything on that I cared much about. Television has changed a lot since I was a little kid; I now have about 100 television channels to choose from along with nearly 10 movie channels. In spite of all the choices, I still have a hard time finding something I want to watch.

When I was a child, my father was an avid viewer of The Lawrence Welk Show, and I vividly recall his excitement when the bubble machine started at the beginning of the show and Bobby came on stage to dance. Regardless of what program was on the other channel during The Lawrence Welk Show, if we wanted to watch TV while it was on then that’s what we were watching.

On the other hand, I had free reign over the television set on Saturday mornings. I’d start the morning with black and white cartoons that were amateurish by today’s standards, with the anticipation of watching The Three Stooges afterwards. Aside from The Three Stooges, there really wasn’t much violence on TV back then – or at least not like what we see today. I thought the Stooges were hysterical, and I spent many Saturdays watching them all day long. Even after seeing virtually every episode many times over, they never ceased to amuse me. It was a sad day when I heard that Curly-Joe DeRita had died in 1993.

As I watched Congress work last week on the Paulson bill, I couldn’t help but be reminded of The Three Stooges. Our group of elected officials held the financial world’s life in its hands, and their actions resembled those of Larry, Moe and Curly-Joe more than competent legislators. Unfortunately, I didn’t find last week to be nearly as amusing as my Saturday mornings growing up…

President Bush expressed his belief this past Friday that Congress would soon reach an agreement on the financial plan bill. He commented that, “the legislative process is sometimes not very pretty.” It goes without saying that President Bush has proven himself to be the master of understatement.

On Thursday evening, I watched just about every news show update on the proposed financial plan bill. During the commercial breaks, I would flip to the Asian stock market reports, and I was amazed to see how stupid statements made by our U.S. legislators affected trading on the Asian market. There was a significant sell-off in Japan, Hong Kong, Korea, and the rest of Asia, which makes me wonder whether our lawmakers know how the state of the United States economy affects the global economy. One exclamation of stupidity after another was being broadcast for the entire world to hear, and quite frankly, I was embarrassed for our country after this display.

The comical contradictions being made by the various members of Congress were almost overwhelming. If they hadn’t been so entirely serious when making these statements, it would’ve been gag material for a television sitcom. In fact, the principal players could’ve easily been substituted by the Three Stooges. Knowing what I do about economics, finance and the problems of the equity markets, the comments grew increasingly outrageous to me. One could easily substitute Senator Chris Dodd (D-Connecticut), Representative Barney Frank (D-Massachusetts), and Senator Richard Shelby (R-Alabama) for Larry, Moe and Curly-Joe.

What, you may ask, was so comical about the contradictions being made by these legislators? While Senator Dodd and Representative Frank continued to express their desire to protect the U.S. taxpayer, both of them have been staunch supporters of Fannie Mae and Freddie Mac for decades. In fact, both received substantial political contributions from these quasi-governmental agencies. In addition, they stocked those agencies with political appointees that did nothing but perpetuate the problem that we are facing today. The taxpayers will pay dearly for that support.

As early as 1995, there was a substantial move by the Clinton Administration to roll-back these governmental agencies, but that move was blocked by Senator Dodd (D) and Representative Frank (D). In fact, I watched clips this weekend of both of them giving speeches of the attributes of these agencies and how they shouldn’t be reduced. I watched footage of former Federal Reserve Chairmen Paul Volcker and Alan Greenspan both testifying before Congress that these agencies were a growing time bomb, but Dodd and Frank blocked any attempt for legislative oversight of these groups.

In 2004, President Bush also sponsored legislation to roll-back Freddie Mac and Fannie Mae and reduce the amount of mortgages they were buying. Senator Dodd and Representative Frank once again bottled up the legislation and it never got out of their respective committees for a vote. So, as I watched the ongoing debates concerning the proposed financial plan, I found it hard to not wonder how these politicians could actually live with themselves given they were blaming everyone but themselves for the predicament our country is facing.

Even more bewildering were the comments made by Senator Richard Shelby (R-Alabama). He stated that there was basically no problem and that the free enterprise system would take care of itself. He felt that no legislation was needed and that no regulation was required. I sat in amazement as Washington Mutual closed on Thursday night and Senator Shelby continued with his same speech. How is it that the largest bank failure ever in the history of the United States had just occurred, yet Senator Shelby saw no problem and felt that no legislative oversight was necessary? Sometimes I find myself wondering what world the people who work inside the beltline come from!!

The financial plan presented to Congress by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke was a total of three pages, but the bill now being negotiated has grown to over 150 pages. I rather suspect that the final draft will be significantly longer. These two brilliant scholars of finance were treated like nitwits during the Congressional hearings, despite the fact that those doing the criticizing didn’t even seem to have a working knowledge of the proposal.

The television networks questioned Warren Buffett, the second richest man in the world, and Bill Gross, the brilliant chairman of the PIMCO bond trading company, about the proposed financial plan. Both men expressed their opinion that the proposed bill, while not perfect, would be an immediate and helpful solution to the credit market crisis. Both almost assured that the bill would not cost taxpayers money and, more likely than not, would make a profit. However, flipping back to the sound bites being made by the legislators, I heard at least a hundred times that the plan would cost the taxpayers $700 billion. It’s amazing that politicians can get so much airtime on national television when they are so completely wrong on a subject!

After I heard Senator Shelby preach that this was strictly a Wall Street problem and that governmental intervention was unnecessary, I became angrier than ever. I was reminded of a story relayed by a former Federal Reserve Governor regarding his grandfather, a hardworking, immigrant merchant with his own store. When the stock market crashed in 1929, he recalled his grandfather basically saying that, “the Wall Street guys finally got what they deserved” and was seemingly thrilled that the crash had taken place.

Within a year of the stock market crash of 1929, his grandfather’s business was gone. Due to the wave that crossed America, credit was withheld from businesses that desperately needed it. He couldn’t get credit lines to run his business and was eventually forced to close down. Unemployment in the United States skyrocketed to the point where one out of every four workers in the United States was jobless. If anyone tries to tell you again that this is only a Wall Street problem, then that person obviously doesn’t realize the magnitude of the issues. It may have started as a Wall Street problem, but it certainly has the potential to transition into a Main Street disaster without governmental intervention.

The front page of Saturday’s New York Times featured an extraordinary statement by Christopher Cox, the Chairman of the Securities and Exchange Commission. He conceded that oversight flaws probably fueled the collapse. The regulations governing Wall Street “were fundamentally flawed from the beginning.” Duh! Do you think so?!?!?

The perfect financial storm hit Wall Street all at the same time. Yes, you can try to point fingers, but there aren’t enough fingers to point when it comes to this issue. It’s too late to review the cause; it’s time to find the solution!!

My posts very rarely contain technical information for the same reason that two-page memos are unpopular – no one today seems willing to read two pages on just about any subject. However, in this particular case, I think it’s important for the public to know the facts. I have written before about “unbridled capitalism.” While I’m definitely an advocate of the goals of capitalism, it’s important for everyone to realize that even capitalism must be subject to some form of law and order.

On the options exchange, there are traded options called “credit-default swaps.” This is a technical term for a market that is essentially a form of insurance. For example, if a company owes you money, you can purchase a credit-default option that will guarantee that you will get your money back if the company defaults on its debts. While this isn’t a requirement, buying a little insurance when you’re owed a lot of money never hurts.

It has come to light recently, however, that these credit-default swaps have become the vehicle of choice for speculators who think a company will fail. By bidding up the price of the credit-default swaps, it makes it expensive for a company to borrow money since the obligor cannot afford the credit swaps. It also tends to scare other investors; the public perceives the borrower to be in financial distress due to the credit-default swaps spiraling higher and higher.

This is exactly what happened with Bear Stearns and Lehman Brothers right before both of those firms failed. Their stock prices had become so low and the cost of the credit-default swap so high that even though neither firm was in financial difficulty at the time, the public perceived them to be in big trouble. Customers began withdrawing assets at an accelerated rate to the point where these companies had no choice but to shut down. They weren’t broke by any stretch of the imagination, but since the public had no confidence in them they lost all of their depositors.

The credit-default swaps market is completely non-regulated. I recently came across an interesting statistic that reflects the abuses being made on this hybrid financial security. It is estimated today that there is roughly $18 trillion in bank and non-bank loans and in corporate and foreign bonds. The insurance to cover the credit swaps outstanding to cover these loans total $54.6 trillion. Therefore, there are now over four times as many credit-default swaps as there is actual debt itself. I can’t think of a better example of the word “speculation.”

Additionally, due to the enormous demand for credit-default swaps covering debt that doesn’t exist, the prices have been pushed up exponentially. Most people would realize that there’s no need to purchase insurance on something you don’t own. For example, I would never be allowed to purchase life insurance on the life of my neighbor because, in insurance vernacular, I do not have an insurable interest in the death of my neighbor. The basic reason for this law is that it is unethical to purchase insurance on a person you don’t have an insurable interest in with the speculation of your neighbor’s subsequent death.

This is the exact same scenario that these credit-default swaps accomplish. By virtue of purchasing a credit-default swap on a company, you are betting that it will fail even though you have no insurable interest in that company. If you’re right, then you’ll make a profit. On Tuesday of last week, the S.E.C. launched a massive undertaking to control credit-default swaps, and it’s my opinion that these swaps above one-to-one should never be allowed.

During the run-up of the oil bubble earlier this year, I made the same statement regarding oil futures. There are now more oil futures being traded than there is oil being produced. Speculators have bid-up the price of oil beyond any realistic possibility of that oil being delivered. Once again, anyone who argues that speculation is not an important component of the pricing of oil just doesn’t understand how financial markets work.

I know many people think that I’m a skeptic, but you may be interested in knowing that the original bill presented to Congress – the one before the bill that failed on Monday – already contained such provisions. Even though members of Congress repeatedly reported that the bill would cost taxpayers $700 billion, they knew this was an inflated figure. In fact, a pork barrel funding of the profits was subsequently written into the bill. As Congressman Frank and Senator Dodd continued to say on national television that they were attempting to protect the taxpayers in this matter, they must’ve had an overwhelmingly guilty conscience. Not only did they know that the $700 billion figure wasn’t accurate, but they were fully anticipating that the fund would generate a profit.

The Dodd/Paulson compromise contained a provision that 20% of the profits earned by the fund would go directly to the Housing Trust Fund – not returned to the taxpayers or used to reduce the deficit, but rather to a completely pork barrel program. Essentially, this fund finances a group called ACORN (the Association of Community Organizations for Reform Now) whose primary function is to provide housing for low income individuals; it’s also a cover to raise money for liberal Democratic politicians. In fact, the Obama campaign admits to paying ACORN over $800,000 during the recent campaign for voter registration. These payments were disguised as payments to a front group called “Citizen Services, Inc.” for “advance work.”

ACORN has been implicated in voter fraud and bogus registration schemes in Missouri, Ohio and at least 12 other states. It uses governmental money to sign up people to vote for liberal Democrats who will then work through Congress to give them more money. Isn’t it amazing that these politicians were arguing that the fund would lose money when they knew that it wouldn’t?!?! They had even devised a way to split up the profits and give them to groups that would campaign for their benefit! But, I guess all of this is a moot point considering Congress failed to pass any bill on Monday.

Growing up, my father was an ardent home movie maker. We had an old 16 millimeter silent home movie reel to watch the films he would make of our family and on rare occasions, he would buy 16 millimeter cartoons for us to watch. I cannot help but be reminded of the Keystone Cops films when I think of what is going on today. If you’re not familiar with this series, they were a hysterical group of incompetent policemen, dating back to the silent film era. They never made it to the talkie era, but I still vividly remember those films. Watching the events surrounding the financial plan develop this past week, I couldn’t help but compare our fumbling Congress to the Keystone Cops.

When I started contributing to the Rollins Financial blog, I vowed that I wouldn’t finish a post on a negative note. There will be an adequate bill approved sometime soon. We have brilliant people heading up this effort to recapitalize the banks. The financial markets around the world have suffered enormously due to the credit restrictions. If the problem isn’t dealt with swiftly, Main Street will also suffer. There will clearly be a recession, and possibly a depression, if people cannot obtain mortgages, car loans or student loans. When the bill is approved, credit will loosen up, making loans available to the public once again.

When all of this is accomplished, perhaps we will finally get back to investing money. Stock fundamentals have been thrown out the window in recent weeks. It doesn’t make any difference whether or not a company is making money or what their future prospects are – they’re being slapped around and their values are being diminished like all others. It’s difficult to anticipate the moves in the market when basic economic fundamentals no longer apply.

Once this bill is in place and the credit markets adjust, then traditional investing will return. I’m hopeful that this will happen in a matter of months and not years. The U.S. economy, while slowing, has certainly not stalled completely. Corporate profits continue to be exceptional and international business is even better. The stock market today is trading at extraordinarily low levels and almost assuredly will go higher. There’s no question that if the bill is not approved, the markets will go lower.

I wrote most of this blog before Congress’ failure on Monday to pass the financial plan bill. As I’m sure you’re all aware by now, the Dow Jones Industrial Average fell a staggering 777 points on Monday. This is the worst-ever point decline ever recorded for this index.

Many of the Republicans that voted against the bill got their two minutes of fame by expressing their reasons for voting “nay” on the bill. Many of them pointed to the speech given earlier by Speaker of the House Nancy Pelosi. Could it be that certain members of Congress believe the financial concerns of the country (and indirectly, the rest of the world) are less important than what Speaker Pelosi said in her speech?!?! It seems childish to vote “nay” because your feelings got hurt – especially when you hold the power to create financial chaos in your hands!

I look forward to better times, when I have better news to report. My hope is that those days are just around the corner.