September 22, 2008

RE:  Treasury Bailout and Financial Markets

There remain more questions than answers as Congress this week debates the largest bailout package in history.  One question asked of Federal Reserve Chairman Ben Bernanke over a year ago regarding the credit crisis was what would be the most beneficial tool to fight the credit meltdown?  His response, paraphrased, was to know the real value of the exotic debt instruments disseminated globally through the financial system.  The essence of the bailout proposal will attempt to address that problem as the Treasury purchases troubled assets from financial institutions in an effort to get to the root of the problem. 

But at what price will these assets be acquired?  If the price is too low financial institutions will be forced to take further losses which will exacerbate the crisis.  If the price is too high the taxpayer’s foot-the-bill and these financial institutions do not suffer any consequence for their greed and bad management.  The crisis is the modern day equivalent of a run on the bank that has caused irrational fear and unreasonably low valuations for the troubled debt.  That has been magnified by new accounting rules forcing mark-to-market valuations even though market value is indeterminable.  This downward spiral must be stopped and that is the essence of the Treasury proposal.

If the bailout is structured correctly the taxpayers, although at risk, will come out ahead.  Once the markets have stabilized a more reasonable value for these debt instruments will emerge and the Treasury can resell them into a viable market place.  That may be easier said than done and it will take time for this to happen.

The debate this week in Congress will be monumental.  An attendee of CFM’s investment committee meetings has often said that politicians in a democracy do not address an issue until it becomes a crisis.  That is because electability is always at stake and they do not have the political will to take a stance on tough issues.  Well, we are in a crisis now and there is bi-partisan support for the bailout but the structure does deserve healthy, but expedient debate.  We are in agreement that Congress should have oversight, and assistance to troubled financial institutions should not be carte blanche.  Given that the elections are within weeks it is highly likely that a bailout program will be enacted by the end of this week and that should go a long way in stabilizing markets.  That is beneficial to all taxpayers because taxpayers are investors too. 

Part and parcel but subsequent to the bailout program is the need to address the erosion of checks and balances in the United States’ financial and accounting systems.  That will happen after the election. How did we get to this place and what can be done to correct the problems?  Greed has always been a part of human nature but creating a regulatory environment whereby honest human beings (the majority) providing honest and worthwhile services in a competitive environment must also be considered.  That is to say that it is easy to overregulate in the aftermath of a crisis.   The essence of the problem can be addressed through reinstating or establishing the following checks and balances:

·         Off balance sheet accounting for structured investment vehicles must be eliminated.  This is the same problem that caused the demise of Enron and both the SEC and Financial Accounting Standards Board tolerated up to 40-1 leverage (off balance sheet debt) by Lehman and Bear Sterns.

·         Credit rating agencies such as Moody’s, Standard & Poor’s and Finch have not done their job and must be held accountable.  Investment advisors rely on these credit rating agencies and their poor judgment has direct and profound impact on our clients.  Further, when credit ratings are subsequently downgraded it wreaks havoc in credit markets as banks, insurance companies and pension plans generally must own only “investment grade” debt instruments. 

·         Upfront commissions or fees for investment bankers and mortgage brokers result in structurally flawed investment vehicles.  Investment bankers need to have equity risk in their underwritings with fees paid over time and tied to the viability of the investment.  Mortgage brokers need to be held to a higher standard when qualifying borrowers.

·         A borrower should be qualified to get a loan.  There is nothing more fundamental than this principal that was ignored when investment bankers found a way to securitize (sell) sub-prime mortgages to an investment public that did not see through the “smoke and mirrors” of the exotic debt instruments approved by credit rating agencies.  Further, politicians pushed for more loans to non-qualified borrowers and Fannie Mae and Freddie Mac were all too willing to accommodate this short-sighted and ill-fated request of populist politicians. 

These simple and fundamental checks and balances will go a long way in re-establishing credibility for US financial institutions and markets without undue and restrictive overregulation.  CFM will write senators and Congressmen and request that they address these issues during the inevitable and necessary reform of our financial and accounting systems.  As investors and taxpayers who have a significant stake in this process, you should also write your representatives.  

One client emailed over the weekend and expressed concern because the fundamental checks and balances in our financial and accounting systems were no longer in place.  We agree with that concern and have attempted to address the matter above.  However, the ultimate checks and balances in our system remain very much in place – that is a two party democracy and a free press.  We are empowered to influence public policy and it is election season. 

Where do we go from here?  As stated above, we will know more by the end of the week, but it is highly likely that the bailout package will be enacted by Friday.  That is also the date of our investment committee meeting and we will provide an update next week.  Generally we do believe the bailout program is necessary and that it will help restore some confidence and stability to the financial markets.  While there remain many hurdles such as weak consumer spending, higher unemployment, huge consumer debt and a large inventory of unsold houses, the American people always work through their problems and cautious longer-term optimism remains a viable theme.  Although oil prices spiked today because of uncertainty regarding the bailout and the weakening dollar, world demand, including China, has dropped substantially.  We believe oil prices will stabilize in the $100 to $125 range and that will help the inflation outlook which allows the Fed to not raise interest rates.  The interest rate environment and the slope of the Treasury yield curve will allow financial institutions to make an appropriate profit on yield spreads once this crisis is over.  Productivity gains have been remarkable as employees hunker down in times of uncertainty.  We are not Pollyanna, but we don’t think the US economy is driving off a cliff either. We don’t believe drastic changes in portfolio allocations are warranted at this time.

Best regards,

Colorado Financial Management