Restoring Trust

PETER R. MACK & CO., INC.

19 EAST 71^ST STREET, SUITE 3

NEW YORK, N.Y. 10021

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October 28, 2008

RESTORING TRUST

 

This is a time when nothing is as important as restoring trust. People around the world must restore trust in their governments and leaders; financial institutions have to restore depositors’ trust and their own faith in competing institutions; markets have to restore trust in liquidity and the historical system of capital flows; and regulators and legislators need to restore trust in their own integrity and expertise.

 

Most importantly, clients have to restore trust in their own financial advisers and money managers, and, in turn, those investment professionals have to rebuild faith and confidence in their own abilities and judgments.

 

It will be a very difficult struggle for everyone.

 

Personally, I’m having a difficult time understanding how the global crisis developed into the panic we’re currently in. I felt that I and my clients were positioned to maintain some defense against the events. Beginning around 2004, I had become quite wary of the financial sector after reading a number of research papers about leverage in the financial markets and institutions from off-balance sheet exposure to derivatives including credit default swaps (CDSs), collateralized mortgage obligations (CMOs), etc. and coming to further understand the fixed income markets.

 

In 2004, the size of the derivative market was already astonishing to me, although it was then probably less than one fourth or so of the size it was prior to the onset of the crisis, and 2004 was even before the explosion of mortgage debt in housing and the emergence of the sub-prime problem.

 

In July 2007, I posted a piece on my blog Notes From The Front quoting Warren Buffet on the hazards of derivatives in the credit markets. His concern proved to be quite prescient.

 

My own concerns were sufficient to keep us out of financial stocks. We had no or minimal exposure to the brokers, banks or the hot names such as Washington Mutual, Fannie Mae, Freddie Mac, AIG or others that have subsequently been taken over or closed at great loss to shareholders.

 

At the height of their popularity, financial stocks represented 21% of the value of the S&P 500, at a time, for example when energy was somewhere around 6%, and commodity and materials were at 3%. The large financial names that descended into dust were the core holdings, the mainstays of most of the portfolios run by large brokers and advisers. The under-weighting of our portfolios cost us some points in relative performance at that time, but spared our clients the massive losses endured by others in 2008, and I am proud of that fact. 

 

FINANCIAL CRISIS - PART 1:

 

The Global Financial Crisis has gone through two, or possibly, three stages. In my view, stage one began in early 2007 with growing concern about housing, mortgages and the revelation of trouble at two Bear Stearns’ hedge funds. In the early summer of 2007, those funds were closed at great loss to their investors, but the markets shrugged off the trouble as isolated and manageable. 

In July 2007, the SEC under Chairman Cox committed the first gross blunder in the crisis by removing the “uptick rule” regulating short sales. Under the rule, any short sales of stock had to be executed at a price higher (or the same) as the previous sale. The purpose of the rule was to give stocks breathing room on the downside and prevent sellers from essentially throwing fuel on a raging fire and driving stocks lower without interruption. The uptick rule had been in effect for many, many years and, in my opinion, had served to soften the downdraft of stocks subject to heavy short selling and prevent “bear raids” on targeted stocks, by permitting buyers to buy while scaling down. Many have defended the SEC’s action by claiming that stocks that go down would go down whether there was an uptick rule or not, a view I totally disagree with. The uptick rule brings order and time in place of chaos. This blunder by Cox seemed to me to be just the start of a pattern of non-performance during his hyper-political administration at the SEC.

For those who may not understand selling short, the process is to sell stock  (that you do not own) first, and hope to buy the shares back later at a lower price. It is simply the reversal of the buy low/sell high practice; it is sell high/buy low.

 

Additionally, also with respect to short selling, the SEC continuously failed to enforce the rules regarding “naked” short selling, a rule that requires short sellers to borrow stock for delivery to the buyer before it is sold short. By its suspension and non-enforcement of these rules, the SEC permitted chaos to enter the markets at a very delicate and sensitive time in the global economy.

 

In November of 2007, FASB (Financial Accounting Standards Board), an independent organization that establishes accounting standards and interpretations of accounting rules, passed Rule 157 which regulated mark-to-market valuation methods for financial institutions. It is too complicated to fully explain it in few words, but the rule forced financial institutions to adjust the value of certain assets on its books – generally infrequently traded derivative instruments - based on actual last sales in the marketplace. These assets don’t trade on any exchange and actual market prices are not readily available. The net result was that forced and troubled sales at fire-sale prices made by capital-impaired institutions became the standard for all institutions and forced all those other institutions to then mark down the value of the assets on their own books. This constant downward revaluation created a new round of capital shortage and book entry losses which then forced more sales to meet regulatory capital requirements, lower values for those assets and created a vicious downward spiral. In my opinion, the passage and implementation of 157 in November 2007 was the second, if not one of the greatest bureaucratic blunders of all time, and represented a major cause of Financial Crisis 1.

 

I should note that the minutes of the October 2007 board meeting of FASB clearly describe that the professional staff of FASB had recommended a one year delay in implementation of Rule 157 but was overruled by the members of the Board in a 4-3 split vote after a very brief debate. This was a huge mistake and in a perfect world the four board members who forced the implementation of this rule would answer to Robespierre, rather than be permitted to remain in the background, preserving their relative anonymity and cupidity.

 

The process of mark-to-market accounting would be similar to houses sold in foreclosure. Hypothetically, you and your neighbor live in a gated community and have identical houses valued at $750,000. Your neighbor has fallen on hard times and needs to sell to raise cash by the end of the week. A buyer offers $450,000, all cash, which is accepted. Under mark-to-market, if you were a financial institution you would be obligated to value your house at the $450,000 of the last sale without regard to any extenuating circumstances or the fact that you don’t have to sell and expect to hold for years. Extending the analogy, your lender would then call you and demand that you put up the $300,000 marked down forcing you to sell at the discount price or even lower. Frankly, it’s an insane process.

 

Once FASB 157 went into effect, banks and investment firms started to announce and take markdowns, yet there was still sufficient capital and liquidity to maintain regulatory requirements. The level of concern began to rise as institutions began to report growing losses. In January 2008, while I was a patient in Yale New Haven Hospital, a trader at Societe Generale, a large French bank, stunned the global markets by recording a trading loss in derivatives of hundreds of millions, causing the market to have a then huge selloff.

 

On March 14, 2008, after Bear Stearns’ common stock had been relentlessly driven down through rumor and intense short selling, the company was facing bankruptcy as customers pulled funds and wouldn’t trade with them. The US Treasury was forced to intervene and arranged a takeover of Bear Stearns by JP Morgan at $2 per share, with the Treasury positioned to guarantee all debt obligations on Bear’s books. (Subsequently, Bear shareholders managed to increase the stock purchase price to $10.) To everyone, this signaled a realization by the Treasury to intervene to preserve the liquidity of the financial system in saving those firms considered “too big to fail” and was seen by most as an ongoing policy commitment by the government.

 

I view this action and this date as the effective end of the viral portion of Financial Crisis 1, although it was very clear that mortgage woes and housing problems would continue to create economic problems in the future. However, the Treasury’s actions generated a firm commitment to restore trust and liquidity in the system and bought the time needed to work out the problems without a global crisis. In England, the saga of Northern Rock was playing out as well, aided by commitments and support from the Bank of England and government.

 

On March 14, 2008, just prior to the rescue of Bear Stearns, the Dow Jones average closed at 11,951. On September 8^th, immediately after the rescue of Fannie Mae and Freddie Mac but before the Lehman bankruptcy, the Dow Jones Average closed at 11, 510, representing a decline of just 3.7% during a period when the mortgage and housing news continued to worsen. Some people believe that this was a case of mistaken complacency in the markets. In my view, however, it represented the global consensus that the United States had formulated a consistent policy of intervention which restored trust in the stability and strength of the financial system and its institutions. I view this as a clear demonstration of the end of Financial Crisis 1.

 

FINANCIAL CRISIS – PART 2:

 

On Monday, September 15, 2008, Lehman Brothers filed for bankruptcy, after the US Treasury and the Federal Reserve failed to provide or facilitate a rescue plan in spite of having provided implicit assurances to investors that the system would be preserved and stabilized. Within hours, the markets began to experience devastating effects. Money market funds which had provided and held short term loans and commercial paper in Lehman now had essentially worthless debt and had to write down the debt, pushing net asset values below the $1.00 level, a condition known as “breaking the buck.” This caused an immediate run on the money market funds as investors pulled trillions out of these funds as well as from deposit accounts in banks and brokerage houses. It soon worsened as the global panic spread around the world. Equity, bond and commodity markets began to crash, causing margin calls and additional forced liquidation, which in term caused more selling and another vicious circle of selling, a process known as deleveraging.

 

Money market funds are a main source of lending and liquidity in the short-term lending market to banks and industrial corporations through commercial paper. In general, money market funds have an average maturity life ranging from 30 – 50 days, depending on their experience and management decisions, which allows for historically expected immediate cash needs. With the run on the funds and need for cash, the industry was thrown into upheaval and has yet to recover.

 

Since the bankruptcy of Lehman Brothers, the Dow Jones Average has dropped from 11,510 on September 8^th to 8,379 on October 24^th, a decline of some 28%.

 

The government’s failure to backstop Lehman, thus breaking the trust that the markets had placed in it, in my opinion stands as the single cause (or at least the major contributing factor) in the global financial crisis that has devastated every single market in the world.

 

It was most likely Secretary of the Treasury Paulson, or perhaps Timothy Geithner, the President of the New York Federal Reserve bank, or the two of them who single-handedly made the fateful and stupid decision that caused individuals, governments and institutions trillions of dollars in losses.

 

Secretary Paulson has been less than candid about why he shifted policy. At a recent press conference, he was asked whether he would admit that it was a mistake. Defensively, and seemingly pleading for understanding, he answered that “there were no buyers for Lehman” as if this was sufficiently exculpatory, and immediately changed the subject.  Of course there were no normal buyers for Lehman without the government guarantee, just as there were no buyers for Bear Stearns other than JP Morgan back in March without Treasury’s guarantee.

 

We don’t know now and maybe we’ll never know the reason, but it seems likely that Paulson and Geithner wanted to teach Richard Fuld, the CEO of Lehman Brothers, a lesson he’d never forget, without understanding the consequences.

 

For months prior to the bankruptcy it was reported that Paulson, Geithner and other officials had “urged” Fuld to find a buyer and sell Lehman. For whatever reason, he didn’t do it.  These people knew each other well, as power players in the industry. Obviously, I wasn’t in the room and nothing has been reported, but I think what this comes down to is simply a personality conflict, a fit of pique, a power play. “We told you to sell and you didn’t, and we’re going to teach you a lesson you’ll never forget. Don’t mess with us!”

 

Wouldn’t it be shocking and surprising if my take on the development of Financial Crisis Part 2 turned out to be true: a global financial catastrophe, man-made and perhaps caused mainly by arrogance and egotistical human error!

 

LOOKING AHEAD:

 

Since the Lehman bankruptcy, markets around the world have crashed; credit has frozen; economic forecasts which just a month ago were cautious on the question of recession, now question whether we can just stop at recession before moving to depression. Our government has jumped into action, rescuing or causing to be merged such institutions as AIG, Washington Mutual, Wachovia, Merrill Lynch, all on the brink of failure; creating numerous plans with acronyms such as TARP intended to shore up lending and borrowing among banks and generally making available the resources of the US Government to keep the financial system liquid and fluid. All the facilities are in place and hopefully the expanded activity will be felt soon and credit restored.

 

Congress has passed a broad rescue plan for mortgages and housing and another stimulus plan for the economy is likely very soon should Obama win and the Democrats hold or expand their control in the House and Senate.

 

In Europe, the G7 and EU have met and developed concerted interventions to backstop the European banking system, and England has done the same as economies weaken and drop into recession. Iceland teeters on the brink of bankruptcy. The Russian market is down 70% on the collapse of oil and overextended lending. The Russian oligarchs, many among the richest men in the world, have seen their industrial empires collapse amid losses in the billions of dollars.

 

In this country, some of the largest and well respected hedge funds are down by 35-40%, and investors are pulling funds, thus causing serious selling. Just last week, SAC Capital, a hedge fund run by Stevie Cohen said that they had sold 50% of their holdings – probably over $20 billion – to raise money, while Calpers, the State of California Pension Plan, was actively selling at these prices to raise money for payouts to retirees.

 

Today’s news carries a convoluted tale about Volkswagen, and enormous losses being taken by hedge funds caught in a short squeeze in a trade gone exceedingly bad. Goldman Sachs and Morgan Stanley are off by considerable amounts as they are rumored to be caught in the maelstrom.

 

The price of oil has dropped from $145 a barrel just a few months ago down to about $60 a barrel today, on commodity futures liquidation. Other commodities from the metals to fertilizer plummeted with amazing speed. At the beginning of the summer, I wrote about oil speculation and low margin requirements being the only reason why oil had risen to excessive highs and destabilized world economies. At the same time, George Soros and the former head of the CFTC (Commodities Future Trading Commission) both testified before congress that speculation by futures traders including hedge funds, had corrupted the system and led to a catastrophic price increase. Their testimony was ridiculed by CNBC and the free-market advocates, and ideological anti-regulation forces grabbed the media’s attention.

     

Just over a week ago, Aubrey McClendon the CEO of Chesapeake Energy (CHK), a listed natural gas company, was forced to liquidate his entire holdings of Chesapeake, the company he founded, selling over 31 million shares to meet a margin call. His holdings, worth more than $2 billion at the stock’s high of $74 in July, were worth a mere $42 million when sold.

 

Recently, Warren Buffett, the legendary value investor, took significant investment positions in General Electric and Goldman Sachs, demonstrating his willingness to bet on the future. As of this writing, he has significant losses on those two holdings, just like everyone else. Given his time frame, I have little doubt that he will once again demonstrate why he is so esteemed. On the other hand, just a few days ago, Alan Greenspan confessed that his philosophical, ideological belief in free markets was flawed, a much belated mea culpa.

 

The consolation to all of us is that governments, including our own, central banks and legislators have given signs that they are scared, as well, and will do anything and everything to sustain the safety and functionality of the global economy. Initially, this means pumping money and liquidity into the respective systems. It means lowering interest rates. It means working in cooperation and coordination with each other. It also means balancing the needs of the people with the needs of the institutions.

 

We have endured a brutal period. We are all shocked at the destruction of our personal wealth and many of us find the machinations of the financial system and the markets beyond any comprehension. We are asked to have faith in our fiduciaries – the regulators and legislators – and many of us feel that while we don’t know much, they know even less. We can all be consoled, however, by knowing and recognizing that every effort is being made to restore trust in the markets, to provide liquidity and stability to the economy. I believe, or in moments of weakness just hope, that these efforts will succeed.

 

I am angry and regret very much that Secretary Paulson, or his associates, made such a catastrophic error in judgment in spilling the Lehman Brothers poison into our well. No matter how great their effort in trying to clean it up after the fact, the reality is that the well has been tainted and only through time and additional filtration can it be restored. The poison is causing a panic; the markets are asking the question whether some chain of inexorable or irreversible events are in place to dictate our future destiny, to bring about a new depression. I believe not. I believe that the depth of the crisis has passed and that the patient will soon begin to heal.

Peter Mack, October 28, 2008

 

Peter R. Mack & Co., Inc .and any of its principals including Peter R. Mack may have an investment position, either long or short, in any securities mentioned herein. Furthermore, although the information contained herein is believed to be accurate, neither the Firm nor its principals make any representation as to the accuracy of any information contained herein and the reader should not rely on the statements contained herein for any purposes. Opinions mentioned herein are subject to change without notification. Material contained herein is for information and educational purposes only.