The Markets Dissect the "Plan"

The stock market was volatile yesterday and will likely remain that way as investors digest the Stimulus Plan and get more details on the Geithner Plan. The objectives expressed by our new Treasury Secretary have many facets but no specifics yet. We believe the structure of each part will be crucial to fixing the credit markets, improving the banking system, and re energizing our economy.

We have been thinking about the Public-Private Investment Partnership to buy toxic assets from the banks. The government needs to attract as many investors as they can in order to grow this fund to a size that will be large enough to effectively clean up bank balance sheets. Given this objective, Mr. Geithner needs a very flexible structure to capture the diverse investment styles and needs of private equity funds, hedge funds, and many other investors.

The distressed assets held by the banks are predominantly either mortgage related or corporate bonds/loans. Generally the investors for these securities are not the same as the vultures who might participate may not want to buy a package of mixed securities. Hence, we would advise Mr. Geithner to create many investment funds which will be segregated by different classes of securities. This will maximize the investor base as specialized funds can buy what they want while multi-strategy funds can participate in many partnerships to buy a diverse set of securities.

The investor universe also has different risk/return profiles. Some investors want leverage while others don't. Therefore, the government needs to offer a leverage option to any investor who wants it but not make it a requirement for everyone who participates in the fund.

Finally, the enormous quantity of toxic assets will scare many institutions from wanting to be first in to buy these securities. No investor is wants to be the first to buy a pool of securites when billions if not trillions more will be for salethe next day, at perhaps lower prices. We would suggest Mr. Geithner should offer some loan loss protection for the first buyers and as assets are removed from the banks' books, the loan loss protection should decline.

Under our framework, the government would create a leveraged loan partnership. The investors in this fund would have the option of receiving some amount of leverage from the government at low interest rates. The early investors could get somewhere between 20% and 50% of downside protection. This will get private investors to be excited to join the government in its quest to clean up the mess. After the first slug of assets are bought by the partnership, the government will likely be able to reduce the loan loss protection and perhaps even the leverage as a larger universe of investors will want to join the partnership. This concept is very similar to the marketing concept of the early adopter.

The above strategy should be used for each asset class that the government pursues from the balance sheets of the banks. A committee of investors should determine the price to bid for each security as they will have the expertise to value them. The government should also commit a large amount of capital to each of the partnerships. This program is the one which will likely be profitable for the U.S. taxpayer and perhaps make up for some of the other losses.

If the government acted alone to buy these toxic assets, they would be assuming 100% of the losses as well as any upside. The public would be distrustful of the prices they paid and perhaps this plan could fail quickly. Therefore, our suggestion to initially offer large loan loss protection wouldn't put the government at any greater risk than if they had purchased all the securities without the help of the private sector. A combination of enough loan loss protection and leverage should be enticing enough for the private sector to partner with the government in its pursuit to clean up the bank balance sheets. If executed well, asset prices will rise as more of them move off the books of the banks. The result will be an improvement in credit markets and a stronger banking system. Of course, the government will need to inject more capital into many financial institutions as these assets are written down by the banks.

We Got the Geithner Objectives but Where's the Plan?

Treasury Secretary Geithner finally had his moment in the sun today to explain the long awaited plan to fix the financial system and end the credit crisis. How did he do? Not very well as the S&P dropped 4.9% while the DOW skidded 4.6%. Mr Geithner articulated his objectives clearly but when trumpeting his plan he lacked details.

Investors have lost faith in the government and were anxiously waiting to here what the new regime had to say. Perhaps all government officials should find a speech coach. John Q Public is ready for fresh ideas and specific details on improving the economy and ending the financial crisis. It would have been better to delay the new plan than to build up expectations for new solutions and let everyone down with scarce details.

We happen to like many of the ideas the Obama crew has announced but most investors are too skittish to trust the government again. The credit crisis and the weakened financial system is not easy to fix. It is easy to knock Secretary Paulson but our country could have easily fallen into a depression with a failed banking system. He was fighting fires for nine months and probably made mistakes but every day had a new crisis and quick decisions were warranted. He ended up with some good decisions and some bad but most investors have concluded he did a horrible job. It is easy to be a Monday night quarterback when the gun isn't pointed at your head 24 hours a day.

Secretary Geithner had many months to learn from some of Paulson's mistakes and today he really got an education on the job. This country wants answers and it wants them now. He needs to take charge and set expectations accordingly. It is easy to under promise and over sell. Unfortunately today he did the opposite. He will get it right in time as the objectives to shore up the banking system, support consumer and business lending, and partner with the private sector to buy up toxic assets are on target. These broad ideas if crafted intelligently will improve the banking system, stem the housing decline, instill consumer confidence, and stimulate corporate spending. The result will be a bottoming of the economy and an improved stock market.

The objectives will take time and the economy won't turn around until 2010 but perhaps we have some basis for optimism.

The market Wait and See

We had calm markets yesterday as investors anxiously wait for the final details of the stimulus plan and more importantly, the Geithner bailout plan. Details from the Treasury Secretary will emerge in a speech today and the next phase of the financial crisis will be unveiled. Banks will get recapitalized again and the bad assets will be ejected from balance sheets. This is what the financial system needs but it won't be an easy process.

In the meantime, the credit markets were once again successfully tested as Cisco raised $4 billion. High quality companies with strong balance sheets are in great demand by investors. This is a mini step to improving the credit markets as the extensive fear leads investors to safe places to put cash in addition to treasuries. As investors begin to move down the quality spectrum and many more non-investment grade bonds are issued, the stock market will begin to end its bottoming process and start a sustained march upward. However, we are not there yet and the weakening economy will keep the volatility in the market and cap any rally.

This Is The Government's Week

The final touches are being put on the stimulus package. We don't think it will have much effect on the markets as it won't create enough new jobs to make a difference. The government needs to spend money now on projects to get the money flowing again in this country. Consumers are scared. They are focused on saving assets and not spending them. Any tax cut won't lead to new discretionary purchases but perhaps reducing debt or squirreling the money away under their mattresses. The government should consider an idea we casually mentioned last week. Instead of a $400 tax credit, lets give American families a $400 gift card to spend at any retailer in the United States. Spending will increase, retail sales will rise, manufacturers will move inventory, profits will increase, and the circulation of dollars will expand. Also, perhaps some jobs will be saved.

Treasury Secretary Geithner will also announce his new Bank Bailout Plan. On September 29th we wrote that the bank problem can't be solved until bad assets are written down to levels where private investors see value. That process will also require banks to take more write-downs which in turn will result in the need for more capital to be injected. We have also proposed a joint fund where investors and the government can jointly buy distressed assets at fair market prices. It looks like the government is finally moving in that direction. The details of the plan will be discussed tomorrow and the markets will be anxiously waiting. Until then, we will need to focus on corporate earnings or more likely losses.

The Volatility Continues

Cisco reported decent numbers but had some concerning words about the economic environment and its effects on business in the foreseeable future. With that back drop, the markets braced for a weak day. As the morning progressed stocks dropped over 1% until rumors about the upcoming government plan started to spread. The hearsay that began to lift the markets was that the mark-to-market accounting rules would be revised to give some relief to distressed assets on bank balance sheets. This may be a short-term band-aid but more aggressive medicine is needed to clear away the toxic assets.

Stocks ended the day up well above 1% as hope that fresh government initiatives would bring stability to the markets while fostering growth in the economy. Tomorrow morning we will find out how many jobs were lost in January and unless it is a really ugly number, the markets could ride into the weekend with expectations of some good news next week. This short-term trade could develop legs but in the end, it is still "all about the economy" and earnings announcements continue to be sour and business is retrenching. Expect the stock market to ultimately test new lows and likely break them in the next couple of months. Until then, perhaps we will see a rally.

We May Have Been Too Optimistic

For many months we have been saying the recession will be longer and deeper than most economists and analysts anticipate. How many times have we repeated the term "It's All About The Economy"? We have been right about those predictions. However, we have been talking about a bottoming process for awhile and it looks to us that the bottom may not have come yet and the process of the stock market gaging the extent of the current crisis and discounting such results may take many more months.

We have suggested that the credit markets will lead the way and loans and bonds are the place to benefit from the unfreezing of the credit crisis. In the past month those markets have rallied about 10% and a number of high yield companies have been able to access the new issue market to raise fresh capital. This bodes well for the financial crisis but the economy remains extremely weak and we anticipate the news to continue to be bleak throughout 2009 and possibly into a good part of 2010. Unemployment could reach 11 or 12% as businesses pare their work forces while trimming many expenses. Very few industries have been spared from the impact of the financial crisis. Health care, for-profit education, and some consumer durable (but not all) companies have maintained some growth in this sour economy.

The credit market remains the best opportunity to garner decent returns but excessive profits may not come in these markets until 2010. In December ,we recommended two closed-end bond funds which were trading at a discount to net asset value. They were PTY and PCN both of which are managed by PIMCO. With the recent rally, the prices of these funds have skyrocketed such that they are now trading for around a 30% premium to net asset value. Too many investors are looking to migrate into fixed income securities and they have elevated the prices of these funds to levels that are too high and they should be sold as the downside risk is greater than any upside gains.

We were at the JP Morgan Credit Conference this week and the investors were optimistic about the opportunity in the credit markets over the next few years. However, nobody seemed to be anxious to deploy too much capital too quickly. Most companies expected weak results for this year and into next year. A few lectures by professionals who have contact with numerous corporate clients also indicated the economic picture is clearly in for worse times ahead.

The government is desperately trying to figure out what to do with the toxic assets on the balance sheets of banks on one hand while negotiating with Congress over a comprehensive stimulus plan. We contend that whatever the plans are they won't be enough. In fact, it is likely the government will likely need to deploy trillions more before the financial crisis is over and the economy is lifted out of the doldrums. Many banks are going to fail and others will need additional capital infusions. Investors will sit on the sidelines until the magnitude of the toxic assets is known and it becomes apparent that the mess is close to being cleaned up. This will take a long time and as a result the economy may remain weak for at least another year.

As Republicans, we generally like the concept of cutting taxes to accelerate the economy but it is not the correct medicine for the stimulus plan. This country needs new jobs and an improvement in the housing market. We do not need a plan to appease each Senator and Congressman in office. A new tax cut will give the consumer fresh cash to put under his mattress. We need consumers to spend money to increase the velocity of the money supply. The consumer is in savings mode so a tax rebate will not lead to new jobs nor will it stimulate economic growth. The government would be better off giving consumers gift cards to the local retailer if it wants to help the consumer and stimulate the economy. We believe the stimulus plan needs to focus on jobs and infrastructure projects are definitely the way to go. The spending should be on projects that have been in the planning stage but can be accelerated. Our roads and bridges clearly need improvement and so does the power grid. Let's improve America now and spend the taxpayers dollars wisely as we try to pull our country out of this economic slump.

Unfortunately, for the stock market none of the above is encouraging. The markets expect a resumption of growth in the second half of 2009 and unemployment to peak at 8-9%. It looks like those numbers are optimistic. We haven't even begun to see the effects of the impending commercial real estate crisis nor have we factored in the impending escalating corporate defaults and consumer defaults on credit cards, auto loans, student loans, and home equity loans. Volatility will certainly remain high and some rallies may ensue with hopeful Obama plans but for investors, cash will remain king and we would suggest caution over the next few months as investors start to realize that 2009 will not be the year the economy hits bottom.

The New Wall Street--Part II

It is clear nobody in government understands what drives Wall Street employees. Of course, the common thinking is it is greed and that is true. Sometimes such greed can lead to too much risk and large losses. That is what helped create the financial crisis in which we find our country. However, not everybody employs undue risk to make outsize profits.

Many successful Wall Street pros utilize sophisticated risk management techniques coupled with their intelligence to return high profits. The new administration and its congressional counterparts want to punish Wall Streeters for their previous misdeeds by limiting bonuses to $400,000. This may still seem like a lot of money and the government, who has saved many of the banks from demise with TARP funds, believe they have the right to set these policies.

We disagree as the brain drain from Wall Street will not only occur in droves but it will lead to reduced profitability at the banks and raise the risk of U.S. taxpayers losing TARP money. Here is why. Let's use a simplistic example. Suppose Wall Street Firm "A" has 2 employees. One employee is extremely bright who carefully manages risk while investing firm money. He generates $20 million in profits and deserves a bonus of 10-20% of these gains. The second employee takes excessive risk and loses $10 million. He deserves no bonus. Under this scenario, employee number 1 would get a bonus of $2-4 million whereas employee number 2 gets no bonus. The firm would have earned $10mm less employee 1's bonus resulting in net earnings of $6-8 million.

Now the government steps in and imposes a $400,000 maximum bonus on all employees at this TARP funded bank. Employee number 1 will be extremely upset as he knows his hard work and intelligence generated $20 million in profits for his firm. He also realizes he can either set up his own firm or move to another firm which doesn't have any bonus restrictions. Upon his exit, Wall Street Firm "A" is left with employee 2. The firm now would generate a loss of $10 million. Certainly such an adverse event will not lead to the payback of TARP money. In fact, such a result is likely to occur at all TARP funded banks and once again, the government will have tried to appease the general public but wind up losing taxpayer money as it weakens the banks that are already in financial distress.