April 2009 Monthly Market Review

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March has been an extraordinary month from a historic market perspective. The volatility we have become accustomed to over the past 7 months did not disappoint, as the S&P500 lost nearly 5% on the first trading day of March and hit its 13 year low on March 3. After February resulted in more stock market losses, the operative word among government officials was changed to “the economy was fundamentally ok.” The Fed and Treasury then launched a new program to pump $200 billion into the asset backed security (ABS) market to spur lending for non-mortgage consumer loans. Ben Bernanke then made an unprecedented move for a sitting Fed Chairman, granting widely watched 60 Minutes an interview, to stress his belief that America has averted the risk of a depression and a recovery could begin next year if the financial sector stabilizes, which he believes is happening. It is our opinion that among existing government finance officials, Chairman Bernanke has the most credibility with market participants. During the interview, he was calm, knowledgeable, and reassuring. In almost all likelihood, that show earned him a second term as the Fed Chief. He provided the market a balm of reassurance that subsequently led to almost daily gains for the rest of the month. Amid the Bernanke balm, the government went to launch a monetary offensive on market and the economy. In all, $1.45 trillion will be slotted for infusion into the system, along with a new plan to move toxic assets off banks’ balance sheets with all vehicles essentially participating in the plan via a leveraged private/public hedge fund.

It is in every American’s interest to have a bull market and we are glad to see that investors can quickly regain their confidence. However, a long lasting stock market rally can only be built upon healthy and sustainable economic fundamentals and prospects. While we believe the initiatives announced in March will likely have a positive impact on the credit market in the near term future, we are wary of some “unintended” consequences that might occur out in the horizon, such as inflation. Further, the general tone Congress has adopted towards the business class is concerning. One reason for such a concern was evident with the rush to “Tax AIG Bonuses” retroactively. It is almost surreal how House of Representative members have casually discussed such a serious issue, essentially making it a bill of attainder.

Chief Justice Earl Warren wrote in US. v. Brown (1965) that the basic reason for a Bill of Attainder clause was to prevent “trial by legislature.” This is because “the legislative branch is not so well suited as politically independent judges and juries to the task of ruling upon the blameworthiness of, and levying appropriate punishment upon specific persons. (http://volokh.com/posts/1237734930.shtml)

Trial by legislature is exactly what took place during the entire sad spectacle. Such extreme actions on the part of Congress carry serious ramifications as the private sector has developed a very jaundiced eye towards working with the government to end this fiscal mess. Similarly concerning was how the government forced GM CEO Wagoner out for failing to deliver results, but did not attempt a similar move for Auto Workers Union Boss Gettelfinger. Wagoner’s effectiveness as a CEO warrants its own discussion, but clearly he could not reach a workable deal if the union did not feel any pressure as well.

Now, let us review some of the government’s actions in March.

Government’s Grand Plan to Spur Lending: The government, namely the Fed and Treasury will pump $1.45 trillion into the economy to kick start lending, assuming the resultant increase in lending will boost spending, which hopefully in turn will revive the economy.

1. The New $200 billion TALF program (Term Asset –Backed Securities Loan Facility) (3/3/2009): The Fed and Treasury launched a much-awaited new TALF program to provide up to $200 billion in financing for up to 3 years, to investors to buy up outstanding debt for autos, education, credit cards and other consumer loans. Before the financial crisis, banks relied on packaging such loans into securities and selling them to pay for additional lending. This process had financed about 25% of consumer loans in recent years until the credit markets froze in October. In the fourth quarter of 2008, credit card ABS issuances were $0, compared to $23 billion a year earlier, according to Dealogic.

TALF intends to recreate a market that has essentially collapsed. The logic is that providing the leverage previous ABS buyers have relied on to generate attractive returns, will hopefully jump start the moribund market. Based on a leverage ratio of 12 times, although TALF provides leverage up to 20 times, investors can borrow approximately $92 million to buy $100 million of bonds backed with prime auto loans, for example, and achieve annual returns of over 20%, assuming no credit impairments. In addition, the Fed, unlike banks, won't demand the investor post collateral if the ABS market value falls over the three-year life of the loan. In the Fed's defense, the TALF demands that collaterals pass heavy pre-screening, and is only eligible to securities receiving the highest-category credit ratings from at least two nationally recognized credit rating firms. The potentially massive return with limited risk will likely lure private investors back to the ABS market. Clearly, by subsidizing the returns investors obtain by lending to consumers, the government continues its policy of encouraging consumer borrowing through easy money. In regards to the end game for the TALF, the government hopes it will rekindle the broader securitization market, instead of trapping the Fed in the uncomfortable position of being the "prime broker" for years to come, which is a possibility. Currently, the Fed plans to keep the program running through December, but said it could be extended.

2. Fed to Pump $1.25 Trillion to Economy (3/18/2009): Through a number of new programs, the Fed will inject $1.25 trillion into the economy. The programs break down as follows: the Fed will spend up to $300 billion over the next 6 months to buy long-term government bonds and an additional $750 billion in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac, on top of the $500 billion such securities it's already buying. It will also double its purchases of Fannie and Freddie debt to $200 billion. Bernanke fired this monetary missile, as cutting benchmark interest rates close to zero has failed to end the credit crunch. By purchasing long-term treasuries, the Fed hopes to influence long-term interest rates, the first of such actions since the 1960s, which came as a surprise. The Fed made it clear it is going to lower mortgage rates and it will be successful. That was a loud signal to buy financial stocks, and this action marked a clear uptrend in the money center banks’ equity prices, with talks of nationalization shifting towards “how long will it take to earn their way out?”

While both the equity market and government bond prices soared, the dollar, meanwhile, fell against other major currencies, which signaled concerns that the Fed's intervention might spur inflation in the long run. The Fed's series of radical programs to lend or buy debt has swollen its balance sheet to nearly $2 trillion, from just under $900 billion in September. The Fed is now committed to buying or loaning against everything from corporate debt, mortgages, consumer loans, to government debt. Fed officials are confident that consumer prices will remain in check and its major concern is deflation rather than inflation. After all, U.S. employers have eliminated 5 million jobs since the end of 2007. Industrial production fell 1.4% in February, the fourth monthly consecutive decline, and factory capacity in use hit 70.9%, matching the lowest level on record.

While all of those actions are creating a calm in the near term, there are serious threats of inflation in the longer-term horizon. After all, where does the Fed get all the money? It prints it. If the Fed cannot unload its securities or raise interest rates quickly enough when economy recovers, we will be faced with hyperinflation. Whether Bernanke can manage to walk this fine line between avoiding deflation and inflation has yet to be seen. Recently one of our sharpest clients quipped, “I will not really care about the money in the wheelbarrow needed to buy a loaf of bread, just give me the wheelbarrow”.

Geithner’s Toxic Asset Plan

On March 23, 2009, the Treasury announced its highly anticipated plan, which aims to remove toxic assets from banks’ balance sheets. The Treasury labeled its plan as a Public-Private Investment partnership, intending to generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time. This plan calls to use $75 to $100 billion in TARP capital and would address both the legacy loans and legacy securities clogging the balance sheets of financial firms.

Targeting mortgages that banks no longer want to hold, the FDIC will auction off pools of loans that a bank wants to sell and will become a co-owner by forming a partnership with the highest private market bidder. The partnership will then raise FDIC-guaranteed debt to finance 86% of the purchase price (leverage of 6:1), with the Treasury kicking in to provide 50% of the equity (7% of the purchase price) needed to buy the assets. To tackle the problem caused by these risky legacy securities, the Treasury will create several investment funds run by private investors who meet certain criteria, such as experience managing similar assets. The Treasury again will act as a co-investor, in most cases contributing $1 of equity for every $1 of equity contributed by the private sector. Lastly, the government will expand TALF to help absorb risky assets dating back several years. The Treasury claims the benefit of this Public-Private partnership is that if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk, along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets. This is completely disingenuous, as the taxpayers are still taking most of the risk “93% instead of 100%”, but would give away 50% of potential gains. In addition, the program is geared to “over-pay” for these assets. By backing 86% of the purchase price with loans, and allowing private investors to set prices on only 14% of the purchase price, investors are really pricing options rather than the underlying asset. This creates a skewed return distribution, which results in a significant government subsidy to both investors and financial institutions. We prepared a simple example tracking out the cash flows from a hypothetical partnership purchase, and estimate that investors can earn 41%. (Please see the tables below.) Joseph Stiglitz, professor at Columbia University, performed a similar exercise for a NY Times Op Ed, and estimated even higher returns. The bottom line is: Since the government is subsidizing the risk of such partnerships, investors are happy to overpay for the assets, while still earning an acceptable return. Thus while the Treasury claims these partnerships will likely reduce the risk of overpaying, their program virtually guarantees overpayment. In this partnership, leverage for private equity is not 6 times as the Treasury announcement seems to be suggesting, but 13 times as for every $1 of private equity capital to finance these deals, $12 will be supplied by the FDIC and $1 by Treasury. To make the deal even sweeter, the debt being provided by the FDIC is “non-recourse”, meaning the FDIC, the Treasury, and the Fed have no recourse to go after other assets of those making equity investments if the securities default. By the way, we just heard big US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals. Sounds Funny? We thought they have big enough headaches handling their own toxic assets. Let us review this program again: high leverage, low borrowing costs, limited risk, and a lucrative return on equity distribution. Sound familiar? Alas, are they not the same ingredients that have brought our banks to their knees? What is different, is that now Uncle Sam is explicitly cheering private investors to embrace those ideals while guaranteeing them limited downside.

Toxic Asset Plan Equity Return Explained:

The Budget Fight

Since President Obama announced his budget in Feb, the Administration has had a difficult time with some leading Democrats who publicly cringed at its massiveness. Based on the analysis of the non- partisan CBO (Congressional Budget Office), the President’s proposals would add $4.8 trillion to the baseline deficits over the 2010– 2019 period. If his proposals were enacted, the deficit would total $1.8 trillion (13.1% of GDP) in 2009 and $1.4 trillion (9.6% of GDP) in 2010. It would decline to about 4% of GDP by 2012 and remain between 4 – 6% of GDP through 2019. The cumulative deficit from 2010 to 2019 would total $9.3 trillion, compared with a cumulative deficit of $4.4 trillion projected under the current-law assumptions embodied in CBO’s baseline. Debt held by the public would rise, from 41% of GDP in 2008 to 57% 2009 and then to 82% of GDP by 2019 (compared with 56% of GDP in that year under baseline assumptions). CBO’s estimates of deficits under the President’s budget exceed those anticipated by the Administration by $2.3 trillion over the 2010–2019 period, with the differences largely attributable to differing projections of GDP growth and revenue outlays. The CBO’s projection of baseline deficits exceeds the Administration’s estimate by about $1.6 trillion.

Just for fun, we did a quick exercise. We consolidated the current S&P500 companies excluding Financials and Utilities, and calculated their leverage. To be conservative, we included every piece of liability and debt for those firms including operating leases. The S&P500 industrials generated revenues approximating $7.5 trillion in 2008 vs. total debt of $3 trillion, suggesting a debt/revenue ratio of 40%, comparable to our current national debt to GDP ratio. As equity investors we know excessive leverage is a dangerous thing as we will be the first one in line to see our investment wiped out. As a nation, exorbitant leverage will be devastating to the economy as it will devalue our currency, allow foreign debtors to dictate our agenda, and we the tax payers will be the first in line to be hurt, seeing our assets worth less, our income taxes rising, and our future shaky. We do not suspect corporate America will ever consider increasing its leverage to 82%, and we don’t understand why the Federal government thinks it is a great idea.

Yesterday, both the House and Senate passed budgets drafted to President Obama’s specifications, largely along party lines. While yesterday’s media was largely focused on the i-Pod that the UK monarchy received as a gift from President Obama, we are saddended by the gloomy prospects of our nation burdened with such massive debt.

What is Next?

Unfortunately, nowadays it is virtually impossible to speculate about the economy or the markets, without also speculating on the political process. We have clearly entered an era where government subsidies have become the norm to “save the economy”. The result is that weak businesses benefit at the expense of the strong, responsibility is punished in favor of recklessness. Elected officials in Congress, seem to pursue grandstanding to further their private agendas, often to the detriment of the President’s desired policies. For example, as Bloomberg News reported about a potential Toxic Asset Partnership participant:

“ I can do very well for my clients without venturing into federal waters which are inhabited by sharks,” said David Kotok, the chairman of Cumberland Advisors Inc. in Vineland, New Jersey, who manages about $1 billion. “We are leery of doing anything with the federal government”

This article notes this behavior is the result of the attempt to retroactively tax AIG officials. The problem with allowing elected officials to run things, is they attempt to create policy as polls come in to guide them about re-election prospects. While such behavior is understandable, it is not desirable.

As we repeat over and over, approximately $9 trillion is sitting on the sidelines, seeking higher returns. The government should pursue policies to unlock those funds to pursue voluntary risk taking activities, not through massive taxpayer subsidies. It is not obvious to us, that a government ultimately legislated by an over-reacting Congress consisting of members with thin or non-existent business resumes can manage the economy. History has consistently shown that governments are just not up to the task. In the short term, the government can subsidize anything by injecting money into the economy as it can keep printing greenbacks. With the US dollar being the mostly widely held reserve currency of the world, the US enjoys an exorbitant privilege. However, this privilege has been hard earned and shouldn’t be taken for granted. The US economy is larger than the next 3 largest economies of the world combined but contains only 17% of the labor force relative to those 3 nations. Our country is highly productive as it is built on a system that has prided itself on private capital, voluntary risk taking, and freedom. The government is a poor substitute for any of these attributes. Unfortunately and potentially dangerous, politics and the economy have become more linked than any other time in the last 30 years. Much like protest from the political left over the war in Iraq led to a change narrative, today fiscal protests from the right seem to be striking a similar chord in creating a narrative that the current administration is not up to the task. In two months, what started as a spontaneous on air rant by Rick Santelli, and his now famous “Tea Party” monologue, has evolved into a grassroots “TeaParty” movement with over 600 demonstrations scheduled for April 15th.

It is ludicrous for some people to blame capitalism for the current crisis and draw the conclusion free market principles should be abandoned. Lets assume capitalism is the only culprit of the economic challenges we face; and assume our GDP declines 5% in 2009 from its 2008 level. Guess what, we still have an economy greater than the next 3 largest economies combined. Lastly, here are the returns for March 2009 (2/27 –3/27), a good month for the equity market: