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Avalon Asset Management Company The Whirl According to TARP
"It sounded an excellent plan, no doubt, and very neatly and simply arranged; the only difficulty was, that she had not the smallest idea how to set about it." - Lewis Carroll, Alice in Wonderland
One of the more curious spectacles that has accompanied our recent descent into the economic inferno has been the rather frequent sight of reporters, especially the ones from financial news channel CNBC-TV, earnestly asking Treasury Secretary Hank Paulson if he would consider staying on in his post in the next administration.
Now, either said reporters are not getting out of the house enough, or we are missing something here. If one stands back just a little bit from the bar, what it looks like to us is that until this year, the guy we thought was running the Treasury spent most of his time watching the dollar collapse while telling anybody who would listen that we had a strong-dollar policy.
You can argue that that's not an entirely fair charge, as anybody who runs the department is pretty much precluded from saying that they don't care about a strong dollar, regardless of what their boss thinks (or in this particular case, didn't think). Well then, in the interests of fair play and our belief in not shooting the fish in the barrel, we're willing to put that one aside. For now.
But the guy that we thought was running the Treasury this year has also presided over the disappearance of three of the country's oldest and largest investment banks, probably the largest credit freeze since the Great Depression, and what may well turn out to be the most severe recession since that same depression. Did we mention that the two largest investment banks were also forced to abandon their investment bank status, or that our domestic auto industry is hanging on by the thinnest of threads?
But wait, it gets better. You know the Troubled Asset Relief Plan, which goes about town under the name of TARP? What started out as a three-page memo with no details has apparently become a somewhat longer memo with no details. None, at any rate, with a shelf life of more than one week. Some of the TARP's actions may yet stand up to the test of time, but we have to say that in terms of implementation, this is not one to put at the top of the old resume. No B-school case-study team would dare turn in such a lemon.
Paulson made it to the top of the Goldman heap, no mean accomplishment, and we've no doubt that one of his fellow alums will find him a comfortable resting spot. Good thing, too, because if the TARP implementation was on our particular curriculum vitae, we'd probably find it hard to get a job washing dishes in the Congressional cafeteria. But it's still a mystery to us why these reporters seem to so sincerely believe that anybody from the incoming administration is going to give him even a nano-second's consideration for the job. Are we just not in on the joke, or haven't they been outside recently?
We probably wouldn't have even needed a TARP to begin with, had the feds not made such a mess of it with Lehman Brothers (yeah, we know we bring it up every week, and so do Jim Cramer and Ben Stein. And we intend to keep bringing it up, because it was the bonehead play of the century and we're tired of seeing luminary financial executives let off the hook with nothing but a shake of the head and a multimillion-dollar severance plan).
The AIG plan wasn't anything to write home about either. That piece of brilliance nipped a forty-billion dollar check out of the TARP last week when it had to have a do-over less than two months after its inception. I'll give Paulson some credit for ringing the alarm loudly when the ship started sinking, but that was well after it had hit the iceberg and let's not forget who was at the rudder. Somehow, we just don't think that there's going to be a groundswell for making him pilot of Titanic II.
The odds of such a movement coming from Wall Street, at least, grow longer with every pull of the TARP. It seems that now it's not going to be used on buying up troubled assets at all, but to be used on something else, which Treasury will let us know about just as soon as it thinks of it. Lack of direction is something that traders especially dislike (is it true that they're starting to call him Tarpo Marx?).
One can argue that the initial shift in tactics to recapitalize the larger banks made sense. That particular scenario has completely mutated from one in which Tarpo originally made all the banks take the money, so that none would appear weaker for taking it, to one in which practically every bank in America has to either apply for TARP money or risk the wrath of the market for not doing so. The idea is that if you're not TARP-eligible, it must be because the FDIC is on the other line with some rather unpleasant news.
Unfortunately, the banks just want the money as cheap capital, or to make strategic acquisitions (i.e., buy up deposits on the cheap, thereby increasing your capital ratios while becoming less of a target yourself). They don't want to actually do something so crazy as to lend it out, much to the distress of people like Congressman Barney Frank, chairman of the House Finance Committee and House of Representatives co-shepherd of the TARP legislation.
Frank seems to be operating under the quaint old notion that banks are lending institutions. Today's modern bank, though, is about deposit-taking and risk management. The latter, you see, is the risk that management will lose their jobs for all the stupid loans they made a couple of years ago. Therefore, they must preserve as much capital as possible, to be later carefully invested in write-downs against outstanding loans already on the books. Only then can they think about such exotic notions as lending money.
That leaves the other lenders, such as the credit card and finance companies, to take up the slack. For their part, the credit card companies are trying their best to help out by raising rates to spectacularly ruinous levels as much as possible. This is the only prudent action to take against rising default rates, of course. That it will have the effect of dramatically increasing those default rates seems to be one of those inconvenient conversations that nobody wants to have. Leave it for the guys that will be here next quarter. In the meantime, Tarpo says to get our paperwork ready. Free government money!
The Obama administration may want to revisit the usury laws. Most of you may not know or remember that interest rates used to be capped at around twenty-one percent; beyond was considered usurious and illegal. However, the soaring inflation rates of the nineteen-seventies began to make it impossible for the card companies to make any money (short term rates were in the high teens), so the laws were repealed. Short-term rates are now at one percent, but the companies claim they need to charge thirty-four percent to make money. Makes you wonder how smart they are too, doesn't it?
Then there are the auto companies. We can see that the AIG do-over was necessary, because the original was so badly conceived, and an equity investment in AIG isn't unreasonable. But we don't think that Tarpo should have written that check out of the TARP account. That's forty billion less for remedial lending, and Congressman Frank hasn't been showing much of a sense of humor about releasing the other $350 billion with no questions asked.
But the automakers need money, and need it desperately. The TARP whirling has created a kind of notion that any kind of company may be able to collect some of that money, and so why not the autos? Despite the easy-money atmosphere congealing around the program, though, Tarpo doesn't want to use any of the money for Detroit and in this case he's probably right; better to appropriate it separately. We're going to need every drop of what's left in TARP and more for our brilliant financial institutions. They in turn are going to need to pay themselves huge bonuses not to do the things anymore that they just paid themselves huge bonuses for doing. It's kind of complicated.
The General Motors (GM) problem remains, though. This is the last chance for the administration to get something right before it runs out of time. There is danger, because many in the administration yearn for the chance to finally put the United Auto Workers, whom they consider to be the spawn of the devil, out of existence forever.
So there is temptation to blunder once more, and that misstep could be the biggest yet. We were watching Cramer's Friday night show, and found ourselves in agreement on one non-trivial item: if GM is driven to file for bankruptcy, you should short everything. It wouldn't take us back to a Great Depression, but it will get us to a smaller one.
We'll admit that the automakers haven't been the brightest bulbs on the tree, but they didn't invent the record-high oil prices or the credit freeze that followed it. All of the carmakers have suffered. If the economy were riding high and GM were in trouble, we might be on the other side of letting it go, but at least that would be an appropriate time for having such a conversation. If the feds don't get this right, it'll be look out below for a long, long time.
There wasn't much news from the government last week, but it did have a sort of virtue in being unambiguous. It was all bad. Meantime, a steady outpouring of lowered earnings outlooks from the private sector filled in the gaps to the downside.
Friday's retail sales report for the month of October was the main event of the week. Like the previous week's jobs report, it was much worse than the consensus estimate, yet even so, not as bad as the whisper number. Expectations had been for a fall of (-2.2)%, and the actual result was reported as (-2.8)%.
That was a big miss, but a week's worth of sharply lower fourth quarter guidance from retailers had built up fears to a level that anything short of four or five percent was going to have diminished shock value. Even so, the phrase biggest decline ever was difficult for traders to ignore and lingered throughout the day (to be fair, it probably isn't the biggest decline ever, because the data series only goes back to 1992. Feel better?).
Although the market had managed to rally the Friday before on the beat of the jobs whisper number, that move had deeply oversold conditions to work with, coming as it did on the heels of the largest two-day point decline that the Dow had ever seen. The retail number had to contend with opposite conditions, a wild technical melt-up from the day before that included the several-hundred point move of the day's waning moments.
The sales number is bad news for fourth-quarter GDP, although one hardly needs that particular raindrop to know how bad of a storm we're in. November is setting up to be even worse. The weekly chain-store sales reports have been deteriorating steadily and went negative on a year-over-year basis last week.
Given the increasing difficulties in the auto markets, the ongoing ones in the credit markets and the endless reporting of the retrenching consumer, another large drop is shaping up for this month. The big shopping day after Thanksgiving, known as Black Friday to retailers, may not be enough this year to push the month back into the black.
Weekly mortgage-purchase applications did improve somewhat from last week, but the index is still in the very weak zone below the three hundred level. The picture wasn't helped by news of record losses at Fannie Mae (FNM) and Freddie Mac (FRE), or by the media's reporting of those losses. The total numbers were large, but most of them came from write-downs of tax assets and from our friend mark-to-market accounting, which took another whack at the market value of the MBS portfolio.
It's so useful to use values from a market that is almost completely dysfunctional, isn't it? As CFA's, it's more or less expected that we thunder from the pulpit on the virtues of honest reporting and genuine pricing, and by extension mark-to-market accounting. We're all for honest reporting, but the fallacy of mark-to-market is that it presumes the existence of a rational market.
A simple model based upon actual cash flows and payment experience can be an oasis of sanity during times of market dislocations. Such models deserve more of our attention, not less. Black Rock's recent disclosure that the Bear Stearns mortgage security portfolio is behaving much better than observed prices would imply demonstrates the weakness of the one-size-fits-all approach.
The problem goes beyond the headline problems with unnecessary write-downs at financial institutions. In the private equity world, for example, historically valuations were marked at the lower of cost or market, which generally meant cost. In a typical venture capital fund, the returns for the first few years would be flat or negative as the portfolio companies evolved. In time, winners would be cashed out and losers written off against them.
Using mark-to-market accounting, though, can introduce considerable volatility into the fund's returns and make life miserable for the investors, while accomplishing no real useful purpose. The end returns on investment aren't any different, while the portfolio companies might lose the main benefits they're supposed to have from being private. For the economy as a whole, capital formation will suffer as investors are discouraged by the increased (and meaningless) volatility. That's not what we're supposed to gain.
The trade figures were better than expected, except that they weren't. The deficit shrank more than expected, thanks to falling oil prices, but falling exports meant that the deficit widened when oil is excluded. The collapse in energy and other commodity prices led to record declines in monthly import and export prices. That's good for inflation, certainly, but the market wasn't in any mood for celebrating the global plunge in demand. The rapidly falling prices count as a silver lining in a very dark cloud, but only for a short time: deflation isn't on the wish list of any of the financial authorities around the world.
Weekly job claims were dolorous,to say the least. They finally crested the five hundred thousand level, and by a wide margin: 516,000. That's a seven-year high, yet the less volatile four-week moving average hit a seventeen-year high. And just to top them all, continuing claims hit a twenty-five-year high as they continue to creep towards the four million level. November's job report is obviously shaping up to be a real bomb. The real question (for investors, anyway) will be how much the markets have already discounted that bomb by the time it gets here.
Next week will bring more bad news. The New York and Philadelphia Federal Reserve banks will report their regional manufacturing surveys for November on Monday and Thursday, respectively. The market is expecting very weak results from both. The central bank will report industrial production for the month of October on Monday, and while it's expected to fall, special factors could distort the picture.
The price indices are due up, with the PPI coming on Tuesday and the CPI on Wednesday. Both are expected to show monthly declines, which as noted above is good for inflation but won't find anybody cheering. The housing market index from the National Realtor's Association comes out on Tuesday afternoon, and the FOMC minutes are due out on Wednesday afternoon. The minutes were real market-movers last year and part of this one, but few are paying much attention to those tea leaves these days. The economy stinks, and we all know it.
StockWatcher returns again next week.
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© M. Kevin Flynn, 2008.