Willow Ridge Capital Advisors

We have a new blog - Smart Nest Egg!

2009-05-06T12:42:00.001-07:00

We've recently launched our new blog, Smart Nest Egg! It's filled with articles on how to protect your wealth. We encourage you to visit the site and signup for free updates.

Click here to go there: www.SmartNestEgg.com

A winter of discontent

2009-02-27T12:28:00.001-08:00

Some say the world will end in fire,
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.
- Robert Frost

There was little in this morning's revision to the fourth quarter GDP estimate to warm the soul. Estimates of annualized economic growth were reduced sharply from the previous of -3.8% to the new estimate of -6.2% making it the fourth worst quarter for growth since WWII. To find worse, you would have to go all the way back to the first quarter of 1982 (-6.6%), the second quarter of 1980 (-8.1%) or the first quarter of 1958 (-10.9%).

The decisive factors in the lowered estimate were downward revisions in inventories, gasoline purchases and exports. I could attempt to put a favorable spin on these revisions. After all, the decline in inventories is good for future growth prospects since that means there is less of a potential overhang of last year's goods to work through. Also, the decline in gasoline sales is mainly a reflection of the dramatic drop in gasoline prices. But no matter how you cut it, the contraction was dramatic and ugly.

Enough said...

2009-02-27T09:45:00.000-08:00

A bumper sticker from Tennessee...

The trouble with troubled assets

2009-02-26T09:36:00.000-08:00

There is a great op-ed piece in today's Wall Street Journal that summarizes the problem with banks' troubled assets. Peter Wallison, a senior fellow at the American Enterprise Institute, reviews the rules of mark-to-market accounting for banks with mortgage-backed securities (which includes almost all banks.) The rules require the banks to calculate what is called the "net realizable value" for these assets based on their best estimates of the cash flows generated by the assets. The net realizable value is then discounted to a price that would reflect market values.

What happens during times like these when there is no market? The banks mark the value down even further to make sure they are being conservative. The net effect of this process can lead to erroneous conclusions. This appears to be what is happening today. According to Wallison,

Paradoxically, many of the banks' most troubled assets are flowing cash near their expected rates, and thus their net realizable values are higher than the values to which they have been written down.

To support his point, Wallison points to last weeks' testimony by Vikram Pandit, the CEO of Citigroup, to the House Financial Services Committee. In that testimony, Pandit stated that the mark-to-market values of its assets are reflected in the losses the bank has taken. He further pointed out that management has a duty to shareholders to not sell assets below their economic value. He flatly stated, "And the duty is, if it turns out [the assets] are marked so far below what our lifetime expected credit losses are, I cannot sell [them]."

This is the trouble with the banks' troubled assets. We have allowed accounting doctrine to paint us into a corner. Finding a way out of the corner has been one of the thorniest dilemmas confronting public policy in my lifetime.

Wallison suggests an elegant and effective solution: the government should simply buy the assets at the net realizable value. This will be a win-win solution for taxpayers, banks, and the broader economy. A broadly diversified portfolio of assets purchased at net realizable value will likely perform well for taxpayers. The purchase price banks will receive in excess of the current market-to-market value will infuse capital into the banking system. And the broader economy will benefit from a functional banking sector.

Why banks need to become utility companies

2009-02-23T14:20:00.000-08:00

The local impact from the breakdown of the financial system is painfully obvious. Schools are facing painful budget cuts next year. Local mom and pop establishments are vanishing. Companies large and small are downsizing and big-box stores like Circuit City, Linens & Things, and EXPO Design Center are closing their doors for good. Our neighborhood is bearing the brunt of a failed banking system that needs fixing.

The recent fallout highlights the need for two distinct banking types: I call them Utility Banks and Investment Banks. Utility Banks are a reliable and predictable source of money for consumers and businesses that drive economic growth. These banks provide consumer loans, business loans, construction loans, checking and savings accounts. Investment Banks, on the other hand, are a source of money for complex and higher risk needs such as mergers & acquisitions, hedge funds, and other speculative ventures.

Utility Banks need to be safe and predictable, and we should be able to rely on them as we do our public utilities. Just as electricity and water are essential services for the health and welfare of our community, a reliable source of money is crucial for a stable economy. A stable banking system benefits more than businesses and schools: non-profits that serve the many charitable causes in our neighborhood rely heavily on financial donations from individuals. The reach of these non-profits throughout our community is profound.

By allowing commercial banks to move into investment banking Congressional leaders from both parties failed to protect the underpinnings of our economy. We learned this lesson during the Great Depression, fixed the problem, and then decades later we removed this safeguard. After bank failures helped fuel the depression, the Glass-Steagall Act of 1933 outlawed commercial banks from engaging in investment banking. One benefit was that customer deposits weren't at risk of loss due to bad ventures of the investment banks, thereby increasing consumer confidence. In 1999, Glass-Steagall was repealed by the Gramm-Leach-Bliley Act. Since then we've seen an expansion craze by large banks. To continually boost profits, Citibank expanded into hedge funds, brokerage services, insurance, investment banking, credit cards, and their loan underwriting standards were virtually eliminated.

Had we separated Utility Banks from Investment Banks, and maintained quality banking standards, we wouldn't be facing these problems. It's time to structure commercial banks so they can be as reliable as electricity and water, to help fuel a healthy, growing economy. We also need to regulate investment banks so their risky ventures don't threaten the foundation of the entire global economy, let alone ours.

Taxpayers are in a bind - we understand the need for a strong local economy, job market and housing market. I think most people understand the need for government to help stabilize the utility aspect of banking to protect deposits and to lend money to consumers and businesses. But we resent the fact that Wall Street investment banks were not regulated or managed properly and now we're footing the bill and losing jobs locally because of that.

Everyone benefits from a utility banking system. Stable employment and housing are surely central to that. Just as important, our children who attend public schools and families receiving assistance from non-profits benefit too.

A moment of sanity in California's budget drama

2009-02-18T08:05:00.001-08:00

As anyone who got a passing grade in Economics 101 will tell you, raising taxes in the depths of a major recession is a really bad idea. So I was glad to read in this morning's news that at least some of our leaders in Sacramento get it. In what the media are calling "a late-night coup", Senate Republicans gave the boot to their fearless leader who agreed to $14.3 billion in tax increases. Former minority leader Dave Cogdill of Fresno had apparently allowed the incessant drumbeat of Democratic petulance to mesmerize him into agreeing to such a ridiculous scheme. The budget deal lacked only a single Republican vote for approval. Hopefully, legislators who may have been close to caving in on this issue took notice of Cogdill's fate and will hold firm despite the inevitable increase in political wranglings.

Let's not fool ourselves even if many in Sacramento do. The problem with our state budget is not a problem of too little tax revenue. Our problem is that we spend way too much. According to the non-partisan Tax Foundation in Washington, D.C., California's per capita tax burden is already the 6th highest in the country. At the same time, Governor Schwarzenegger is proposing a 6.3% increase in spending for the 2009/2010 budget. Our leaders in Sacramento need to come back to the reality the rest of us are dealing with. If you don't have it, don't spend it.

For more on this news item, click here.

What's up with Timothy Geithner?

2009-02-17T07:36:00.000-08:00

I have spent the past week trying to make sense out of Timothy Geithner's speech and I admit I have been having trouble. Given the financial talent in the Obama Administration, I know they understand that the key to our current economic woes is the banking sector. This is why Geithner's performance is so puzzling to me. I hope we are not hearing a reprise of the same mournful tune sung by the discredited Bush Administration.

For the past 18 months it has been abundantly clear that the banks need to get rid of the toxic assets poisoning their balance sheets. In October 2007, Citigroup, Bank of America and JP Morgan announced they were going to set up an $80 billion fund to buy troubled asset from entities called Structured Investment Vehicles or SIV's. These SIV's were set up by banks to allow them to buy illiquid but high yielding assets in a way that would keep them from clogging up their balance sheets. Many of these assets turned out to be toxic. It was a financial slight of hand that raised serious corporate governance problems. The October 29, 2007 edition of Businessweek reported that these SIV's had assets of $325 billion.

For a number of reasons, the SIV rescue plan was abandoned, but I think it is interesting to note that if all the SIV assets would have been purchased at that point in time, it would have only cost $325 billion. There would have been other problems for sure, but a large part of the problem would have been cleaned up.

In October of last year, Congress approved $700 billion - more than twice the amount of SIV assets - to fund the Troubled Asset Relief Program with the intent that it would be used to buy troubled assets off the banks' balance sheets. Instead, in an abrupt about-face, it was used to make direct equity investments into the banks. There was little accountability and accusations of political abuse of the fund have continued to undermine its credibility. The worst part is that it did nothing to address the root cause of the problem.

Now, Geithner says we need another $1 trillion to get these troubled assets off the balance sheets of banks. Yet, again, he is balking at taking decisive action to make this happen. Instead, he is proposing an ill-defined "public/private partnership" in which the government would lend up to $1 trillion directly to private entities (aka "hedge funds") to go and buy these assets from the banks. This is a ridiculous notion.

To put it in perspective, at the end of the last reported fiscal quarter, there were about 744 banks operating in the US with total assets of $8.4 trillion. Geithner's $1 trillion therefore represents 12% of the total assets in the banking sector. There is simply no way that 12% of the entire banking system's total assets are bad. $1 trillion is a stupid number. It is a "shock & awe" number. It is an attempt to draw a line in the sand.

Unfortunately, as we all found out last week, the market and economy are beyond rhetoric. It is time to actually do something. Now, that would be shock and awe.

Bailout? What bailout?

2009-02-06T09:49:00.000-08:00

I've been conducting an informal experiment for the past week or so. In the middle of a conversation, I'll casually ask the person what he or she thinks about the banking bailout. In almost every instance, my question elicits a response somewhere between a cynical snort and a vitriolic tirade. Nobody (so far) has been excited about it, but very few people have been ambivalent or agnostic. Almost everybody has an opinion.

Most people reading this blog are probably not surprised by the responses I recieved. But if you and I were sitting together having this conversation, I would now ask a different question and the resulting conversation might surprise you after all. I would ask, "Who was bailed out?" If you are like most of the subject of my surreptitious experiment, you might say "Well, you know...the banks!" I would probe a little deeper. "Do you mean the bank shareholders?" At this point, you might get a little annoyed and want to change the subject, but I would continue to press, because clarifying our understanding on this point gets to the heart of the issue.

Before I go any further, I need to make one point very clear: I loathe the idea that any tax payer money has gone to pay a bonus to anybody involved in causing the current financial crisis. Those bonuses were an abuse of the public trust and I believe that money should be returned to the tax payers with interest. However, excluding those abuses, the fact remains that the bailout did not provide a windfall to shareholders or managers. The truth is, the taxpayers - you and I - are the primary beneficiaries of the bailout. To illustrate my point, let's look at what has happened to the shareholders of some of the firms at the center of this crisis: Countrywide Funding, Citigroup, Washington Mutual, and Lehman Brothers.

Countrywide Funding
Countrywide Funding was one of the major culprits in the mortgage crisis. Partially through its efforts, subprime mortgages became a major proportion of mortgage originations in 2005 and 2006. If you owned shares in Countrywide during those years, you made a tremendous profit. However, what has happened to the value of your investment since? To find out, let's assume that you owned $10,000 worth of Countrywide Funding on December 31, 2006. By the end of 2007, your holdings would have dropped to $2,106 or a decline of 78%. If you continued to hold your same number of shares in hope that the sale to Bank of America would save you, the value of your holdings would have fallen to $980 by the time the merger was consumated. And if you still held your new shares in Bank of America in hope of the government rescuing you, your investment value would have dropped to $208 at the close of business yesterday. In all, owners lost 98% of their investment. It is hard to call that a bailout.

Citigroup
As the largest bank in the United States, and one of the largest in the world, Citigroup can't help but be involved in every financial storm. The current financial hurricane is no exception. Through its mortgage operations, Citigroup is one of the largest originators and services of residential mortgages in the country. Through its investment banking operations, it was one of the major players in creating esoteric mortgage-related securites, some of which turned out to be the toxic waste that precipitated this financial meltdown. If you had invested $10,000 in Citigroup at the end of 2006, it would have been worth only$5,526 by the end of 2007. By the end of 2008 it would fallen to $1,328 and, if you still held on to your position praying for a bailout to save you, your investment would now be worth only $700 for a loss of 93%.

Washington Mutual
WAMU, the largest thrift in the country, was the product of an acquisition binge that started after the S&L crisis in the late 1980's and continued through 2006. It introduced or actively promoted several innovations in the mortgage market that many now recognize were foolishly abused and severely weakened the overall capital markets. These innovations drove tremendous profit growth and allowed WAMU to outpace, and eventually acquire, many of its competitors. Unfortunately, the glory days did little to protect shareholders from the bank's collapse. A $10,000 investment at the end of 2006, shrank to $2,991 by the end of 2007. On September 15, 2008, the firm failed completely and the FDIC shuttered it. Branch offices and deposits were sold to JPMorgan Chase for a nominal amount, but the shareholders received nothing. They were literally wiped out.

Lehman Brothers
Lehman was another firm that had grown rich because of its deep roots in the mortage market. It was the leading underwriter of mortgage-related securities and was responsible for originating many of the toxic assets known as collateralized debt obligations or CDO's. As with the other firms highlighted in this post, the profits from these activities were astounding and the shareholders benefited from rapid earnings growth. In the early stages of the financial crisis, Lehman remained relatively unscathed. A $10,000 investment at the end of 2006 would have only lost 15% by the end of 2007. However, as the extent of Lehman's exposure to toxic assets became clear, the market lost confidence in Lehman's viability. In September of 2008, Lehman was forced to file for protection under Chapter 11 of the bankruptcy code. Shares now trade at around $0.03 for a near total loss to shareholders.

This not an attempt to generate pity for these firms or their owners. Rather, my point is to show that the market has been very effective in punishing the owners of firms that lie at the heart of our financial crisis. The efforts of the Federal Reserve and the U.S. Treasury did little or nothing to "bailout" these owners, but they did prevent a total collapse of our financial system. Given the rapid and huge dislocations in the world economy caused by the crisis as we have experienced it, we can only guess at how bad things might have been had the "bailout" not been pursued.

More on Wall Street bonuses

2009-01-31T10:29:00.000-08:00

After my last post about Wall Street bonuses, I found a copy of the December 8, 2008 letter from New York Attorney General Andrew Cuomo to the Merrill Lynch board of directors. I think it sums of the the feeling of many of us very well. It is indicative of the Board's arrogance that they went ahead and paid the bonuses in spite of the objections raised by the Attorney General. If such bonuses were truly in the best interests of all the stakeholders in Merrill Lynch, including the taxpayers who bailed the firm out through the capital infusion into Bank of America, they should have made their case before the bonuses were paid.

Now, in the spirit of full disclosure, John Thain, then CEO of Merrill Lynch ended up relinquishing his claim on any incentive compensation as did four other senior managers. But it still begs the question about where the remaining $5 billion in bonuses went and whether they were truly in the best interest of all stakeholders.
Cuomo Letter to Merrill Lynch's Board

Publish at Scribd or explore others: john thain andrew cuomo

Let's finally pop the Wall Street bonus bubble

2009-01-29T09:33:00.000-08:00

Wall Street has a tough public relations problem. It is hard for rank and file Americans to feel much sympathy for an elite group tucked away in a remote nook of Manhattan who are mostly young and mostly overpaid. The events of 2008 only magnify the problem demonstrating clearly that Wall Street is a world apart from the place the rest of us inhabit. The bonus debacle is a clear case in point.

With all the carnage in the financial markets and the need for massive government bailouts, how is it that Wall Street can justify paying $32.9 billion in bonuses? The Merrill Lynch/Bank of America case was particularly egregious, paying out $5 billion in bonuses in December and then asking for $20 billion more in government money in January. There is no justification for it - only rationalizations based on self-serving assumptions and a broken compensation scheme that rewards short term thinking and inordinate risk taking.

Among the self-serving assumptions is the notion that these firms have to pay these kinds of bonuses to attract and retain top talent. I simply don't believe it. While there are "Michael Jordans" in every industry--talent so unique and compelling that it commands top-dollar wages--the sorry fact is that most of the really highly paid people on Wall Street are just normal (albeit, ambitious) folks who happen to be in the right place at the right time. They are the winners of the social lottery. They are the lucky few.

I don't begrudge them that fact and I certainly don't subscribe to the notion that we should regulate their wages lower. However, Wall Street would do well to take a closer look at how they structure compensation to drive more of what they really want: solid returns and tightly managed risks. Wall Street has paid lip service to this idea for a long time, but, as we discovered in 2008, this has been more mantra than operating practice.

Wall Street says it pays for performance. The more a trader or broker or M&A specialist performs (i.e., generates profits or revenues), the more she gets paid. Consequently, she spends a lot of energy worrying about the profit side of things and less time thinking about the way those profits are made. This reasoning is faulty. In fact, it matters a lot how the profits are made.

In the book Fooled by Randomness, author Taleb Nassim highlights this point with a hypothetical situation. Suppose an eccentric billionaire proposes to pay you $10 million to play a round of Russian roulette. Chances are, you will walk away with $10 million. Under Wall Street's rules, you would be deemed a hero (and you would earn a big bonus.) However, if you play that game enough times, you will probably die young. (This maybe why the average Wall Street trader is only 32 years old.)

As this situation illustrates, it makes a huge difference if the trader is lucky or smart. Wall Street gets in trouble because it doesn't distinguish between the two and pays the same regardless. As we learned in 2008, this can have devastating consequences. Isn't it time for Wall Street to wake up and realize they need to change the way they view the world? Isn't it time to finally pop the Wall Street bonus bubble and bring these guys back down to earth--where the rest of us live?

An eye on deflation

2009-01-28T12:27:00.001-08:00

When central bankers get together and stay up late telling spooky stories, the one that really gets them is the one about the deflationary spiral. I'm sure there are a lot of those stories being told this week at the gathering of the world's elite in Davos, Switzerland. And with good cause. While central banks have a huge box filled with inflation fighting tools, they really have only one thing to use against deflation: lower interest rates. Unfortunately, that doesn't always work.

Inflation is a monetary phenomenon. As Milton Friedman described it, inflation stems from too much money chasing too few goods. The way to fight inflation, therefore, is to reduce the amount of money floating around. As the money supply is reduced, economic growth slows, demand for goods goes down and market prices adjust to balance supply and demand. (My economist friends would cringe at this simplification, but it captures the main idea.)

A deflationary spiral, on the other hand, is primarily a problem with confidence. Lower demand leads to lower prices, which leads to lower production. Falling production leads to lower employment which, in turn, leads to even lower demand and an accelerating vicious circle is established.If you think back over the implosion in our economy over the past 18 months you can probably identify this type of pattern emerging. There is a systemic slackening of demand that is translating into declining price levels, i.e., deflation. We have yet to see a full blown deflationary spiral, but we are starting to see the outlines of what could become one.

The Fed acknowledged this risk in its press release earlier today:

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. (Federal Reserve Press Release, 28 January 2009)

The risk we face as investors is that equities do not tend to do well in deflationary spirals. Equity prices are driven by profit expectations and profits deflate as prices deflate. A persistent spiral would translate into persistent profit erosion. In fact, the major collapse in equity values last year was probably due, in large measure, to the market discounting the likelihood of future deflation.

The question we now have to ask ourselves is whether the current deflation develops into a full deflationary spiral. For the record, I tend to doubt it. Our current problems are almost completely attributable to a broken financial sector. If we fix that, the other problems will tend to heal themselves.

At the risk of sounding like a broken record, the measures being taken to finally get the toxic assets off bank balance sheets should go a long way to addressing the underlying confidence problem. This doesn't mean we are out of the woods, but it does lay the foundation for economic recovery and an associated improvement in asset values.

A very vigorous Fed

2009-01-28T11:55:00.000-08:00

If anyone doubted the Federal Reserve's resolve to face down the current liquidity crisis, today's statement from the Fed's Federal Open Market Committee (FOMC) should answer their concerns. In language that was refreshing for being direct and unambiguous, the Fed stated the following:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and preserve price stability.
The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities...and stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant.
The [FOMC] also is prepared to purchase longer-term Treasury securities if evolving circumstances [warrant.].
The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.

Though normally conservative by nature, I welcome the Fed's vigorous stand. The global deflation in asset prices, kicked off by the botched private sector response to the banking sector's asset problems in late 2007 and catalyzed by the abysmal political response last fall, has the potential to do a lot more damage.

In contrast with some of the truly wacky ideas being tossed around (like the notion that a massive government spending program is going to solve the problem), the Fed's actions indicate a sound understanding of the deep dislocations currently occurring in the capital markets. Their vigorous response to the credit log jam is the only thing staving off a total collapse.

TARP reform: Obama's first test

2009-01-21T19:16:00.001-08:00

Lest we fall into the trap of believing that political pork and self-dealing went out of favor when the Republicans left Washington, I want to point out a very telling article in tomorrow's Wall Street Journal. As the Journal article makes clear, pork is non-partisan--especially when it comes to the chowing down at the huge trough created by the U.S. Treasury's Trouble Asset Relief Program or TARP.

In the article you will read how several congressmen, including Rep. Barney Frank, chairman of the House Financial Services Committee, used their influence to make sure their pet banks benefited from the government's largess--even banks that didn't qualify under the Treasury's already diluted standards. One such bank, the troubled OneUnited Bank in Boston, had tier 1 capital of only 1.8% (well below 6% desired by regulators) and had been hit with a strong enforcement action from the FDIC and Massachusetts regulators last October for "poor lending practices and executive compensation abuses." OneUnited was clearly outside the Treasury's vaguely stated criteria of investing only in healthy banks. This didn't stop Barney Frank from personally shepherding OneUnited Bank through the approval process, however. In the end, OneUnited received a $12 million injection from TARP.

Some critics complain that the investments are doled out arbitrarily and that you need to have the right Washington connections. According to the article, the Congressional Oversight Panel, the group charged with monitoring the administration of TARP funds, complains that "the process for allocating money lacks transparency and accountability. The Treasury declines to explain why one bank is chosen for a federal investment and not another." Its all in the article and it's worth reading.

I bring it up here because I think TARP reform represents the clearest chance for the new president to show that it will not be "business as usual" in an Obama Washington. The country--even the world--is looking to this Administration to be something different, something special. Cleaning up this mess and making the process more transparent and less political will send a confirming signal to the world that the U.S. really is ready to lead again. This kind of leadership may well be the most effective mechanism for initiating a global financial sector recovery.

"Hope and change" for the financial sector

2009-01-20T11:11:00.000-08:00

Modern communications technology is amazing. Earlier today I sat at my computer with two windows open simultaneously. In one, I watched the inauguration of President Obama on a live video feed from Washington, D.C. while millions of onlookers crammed the National Mall. In the other window, I watched a live feed from New York showing the movement of the stock market as millions of shares traded hands in a series of free exchanges worth billions of dollars. Both events were remarkable by any standard.

The fact that the markets didn't seem to notice the remarkable event happening just a short flight south of Wall Street was indicative of our current problem. The financial world has become so preoccupied with its own internal woes that it can't see anything else. It is frozen, like a deer in the headlights, unable to comprehend that its danger grows every moment, the danger increased by its own lack of action. Every day the financial markets remain frozen sinks us deeper into a recession which, in turn, causes the overall credit worthiness of our economy to drop another notch. With every slip in credit quality, the outlook for banks becomes bleaker and the viscious cycle goes on and on.

The way out of this mess is for banks to accept the fact that they have to make some significant changes. Banks need to act now to move toxic assets off their balance sheets and into a separate entity where those who want to take those risks can do so. This strategy, called "good bank/bad bank" is not new. It was a core element of the process that allowed us to work our way out of the S&L crisis of the late 1980's.

Implementing this strategy will cause existing bank shareholders to take a big hit. After all, banks would need to write down the value of their toxic assets to a level that would attract investment in the "bad banks." Unfortunately, it may be banks no longer have a choice. The market action in bank stocks over the past couple of weeks makes it clear that they are running out of time. The good news is that such a restructuring would relieve the owners of the remaining banks (the so-called "good banks") of an albatross that has been around their necks for a long time and would allow them to concentrate on the future, to raise capital and to begin lending again. The sad reality is that if this course had been followed six months ago, the cost would have been significantly less than is will be now. If we don't do it now, it will cost even more in another six months.

There is now easy way out of this mess. There is no simple, clean, or fair way to set this right. But if the Obama Administration really is going to stand for "hope and change," we need to start right now in the beleagured financial sector.

On the edge of oblivion, Citigroup finally gets serious

2009-01-17T16:38:00.000-08:00

Even the vultures weren't showing too much interest in Citigroup's carcass this past week. In an unsettling resurgence of last fall's run on banks, Citigroup shares have imploded over the last five trading days. On Friday, 1/9 Citigroup closed at $6.75; one week later shares closed at $3.50.

The catalyst for the meltdown was Citigroup's announcement that it was going to split off its Smith Barney brokerage unit into a joint venture with Morgan Stanley. This announcement led to rumors that Citigroup was poised to take further drastic action. On Wednesday the lead story in the Wall Street Journal was that Citigroup would shrink itself by a third. Finally on Friday afternoon Vikram Pandit, Citigroup's CEO, announced the expected restructuring. Under the plan sketched during Citigroup's quarterly earnings call, Citigroup will create a separate unit called Citi Holdings to hold non-core businesses and assets.

In the old days this sort of restructuring was called "good bank/bad bank" and it is something we have been calling for for many months (see our post dated March 22, 2008 "10 Amazing Days"). The only way we are going to get out of this economic tailspin is to get the banks back into the banking business. And the only way that will happen is if we remove the toxic waste from their balance sheets.

It isn't pretty--toxic waste cleanups never are--but it has to be done and it needs to happen now. I, for one, am glad to see Citigroup's management finally waking up to the reality of the situation, even if they had to go to the edge of oblivion to see it clearly.

What Detroit really needs

2008-12-02T15:58:00.000-08:00

The Big 3 automakers are back. You will recall that Congress sent them packing last month telling them to try again in December after they had put together a new business plan. In a press conference this morning, Nancy Pelosi said of the carmakers, "We want to see a commitment to the future. We want to see a restructuring of their approach, that they have a new business model, a new business plan." She continued, "It is my hope that we would pass legislation to help the industry." To hear Pelosi talk, it sounds like Congress has become the "venture capitalist of last resort."

I have a real problem with Congress acting as venture capitalist. Given the economic disaster we are currently working through--much of which can be traced to bad ideas and lousy policy from both parties--why should we have any confidence that Congress knows a decent business plan when they see it? Detroit doesn't need a bailout. Detroit needs bankruptcy.

Chapter 11 of the U.S. bankruptcy code was meant to provide breathing room for companies needing to restructure their businesses. In Chapter 11, a company continues to operate, but debtors are shielded from the demands of creditors while they work through the thorny issues that called the company's viability into question in the first place. This is exactly what the U.S. car companies need. They have too much debt, are captive to too many costly labor contracts, are hamstrung by inefficient work rules, and are stuck in too many poorly designed contracts, including severance agreements with inept senior managers. A Chapter 11 bankruptcy would allow these companies to systematically work through these problems under the auspices of bankruptcy court.

And this is where Congress really is needed. It has an important role to play in facilitating, not preventing, this process. When a company declares Chapter 11 bankruptcy, it continues to operate, making and selling products. Because its operations continue, it needs ongoing access to working capital. However, in Chapter 11, the traditional sources of working capital dry up as investors become concerned about the borrower's credit worthiness. Often companies in Chapter 11 turn to "Debtor in Possession" or DIP financing for their working capital. Unfortunately DIP financing is scarce right now.

Congress can help make DIP financing available to the Big 3. It can facilitate private lenders by providing loan guarantees or it could potentially make DIP funds available directly. Of course, the Big 3 and Big Labor have studiously avoided discussing this path of action. They try to paint the issue as a choice between bailing out and shutting down. In this they are disingenuous. There is a third way. Chapter 11 is what Detroit really needs.

Winning in a recession

2008-12-01T10:04:00.000-08:00

It is official. The folks at the National Bureau of Economic Research (the official arbiter of when recessions begin and end) announced today that the U.S. economy is in a recession. While I don't consider that news (anybody with enough life in them to fog a mirror probably figured that out a long time ago,) I was surprised that the NBER said the recession began in December 2007. With 11 months of recession behind us and no recovery in sight, some investors are bound to feel frustrated. How are we supposed to win in this kind of environment anyway?!

To answer this question, we need a little perspective. Since 1929, there have been 13 recessions which have lasted, on average, about 10 months. A sampling of these-the recessions since 1960-are shown in the following table.

The current recession is likely to last a while meaning it will likely to be on par with the Volcker recession in 1981-1982 or the oil embargo recession in 1973-1975. In both cases, the economy contracted profoundly and the future looked bleak.

For example, from the onset of the 1973-1975 recession to its end, the economy contracted by 2.6% and the S&P 500 lost 20% of its value. However, at the market's worst levels in September 1974, the S&P 500 was down 41% from where it started the recession. In other words, the market actually cut its losses in half while the recession was still in full swing. And from the trough to the top of the ensuing expansion in January 1980, the S&P 500 gained almost 90%.

A similar story unfolded during the Volker recession of 1981-1982. At its nadir in August 1982, the S&P 500 was down 19.8% from where it started the recession in mid-1981. However, by the time the recession ended in November 1982, the S&P was actually 9.9% higher than where it started the recession. But that was just the beginning. By the end of the ensuing expansion, the S&P 500 rocketed over 245% from its August 1982 recession lows.

This experience is typical of other recessions. A study conducted by Ned Davis Research shows that since 1929, the stock market typically bottoms out about 60 percent of the way through a recession. Based on this experience, the way to win during a recession is to make sure your portfolio is structured correctly and then to hold on.

Of course, nobody knows what the future will bring. It may be that this recession and its recovery will bear no similarity to past recessions. But I doubt it. I have found great wisdom in Mark Twain's quip that "history doesn't repeat itself, but it does rhyme." I have rarely been disappointed by taking the opposite side of a trade from someone who claims that "this time it is different." It may take a while to correct, but I am usually not disappointed.

Mercedes-Benz for the price of a Dodge

2008-11-20T14:05:00.000-08:00

Everyone understands that getting a 2009 Mercedes Benz S-class for the price of a 1964 Dodge Dart is a phenomenal value. But how does that translate into stock market investing? As of today, the S&P 500 has fallen to its lowest level since April 1997, so we clearly have Dodge pricing. But what value do we get in return? Are we getting the stock market equivalent of a Mercedes or are we getting a Dodge?

What exactly are we buying when we buy stocks? We are buying the stream of profits that those companies earn, which is measured in earnings per share (EPS). Since earnings per share increase over time, we likewise expect the price per share to rise.

In the table below, I compare the aggregate earnings per share of the S&P 500 today vs April 15, 1997. Benjamin Graham, the father of stock market investing (and Warren Buffett's mentor), taught that when evaluating the earnings of stocks, you must look at several years worth of earnings history to get a more accurate picture of the earning power of that company. For this exercise, I use the average of the previous three years earnings.

So is the stock market today giving us a silky-smooth, German-engineered machine, or a rusty bucket of bolts? Well, for the same price of the stock market in April 1997, we're getting about double the earnings power - $80.15 vs. $40.21 per share. From a value perspective, we're getting twice as much value today for our money.

The P/E ratio is simply the price per share of the stock market (measured by the S&P 500 index) divided by its earnings per share. Usually, this ratio rises when investors are confident and falls when investors are nervous. Currently, we have other factors at work in the financial markets which are driving stock prices down further, regardless of how good a value they are. What's driving this illogical behavior? Today's Wall Street Journal includes an excellent opinion article explaining five forces driving share prices lower. I highly encourage you to read it -- it's quick and easy to understand. Click here to read the article => WALL STREET JOURNAL

The portion of your portfolio that you may need to withdraw within five years should be invested in fixed income. Beyond your needs within five years, selling stock today is like walking away from a Mercedes Benz at a bargain basement pricing.

New depths in equity value

2008-11-19T22:30:00.000-08:00

The market is plumbing new depths in value, at least depths that are new in the 22 years I've been in the markets. I would be interested if any readers can tell me the last time the dividend yield on GE stock exceeded the yield on GE bonds. It does now. After the market's recent pummeling, GE shares carry a dividend yield of 7.70% while GE Capital senior notes due in June, 2014 have a yield to maturity of 6.04%.

I guess that's what happens when you combine the "perfect storm" of

a global credit squeeze,
a firm with a lot of debt maturing in the next five years , and
a global recession likely to pressure the earnings of industrial and financial conglomerates.

Still, we are talking about the stock of triple A-rated General Electric with a dividend yield that rivals the yield to maturity on notes issued by single A-rated financials. Something doesn't add up. This is getting to be scary cheap.

IRA's: Changing the rules?

2008-11-19T08:17:00.000-08:00

The market meltdown has the Feds rethinking the rules on minimum required distributions from IRA's. According to today's Wall Street Journal, several ideas are being considered including allowing taxpayers to delay their distributions altogether. Another idea, endorsed by the Obama team, is to exempt from tax any withdrawals made this year and next up to the minimum required amount.

Although the details of the rules governing these distributions can be somewhat confusing for most people, the issue at stake is pretty straight forward. Once investors turn 70 1/2 years old, the IRS requires them to take a minimum distribution from their IRA, 401k or similar tax-deferred retirement savings programs. The withdrawal is taxed as current income. The amount that must be withdrawn is based on a set percentage of the value of the portfolio as of December 31 of the year preceding the distribution. For example, minimum required distributions for 2008 are based on portfolio values as of December 31, 2007.

The problem right now, of course, is that portfolio values today are well below their December 31, 2007 levels. Therefore, a distribution from an IRA taken today but based on year-end levels, represents a much higher proportion of the portfolio than originally intended. Requiring the higher proportion distributions could have huge ramifications for the ability of retirement accounts to last over the investors' lifetimes.

Given the uncertainty surrounding this issue, investors should probably hold off taking any required distributions for now. We can get the paperwork in place in case no changes are made this year and then submit the distribution requests in time to make the December 31 deadline. For those who have already taken their distributions, I am researching what recourse we might have. Like most everything else economic and political right now, this issue is moving fast, so stay tuned for further updates.

Pushing on a string

2008-11-03T12:39:00.000-08:00

If you recall from one of my posts a few weeks ago, the U.S. is in danger of slipping into what economists call a liquidity trap. A liquidity trap occurs when the Fed tries to pump money (or "liquidity" ) into the financial system, but the banks don't pass it along. The latest indication of this liquidity trap can be found in the results of a Federal Reserve survey of bank executives.

According to the survey, a large proportion of domestic banks reported having "tightened their lending standards and terms on all major loan categories over the past three months." These banks also reduced credit limits on credit card accounts for both prime and nonprime borrowers. About 80% of the tightening came from large banks; only 55% of smaller banks reported tighter standards. About 85% of large banks reported tighter standards for commerial and indutrial loans made to large and mid-sized companies, while 75% reported tighter standards for small companies.

The reason for the tighter standards, of course, is the uncertain economic outlook and the banks' reduced tolerance for risk. But these are exactly the trends the U.S. Treasury and the Federal Reserve are trying to stave off with their massive interventions.

What the survey doesn't mention is that much of the reticence for lending stems from the hyperactive efforts of bank regulators as they audit bank operations. The hypocrisy of the situation is almost unbearable. These are the same regulators who turned a blind eye as the banks gorged themselves on subprime assets during the recent credit bubble. Where were they then?

The point of this post is not to suggest banks should go back to making stupid loans. My point is that we face a fundamental disconnect between monetary policy and regulatory policy--a disconnect that exacerbates the economy's skid toward a liquidity trap. Until this conflict softens, the Fed and the U.S. Treasury are going to be frustrated in their attempts to reignite this economy.

Get out and VOTE

2008-11-01T23:03:00.000-07:00

I had a great experience today. My family and I have become very involved in a particular political issue and I spent the day campaigning for it. For most of the afternoon, I stood shoulder-to-shoulder with people who oppose my point of view, both sides campaigning vigorously, yet both sides remaining respectful of the other. When the day was over, we still didn't agree with each other, but we did agree on one thing: we were thankful to live in a country where we could freely express our views without threat or fear.

On Tuesday we will have the opportunity to participate in one of the most momentous elections in a generation. Much is at stake in many different areas. We at Willow Ridge Capital Advisors urge all who are eligible to exercise your franchise responsibly. Please take time to study the issues and vote according to your conscience.

May God bless you in your decisions; may God bless America.

OPEC: The Writing on the Wall

2008-10-24T16:09:00.000-07:00

The thirteen nations that form OPEC are in for some very hard times and they know it. In an attempt to keep a floor on oil prices, OPEC announced they would slash output by 1.5 million barrels per day - the largest production cut in nearly 8 years. Unfortunately for OPEC (but not for us) they have little chance of success. Unless things change dramatically, they are about to fall victim to the inherent weakness of all cartels: the near irresistible urge to cheat. Here's how likely plays out.

In normal economic times, the purpose of OPEC is to artificially restrict the supply of oil from the market. Because demand outstrips supply, the price oil rises. As long as supply is restricted, the price will stay higher than it otherwise would be. In bad economic times (like now), OPEC tries to restrict supply in order to keep members from oversupplying the market and driving prices dramatically lower.

However, the nations of OPEC are hugely dependent on oil revenue. According to calculations I made based on information i gleaned from the CIA Factbook website, oil accounts for more than 70 percent of the government revenues in OPEC countries, more than 80 percent of their foreign exchange earnings and more than 40 percent of their GDP. Furthermore, these countries engage in huge social spending to head off latent civil unrest stemming from the relatively poor living conditions of their rank and file citizens.

As demand falls, cartel members race to outproduce each other. They have no choice. They need the foreign exchange to pay for imported consumer goods and they need budget revenues to pay for social programs and all this while their GDP is collapsing. It takes a very strong regime to tell its complaining citizenry to take a hike while they have plenty of oil to exchange for the things they desperately need.

The bottom line for the oil consuming world is that oil and oil-products are likely to get a lot cheaper in coming months. This is a silver lining to the otherwise difficult economic environment we face and it provides us with a unique opportunity to move the economy to greater energy independence before the inevitable resurgence in oil takes place.

Buffett buys American

2008-10-17T11:13:00.001-07:00

Warren Buffett wrote an outstanding op-ed piece in this morning's New York Times titled "Buy American. I am." (Click here to read it.) He did a great job laying out his own reasons for buying U.S. stocks at this point in time, but the following paragraph pretty much sums it up:

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Buffet continues:

Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month - or a year - from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Good advice, Mr. Buffett. Buy American.

Of bulls & bears

2008-10-10T15:08:00.000-07:00

Recent market turmoil has prompted several questions about the relative longevity of bull and bear markets. The above graph (produced by our friends at Dimensional) helps answer the question by plotting bull and bear market periods in the S&P 500 Index from January, 1926 to July, 2008. (Click the on chart for a larger version.)

The rising trend lines in blue designate the bull markets occurring since 1965, and the falling trend lines in red document the bear markets. The bars that frame the trend lines help to describe the length and intensity of the gains and losses. The numbers above or below the bars indicate the duration (in calendar days) and cumulative return percentage of the bull or bear market.

Investors may draw a number of lessons from this graph.

Since 1965, bull markets in the S&P 500 Index have lasted longer than bear markets and delivered price gains that are disproportionately greater than the bear market losses.
Fluctuating performance within each trend illustrates that volatility and uncertainty occur even within established market cycles: bull markets may have short-term dips, and bear markets may have short-term advances. The immediate trend is not readily apparent to market observers, and in fact, may become clear only in hindsight. This illustrates the difficulty of accurately predicting and timing market cycles.
The graph suggests the importance of maintaining a disciplined investment approach that views market events and trends from a long-term perspective. Investors who react emotionally to short-term movements are at risk of making ill-timed decisions that compromise long-term performance.

On the methodology
Market cycles are identified in hindsight using historical cumulative returns including dividend reinvestment. All observations are performed after the fact. A bear market is identified when the market experiences a cumulative loss of at least 15%. The bear market ends at its low point, which is defined as the day of the greatest negative cumulative return before the reversal. A bull market is defined by data points not considered part of a bear market.

Keep in mind that this graph does not show total compounded returns or growth of wealth since 1965. Once the cycle is established in retrospect, the first day of that cycle resets the performance baseline to zero.