investing

Banking / Financial / investing — 0 Comments
26
Aug 11

Bank of America – A Cautionary Tale

Many of my friends follow the advice of Bruce Berkowitz, founder of the Fairholme Fund.  They occasionally ask for mine as well.  Mr. Berkowitz has been one of the most successful mutual fund managers over the past several market cycles.  After the 2008 financial crisis, Mr. Berkowitz invested heavily in financial stocks such as Bank of America, Citicorp, AIG and others.  I did not want to disagree with a guru such as Mr. Berkowitz, but I expressed doubt about investing in financial stocks, especially the trio he selected.  Why? Even for an expert it is difficult to get an accurate financial picture of large financial companies.   Problems are often held off the balance sheet in structured investment vehicles that are discreet and hidden.   It is impossible to examine the net exposure and counter party risks associated with their burgeoning credit derivative businesses.  In fact, the financial crisis and testimony before the Financial Crisis Inquiry Commission revealed that even executives inside these institutions did not fully appreciate the risks their companies were undertaking.  Suspension of “mark to market” accounting further clouded the true financial picture of securities and mortgages the banks held.

In March 2010, Mr. Berkowitz gave an interview to Barron’s.  He described his rationale for investing in the big three mentioned above:

The financial system in the United States doesn’t work without Citigroup and Bank of America and, hence, the government’s involvement. But what’s nice about the government is that at the end of the day, it will make a profit on all of its investments in these companies.

There are just certain institutions that are interwoven into the fabric of the United States. That’s the case with Citigroup and Bank of America, which make up a key part of our banking system. The same is true for AIG in the insurance area.  See After the Apocalypse

Mr. Berkowitz believes that these “too big to fail” financial institutions are essentially in partnership with the government and will be assured profitability and ever rising stock prices.  When I realized this, I firmly decided that he was wrong and that his strategy would ultimately fail.

On Tuesday, Bank of America closed at $6.30 down almost 2% on the day and nearly 48% for the year.  (After Thursday’s announcement of Warren Buffet taking a stake in the preferred stock of the company the price has recovered to the mid $7 range.)  Fairholme Fund is down nearly 13% this year.  While of course I am skeptical of Mr. Berkowitz’s strategy, I urge the more important point about the havoc the government has fostered, the risks of investing in any financial firm, and the folly of blind faith in guru investors.

What is Wrong with Bank of America?

The short answer is that no one knows for sure.  But there are two ominous signs: the drop by nearly half of the yearly stock price, and the soaring cost of insuring Bank of America debt in the credit derivative market (385 basis points –August 23).  Yves Smith of Naked Capitalism summarizes the distress in the stock:

  • An analyst believes that the company will need to raise $40-50b in additional equity diluting current shareholders
  • The company is having difficulty in selling assets which would improve their financial position (China Construction Bank, Merrill Lynch)
  • The company is unable to complete a broad settlement of mortgage litigation
  • The stock is susceptible to manipulation by high frequency traders
  • The company’s second liens are overvalued
  • Commercial loans are impaired, and have not been recognized as such.
  • Management has overstated good will from the Countrywide and Merrill Lynch transactions
  • There are undetermined European exposures, especially to the debt of foreign banks.  See Why is Bank America’s Stock Cratering Yet Again? It’s the Extend and Pretend Endgame

Extend and Pretend

It was governmental policy to suspend mark to market accounting policy.  Basically this permitted the banks to make their own value determinations for mortgages and other potentially impaired assets.  Ms. Smith points out how pernicious this policy is:

We are now seeing the downside to extend and pretend. Years of regulatory forbearance mean that investors know the marks on the balance sheet of a beast like Bank of America (and frankly all the other big banks) have a ton of air in them. And now that the economy is looking seriously wobbly and the odds of son of Credit Anstalt are well above zero, it means big banks are at real risk of getting seriously whacked in a major stress event. Worse, with Dodd Frank (supposedly) barring bailouts and Tea Partiers on an anti-bank, anti-Fed, anti-spending warpath, it might not be so easy for the authorities to rescue a big bank if a run started…. See Why is Bank America’s Stock Cratering Yet Again? It’s the Extend and Pretend Endgame

Credit Anstalt refers to the 1931 failure of an Austrian bank which set off a chain of European bank failures, deepening the Great Depression of the 1930’s.

Investors are wary that Bank of America could collapse just as Lehman and AIG did in 2008.

Understanding Banks

This brings us to gurus and financial analysis.   Mr. Berkowitz is not the only guru piling into Bank of America stock.  John Paulson (who worked with Goldman Sachs to short the mortgage market during the 2008 financial crisis) and David Tepper, both considered two of the best hedge fund managers, also bet heavily on Bank of America, Citicorp , AIG and other financial stocks.   But in a brilliant analysis, Steve Waldman, author of Interfluidity, points out that it is near impossible to evaluate large, complex, financial institutions:

Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.  See Capital Can’t Be Measured

Thus, it is hubris to posture on the investment potential of Bank of America or other financial institutions.   Thinking about Mr. Berkowitz’s comments in Barron’s, it appears that his investment was faith-based, meaning that he relied on the government bailing out Bank of America, again and again ensuring stock market profits.  Government is often an unreliable business partner.

Some Lessons

Extend and pretend accounting games are catching up with the “too big to fail” banks.   European banks are already in shambles. Distrust between and among banks is high and growing.  This can lead to a dramatic loss of liquidity when least expected. And thus could begin the next wave of financial crisis.

Investment gurus usually have one or two good ideas during their investment lives.  Investors who follow the recommendations of these gurus once the financial environment is radically different do so at their peril.   It pays to be skeptical.

Finally, reliance on government to protect investors is folly.  Remember it is the government that coaxed Bank of America into purchasing the troubled Countrywide and Merrill Lynch companies.   In the current Tea Party-dominated congressional environment will another TARP be enacted to save the banks?  With Rick Perry calling money printing by Ben Bernanke treasonous, will the Federal Reserve be able to step in and save the banks?

At the moment the market is putting much weight on the Buffet purchase of Bank of America preferred stock. Investors should think critically about this purchase.  First, it gives lie to the claim of Bank of America management that it did not need to raise additional capital.  Second, the Buffet deal came at a high price to current shareholders. It was a costly financing.  Third, it is merely a small down payment on the much larger sums of money that the company must raise to maintain appropriate capital ratios.  I wish Mr. Berkowitz and other investors much luck, but I think we have not heard the end of Bank of America’s troubles.

 

 

 

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15
Dec 10

Market Discipline and Sustainable Growth

Many of the Federal Reserve maneuverings are well documented and analyzed: asset purchases of junk value mortgage backed securities, QE1 and QE2. Many of these strategies exceed the Fed statutory mandate of ensuring stable prices and full employment raising  political and even constitutional problems.

Less discussed are two economic consequences:  destruction of market discipline and weakening sustainable growth.  Administration economic policies have prompted unlimited and bogus guarantees to various enterprises.  Moreover, these policies have intruded in the marketplace, backstopping and buttressing private companies that ought not to be supported.

Destruction of Real Risk Taking

In A Desperate Fed – QE2.0 is a Hail Mary Toward the Wrong End Zone, Atlantic Capital Management (ACM) brilliantly dissects QE2. (Note-the report should be read in its entirety at Zero Hedge).  ACM posits that the Fed’s objective is to create negative real interest rates, thus making safe investments expensive.  Worse, the Fed hopes to promote spending over saving, and risk taking over liquidity in order to “stimulate” the real economy.  ACM characterizes this policy as “forced distortions of normal economic functioning.”

The ACM report breaks down and details the harm:

  • Growth in household spending will be more difficult through increases in energy and food prices more than offsetting the effect of lower mortgage payments through lowered interest rates.
  • QE2 may aid US exports, but at the same time will lower the value of the US dollar.  But who will buy our goods?  Imported Chinese goods will be more expensive, without American goods or services being sold to the Chinese middle class.  Moreover, our largest import, energy, will become more expensive.    Exporting to Europe seems a long shot with the EU’s current budgetary problems.  And the threat of a currency war remains, as all nations simultaneously seek to devalue their currencies.
  • Without much final demand, most of our “recovery” has focused on inventory building, with little corresponding pull from consumers purchasing goods.
  • The government controlled auto industry and financial arm, Ally Bank, has again fostered auto industry inventory buildup with lack of the “pull” of final sales.  The suspicion is that building inventory is related to the highly publicized and promoted GM IPO to justify government intervention.
  • Zero interest rate policies have discouraged new bank loans.  Instead, banks make profits from borrowing short term at a virtual zero cost and purchasing longer dated Treasury securities.  Similarly, smaller banks are reducing their loan portfolios and not making perceived risky loans to businesses and consumers.

In sum, the economy is devoid of the real risk taking that produces a sustainable recovery and a thriving business environment.

Destruction of Market Discipline

ACM’s prescription for the ailing economy: market discipline.  What is needed to dispel the economic uncertainty which discourages productive investment and real risk taking:

…is for businesses and investors alike to know without any sliver of a doubt that government and businesses and consumers are being forced to regulate themselves.   With the threat of illiquidity and bankruptcy never far away, economic actors will behave as if their survival depends on maintaining sound and sustainable habits. And that brutal market discipline is what makes investors less uncertain about investing, makes banks less uncertain about lending to households, makes businesses less uncertain about future growth.  Discipline leads directly to long-term sustainability and high quality wealth. See A Desperate Fed – QE 2.0 is a Hail Mary Toward the Wrong End Zone

The Fed and the government have opted for QE2, government guarantees, zero interest rate lending to favored banks, and nationalization of businesses over market discipline.  They have removed market enforcement “in favor of political hocus pocus, ‘nobody loses’ nonsense.”  Market discipline would be even a greater economic tonic than increased government regulation.

Sustainability

Separately, economist John Hussman attacks the Fed also on the grounds of undermining a sustainable recovery:

From my perspective, an “economic recovery” that requires a tripling in the Fed’s balance sheet, continues to average 450,000 new unemployment claims weekly, and relies on fiscal stimulus to counter utterly stagnant personal income, is ipso facto (by the fact itself) not a “standard” economic recovery. We have swept an enormous volume of bad debt under rugs, behind dams, and in back of curtains (not to mention in off-balance sheet vehicles such as Maiden Lane that were created by the Federal Reserve). But it is all effectively still there, festering. Meanwhile, our policy makers are trying to reignite financial bubbles in order to create an illusory “wealth effect” to propagate spending patterns that were inappropriate in the first place.  See The Cliff

Hussman believes that the stock market is richly valued with possible peak earnings.  Against a backdrop of higher inflation and diminishing ability of the government to intervene in markets, current corporate earnings are not sustainable.

A Seriously Unbalanced Economy

ACM and Hussman paint a portrait of a seriously unbalanced economy.  Government interventions and policy gimmickry only worsen our economic problems.  This could end one of two ways: our policy makers like Dr. Bernanke come to their senses, or external forces impose market discipline.

Perhaps the recent dramatic decline in the 10-year Treasury note is just such a market warning sign.  Until then smart investors should be very cautious when investing in the financial markets.

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American Society / deflation / Economics / Financial / investing / Political / The Federal Reserve — 0 Comments
18
Oct 10

Ben Bernanke is a Dinosaur

Ben Bernanke and I are almost the same age.  In this age of public confessions, I have one.  Ben Bernanke and I are dinosaurs.  Ben and I went to school during the 60s and 70s.  During that period inflation was the major economic problem.   In 1973, the Arab oil embargo kicked inflation into high gear, and wages soared.  It was not until Paul Volcker pushed interest rates to nose bleed levels did the Great Inflation subside.  Mr. Bernanke seeks to solve 2010 problems with remedies that may have worked in 1973.  Since he is fighting the last war, I do not think he will be successful.

The New Reality

That was then.  We need to look at now:

  • Consumers are Deleveraging -  That means people are paying their debts, leaving less for discretionary purchases. Deleveraging is emblematic of a solvency problem, not liquidity.  Adding liquidity through QE2 (quantitative easing) does not remedy the solvency issue.
  • Demographic Trends – As the large number of Baby Boomers near retirement the trend shifts from spending to savings.  In a zero interest rate environment savings become vital.
  • Global Overcapacity – Overcapacity exists in key industries such as electronics, autos and steel.
  • Depressed Housing Prices – Housing prices remain depressed, removing a major asset which consumers borrowed against to enable personal spending.
  • High Unemployment – With so many people looking for work, employers feel little wage pressure (except for awarding large Wall Street bonuses).
  • Price Deflation – We see free or cheaper goods and services.  Can’t afford a movie ticket?  Choose from free movies on broadcast television or the internet.  Don’t want to spend money on a personal seat license, tickets and parking for an NFL football game? Stay home and watch it on television.  Want to see your favorite Broadway show? Wait for the tickets to be half price at TKTS.
  • The Internet as a Deflationary Force – From the time I began blogging and said the internet was a deflationary force,  its impact has only intensified.   Amazon and other online sellers are only exacerbating the decline in commercial real estate values.
  • Endless Amounts of Commercial and Industrial Space – The confluence of the depression in the FIRE (finance, insurance, real estate) economy; manufacturing and service jobs being moved offshore and the rise of online retailing has depressed the commercial and industrial real estate market.  A short trip around my relatively prosperous hometown reveals vacancies in everything from retail, apartment, warehousing, office, medical and manufacturing space.  New for sale and for lease signs seem to sprout up each week.

Rosenberg and Deflation

One thesis espoused in this blog is that we have inflation in everything we need (gasoline, basic foodstuffs) and deflation in everything we do not need (plasma televisions, vacation homes).  David Rosenberg debunks the fear mongering of inflationists.  See Rosenberg Still Sees Deflation Despite Consistent Speculative “Limit Up” Opens in Pretty Much Everything

Despite a speculative equity market binge, a weakening U.S. dollar, an economy that seemingly avoided a double-dip recession last quarter, and a renewed boom in commodity prices, what continues to prove elusive in this questionable recovery is pricing power in the broad retail sector.

How apropos it was for Ben Bernanke to utter the word “deflation”, not once, but twice, in his Boston speech this morning. Because fifteen minutes later, the September consumer price index data were released and showed a goose-egg — that is 0% — on the key core CPI measure (which excludes food & energy), for the second month in a row. In the past, this has happened but 7% of the time, so it is a rare enough…event to at least mention.

The headline rate of inflation, despite everything that has been thrown at it in terms of unprecedented monetary, fiscal and bailout stimulus, sits at 1.1% today. The core rate, proven to be the key driver for bond yields, which is why it is a focal point, is now running at a mere 0.8% year-over-year rate, the lowest since March 1961 when Ben Bernanke was in grade school.

While QE1 may have worked in terms of bringing mortgage and corporate spreads out of orbit and preventing an all-out contraction in the money supply, it has not managed to stop the economy from sputtering, the unemployment rate from remaining near 10%, and underlying inflation from grinding lower. Consider for a moment that when the Fed first hinted at QE1 in December 2008, the jobless rate was 7.4% and the core inflation rate was 1.8%. See Rosenberg Still Sees Deflation Despite Consistent Speculative “Limit Up” Opens in Pretty Much Everything

Rosenberg supports the thesis that inflation in discretionary purchases has declined or remain unchanged.

While commodity prices have been firming of late with the downdraft in the dollar, what is key is that we are seeing discernible deflationary trends evolve in many segments of the service sector. Movies, personal care services, hotels, delivery services, and education all deflated last month — education deflated at its fastest pace ever…

Moreover, despite what the price of cotton is doing, clothing prices are still in decline, and other “goods” such as furniture, appliances, audio-video equipment, motor vehicles and home improvement all posted price declines last month as well.  See Rosenberg Still Sees Deflation Despite Consistent Speculative “Limit Up” Opens in Pretty Much Everything

The Last Voyage of QE2

Ben Bernanke is determined to institute a second round of quantitative easing (QE2) through direct purchases of Treasury securities.  The goal is to induce inflation, but the evidence clearly does not support that outcome.   Good luck, Dr. Bernanke.

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13
Sep 10

One Year of Blogging

After one year of blogging on economic, corporate, social and political issues, I thought I would try to make sense out of trends:

  • The rule of law has taken a major hit in the United States.  Some examples of this phenomenon are the unlimited guarantees to Fannie Mae and Freddie Mac, guarantees to banks and favored companies, and Federal Reserve purchases of mortgage backed securities. See Shredding the Social Fabric
  • We have exposed monetarist and Keynesian economic solutions as intellectually bankrupt.   Amazingly, the decision makers who believe in these theories have not been fired.   More amazingly, with all the evidence that we are still mired in a deep recession, we keep trying the same tired strategies.
  • Obama’s economic acumen and performance has been disappointing.  His monomaniacal focus on a health care bill that the country cannot afford hampers new hiring.  Worse, it enriches the insurers and big pharmaceutical companies.  And worst, he has wasted important political capital.   Further, with his tepid financial reform bill he missed a real opportunity to address citizens’ concerns about the excessive power of Wall Street.
  • Congress should be tried for malpractice.   Members of Congress did not read the financial reform or the health care bill.  Nancy Pelosi had the temerity to implore Congress to pass these bills so she and the public could find out what is inside.
  • The Executive Branch and Congress appear to be for sale to the highest corporate bidder.  Industry lobbyists essentially control Congress and the executive branch.
  • Where has leadership gone?  Congress used to produce real leaders: Everett Dirksen, Hubert Humphrey, Robert Taft, William Fulbright, Sam Nunn, Henry Jackson and others.  We may not have agreed with their views, but they were serious, well-respected, independent minded individuals.   We never doubted that these leaders put the country’s interests first.  The Executive Branch also produced great leaders.  Compare past Secretaries of the Treasury– Andrew Mellon, Douglas Dillon and Lloyd Bentsen– to the flawed and unworthy Timothy Geithner.
  • Political clout, not reason and merit, determine current policy.   GM, GE, the banks, municipalities and others were saved from extinction because of campaign contributions and union ties.  Picking winners and losers based on political considerations generates cynicism and undermines the guarantee of equal protection under our laws.
  • Zero interest rate policies encapsulate everything that is wrong with our current system.  We have impoverished the thrifty and the prudent and rewarded the profligate and the incompetent.   On the backs of savers, we have bailed out the banks.  This is particularly heinous because the victims of this policy are the retired and elderly who have watched their savings dwindle and their retirement lifestyles vanish.  An economic policy which encourages savers to speculate in the stock market or buy junk bonds is unconscionable.
  • Promises of better corporate behavior after passage of Sarbanes-Oxley have been false.  Congressional pressure on the Financial Accounting Standards Board to suspend mark to market accounting has created the “extend and pretend” economy.  We no longer properly recognize losses; banks know this and refuse to lend knowing they can obfuscate the true state of their balance sheets.  More damaging, the true financial condition of the banks leads investors to purchase equities essentially under false pretenses.  Many of the bank stocks have declined significantly from their peaks.
  • Culturally, extend and pretend has permeated beyond our financial culture.  BP and the government hid many facts about the Gulf oil spill.     Even now we probably do not know the full extent of the damage and independent researchers have been denied access to information.
  • Corporate Boards of Directors are still not paying attention. In the case of Mark Hurd the violation of corporate financial policies was rewarded with a generous severance package.  (Trust in a corporation is predicated on the integrity of their financial policies.)   His unemployment did not last very long, as Oracle recently named him co-president.  Did character matter to Oracle or its Board?  Does anyone have any shame anymore? Was the HP Board afraid to fire Hurd for cause?
  • We are becoming a divided country.  The government protects the rich and the poor.  The middle class is being economically squeezed by inflation in basic goods, unemployment or the threat of it, rising health care and education costs and diminished retirement savings.   All these things plant the seeds of political upheaval.
  • Finally, blogging serves an important purpose in presenting an alternative viewpoint to mainstream media.  Blogging is the antidote to endless economic cheerleading by paid media and government officials. Blogging has become the new millennium’s populist forum. For example, bloggers steadfastly maintained that we have not emerged from the recession/depression and there were never any “green shoots” of recovery.  The mainstream media now feigns surprise at reports of economic weakness and prognostications of a double dip recession.

Watching the passing parade of economic and political folly is both depressing and exhilarating.  Depressing because we believed there would be a change in business-as-usual Washington.  Exhilarating because the public is awakening to the fact that they have been misled.  And that augers a change in the status quo and perhaps a better tomorrow.

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19
Aug 10

Artificial Sweeteners

Artificial sweeteners have been the subject of health concerns.  Aspartame, for example, has been found to be a migraine headache trigger.  Products containing it carry a health warning for PKU, a rare hereditary disease.  Today we learn that diet sodas markedly increase the risk of pre-term deliveries.  See Add Diet Soda to the List of Things to Avoid While Pregnant.

Similarly, the Federal Reserve and the Administration have not trusted that the economy can heal through natural market forces.  Instead we have been served up the economic equivalent of artificial sweeteners.  Concerned by slow growth, not even negative growth, the government again is firing up the machinery for money printing and stimulus.

In each instance, the government is intervening, distorting, and artificially “sweetening”  the bond market, the housing market and, indirectly, the stock market.  What are the consequences?

There is No Free Lunch

Martin Hutchinson in The Peril of False Bottoms targets faulty government policy as the reason for our anemic economic recovery.  Excessive economic stimulus and a misguided zero interest rate policy has created false bottoms in the housing and stock markets.    A false bottom is defined as a stabilized “price far above the likely long-run price equilibrium of the assets concerned.”

Bernanke has precedent for providing excessive liquidity and holding interest rates too low for too long.  Greenspan reacted to the internet stock market crash by flooding the market with liquidity.  Doing this drove the market to over 14,000 on the Dow Jones Index and created a housing boom.   In the 2008-2009 real estate and stock market crash we learned  how flawed this policy was.

More on False Bottoms

Hutchinson points out federally inspired housing market distortions:

House prices are currently 47% above their level in January 2000, according to the S&P Case-Shiller 20-city index, compared to a 49% rise in prices since that time – in other words, they are in real terms at the same level as at the top of an immense speculative boom.During the recent contortions, the U.S. monetary and fiscal authorities have established false bottoms in two markets. The first is housing, where subsidies to first-time buyers, ultra-low mortgage rates, government guarantees on $700,000 home mortgages and foreclosure-avoidance schemes have prevented the housing market from falling even to its average level where the average house price is about 3.4 times average earnings. The Peril of False Bottoms

These misguided policies have consequences:

…with additional buyers having been sucked into the market, it is now likely that house prices will fall further than this. Indeed, if the appalling suggestion put forward last week that the government through Fannie Mae and Freddie Mac forgive $1 trillion of defaulted home mortgages is put into effect, they will undoubtedly do so. Nothing could be more designed to destroy confidence in the housing market than a massive subsidy to the most foolish and improvident home buyers, at the expense of the thrifty and careful renters who are the major source of potential new demand for housing.

If the buyer pool is attacked in this way, or forced into unnecessary losses by being made to buy too soon, house prices may not bottom out at the market-clearing level … but may continue falling.  The Peril of False Bottoms

Wither the Stock Market?

The stock market is the second false bottom:

Currently at 10,650 as I write, the market is 35% above its appropriate “middling” target. The “trailing” P/E ratio of 20.4 on the Standard and Poors 500 is also above its historic average, even though corporate and bank earnings are currently inflated by ultra-low financing costs and a steep yield curve. Thus at some point we can expect reality to intrude, and the market to drop to its likely cycle low in the region of 5,000 on the Dow Jones index.

Again market prices are too high for any intelligent buyer.  And worse, buyers will then be unavailable to buy stocks at the bottom. The Perils of a False Bottom

Politics v. Economics

Politicians are worried about the next election.  Thus, we see the desperation of the Administration to throw economic caution to the wind.   Zero interest rates, forgiveness of imprudent debt, subsidies to overpaid public sector workers (with no corollary “give backs”) are all hallmarks of erratic and misguided government policy.  They also sacrifice long-term prudence for the feel good of short term stimulus.

Who will pay this price?  Unfortunately, it will be stock market investors, pension plans, life insurance companies and homeowners.  Directly or indirectly, that is virtually all of us.  We need to beware politicians handing out artificially sweetened candy. Just like aspartame and our physical health, artificial economic sweeteners can be harmful to our financial health.

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25
Jun 10

Bridging the Gulf

Richard Bove is a purported expert on bank securities and is now vice president of equity research for Rochdale Securities, LLC.   He recently recommended purchase of a dozen gulf coast banks headquartered in Alabama and Louisiana, four of which have major exposure to Florida as well.   Mr. Bove’s thesis:  the Deepwater Horizon oil spill could benefit bank deposits just as a hurricane has done.   He reasons that federal funds plus the $20b BP established escrow fund will find their way into these gulf coast banks. See Bove: Oil Spill Could Boost Bank Deposits; Analyst Says Banks Could Benefits from Oil Spill

A savvy investor should consider the source of recommendations.   In 2007 and 2008, Mr. Bove was dismissing subprime mortgage problems and minimizing the financial crisis.  Months before the collapse of Bear Stearns and Lehman Brothers, Mr. Bove was still recommending these stocks, albeit, with reduced price targets. See e.g. Richard Bove’s Recent Note on Lehman Brothers

Perhaps there is a larger picture that Mr. Bove and other analysts are not noticing in the Deepwater Horizon crisis.

Implications of the Oil Spill

Destruction of marine life, the ocean, marshes, beaches and wetlands has been the focus of Deepwater Horizon news reports.  Only at the margin of such reporting do we read about the effect upon humans and the future habitability of the Gulf Coast.

-          Breaching the sea bed has not only resulted in oil spewing into the gulf, but also a host of toxic chemicals and gasses: methane, benzene, hydrogen sulfide, methylene chloride and others. See Health Risks from Oil Spill: “Some of the Most Toxic Chemicals We Know” , “Every Place can be Ground Zero”, CDC Advises “Everyone to Avoid Oil

-          These gasses are already present in the atmosphere in concentrations above federally recommended guidelines.  See May Levels of Toxic Gasses in the Gulf Back Up Claims by Lindsey Williams

-          Individuals as far away as Atlanta have complained of breathing, headaches, and nausea related to the spill and gas emissions. See Oil Blowout Fumes Sickening People in Atlanta

-          A major gulf storm could transform these chemicals into a “toxic rain” with harmful effects upon livestock, crops and humans. See Oil Hurricanes May Cause Toxic Rain and Food Security Issues

-          Florida uses desalinization plants along the gulf coast to provide freshwater .The state has warned of a water shortage if the spill reaches Tampa Bay and other plant locations. See Three Oil Leaks in Gulf Possible, FL Power and Water Supplies May be at Risk

-          Similarly, Florida officials have warned about power shortages as nuclear and conventional power plants both rely upon gulf waters for cooling. Oil from the spill could clog the intakes.

-          The Gulf Coast relies upon fishing, tourism and retiree populations.   Real estate brokers report the market is dead. See e.g. Gulf Real Estate  Prices Continues Slide as BP Oil Spill Continues

What If?

Sometimes we need to go a little further than Mr. Bove’s partisan and simplistic analysis and ask the worst case question: What if?  What if the Gulf Coast becomes uninhabitable?  Those recommended regional banks have commercial loans to businesses in the region.  It does not take genius to extrapolate the downward effect on real estate if people en masse move out of the area.   If Californians are walking away from houses with declining value, will Gulf Coast residents continue to pay their mortgages when they may need to evacuate their home and move north to avoid toxic gasses?  Who will be manning the businesses and farms in the region?   Will these fleeing residents continue to pay their credit card bills?

Past is Not Always Prologue

Like many Wall Street analysts, Mr. Bove recalls the past and extrapolates from it to predict the future.   Perhaps the Bove’s of the world need to be less historian than futurist.  That is, they need to ponder the uncomfortable possibility that this time things may just be dramatically different.  Perhaps the analysts need a little more non-televised rumination and non-linear thinking before their self promotional visits to CNBC.  If Mr. Bove could not conceive of Lehman or Bear Stearns failing, why should we trust that he can predict the profitability of Gulf Coast banks?   Maybe it is time for him (and us) to bridge the knowledge gulf.

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4
May 10

Goldilocks and Scary Headlines

In the previous bull market cycle, Larry Kudlow of CNBC touted the perfect “goldilocks economy.”  While not using the terms goldilocks economy, Michael Hanson, economist for Bank of America, is again touting a benign investment environment.  He predicts that over the next several years the economy will grow at 2.5-3.5 percent, interest rates will remain low and inflation will be subdued.  He also maintains that the growing federal deficit is the only “minor” concern.  B of A’s wealth management approach appears to be the fairly standard mantra:  emphasize tax efficiency, and diversify among various asset classes.

This blog does not provide advice as might your investment adviser, guru or astrologist.  However, I find something deeply disturbing about the aforementioned advice and forecasts.  The core of this philosophy is that past is prologue, and the next fifty years will look just like the past twenty-five.  But asset diversification strategy did not take into account that in 2007 and 2008, with the exception of US treasury securities, all markets declined simultaneously.  Robert Prechter of Elliott Wave called this phenomenon “It’s All One Market.”  And indeed diversification assured portfolio losses of 40% or more.

The Real World Intrudes

Counter to the “goldilocks” world view espoused by CNBC and wealth management firms, messy facts keep cropping up daily.  Recent cautions for any investor or policy maker:

More than a Million in the U.S. May Lose Job Benefits – Congress is concerned with federal deficits and extended unemployment benefits. They believe that these benefits are a disincentive to finding work, and they are disinclined to extend the 99 week ceiling.   Thus, 1 million people face an immediate loss of benefits with an estimated loss of 400,000 per month thereafter.

Morgan Stanley: Strategic Defaults Reach 12% – These are the mortgage holders with the capacity to pay, and yet choose to default.   Twelve per cent of all mortgage defaults in February 2010 were of the strategic variety.  As I predicted, “bailout nation” has given license to strategic defaulters to just walk away from their underwater home values.  See Flirting with Economic and Political Breakdown.

Is the UK Preparing to follow the PIIGS into the Abyss

With $2 Trillion in 3 Year Funding Needs by the PIIGS, the IMF is Helpless to Do Anything but Sit Back and Watch

Spanish Unemployment Rate Tops 20%

Containment Fails: European CDS Explode as Market Looks to Future Bail Outs, Bank Runs

Mainstream media keeps reassuring the public that the crisis in Greece is well contained.  But just remember how Ben Bernanke assured the financial markets that our subprime crisis was also well contained.  Government financial profligacy is having major repercussions in the European financial markets.  Bailouts of private banks, out of control public sector salaries and pensions, overregulation, and (with the assistance of American investment banks) financial chicanery to hide public indebtedness debt have come home to roost.  Credit spreads, the difference between the gold standard German bonds and other European government debt, especially the “PIIGS” (Portugal, Ireland, Italy, Greece, Spain), have widened to alarming numbers.   Even the UK has experienced widening of credit spreads against German bonds.  Eurozone unemployment is soaring.  Despite EU and IMF efforts to bail out Greece, credit spreads again widened today and the Euro plunged.

Justice Department Opens Goldman Sachs Criminal Investigation Sources Say – The significance here is not whether or not the government can prove that Goldman committed crimes.  Rather, the importance of the investigation is that the tide has turned.  Financial firms will be on the defensive and unfortunately their most profitable products operate on the edge of the law.  Inevitably, more government oversight will cut profitability and remove one more support from the already fragile economic recovery.  See also Watershed Event in the Financial Crisis – SEC v. Goldman.

Uncertainty Abounds

Risk and reward need to correlate. Perhaps diversification and the rosy scenarios of years past will win out.  But this small selection of troubling headlines suggests otherwise.  I would view the diversification thesis very skeptically.  As they used to say on television’s Hill Street Blues: “Hey, let’s be careful out there.”

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