Unprecedented - Part II

It Is Different This Time

Potentially one of the most costly trappings for investors is succumbing to a belief that ‘it is different this time’. For instance, assuming that the economic engine of the United States is permanently broken or we are destined to the Japanese experience of permanent malaise may lead us to make the wrong choices when it comes to investment strategy. Just over a year ago we experienced a ‘financial panic’. It was not the first and it will not be the last. A financial panic is characterized by a ‘run on the banks’. Our recent experience was a ‘run on the system’. What happens in a financial panic is that all financial players move in unison to ‘safe assets’ leaving financial institutions without risk capital to operate.

Banker Panic of 1907

While the Great Depression was kicked off with a series of ‘bank runs’, the most similar episode to recent Panic of 2008 was the Banker’s Panic of 1907. The stock market peaked in 1906 and fell 40% over the next year during a time of recession. In the fall of 1907, with the economy and financial markets already on shaky ground, a number of financial institutions extended money to a group of investors (think subprime lenders) making big one-way bets. When the investor bets soured (think housing bust) it led to the collapse of a prominent broker dealer in New York City (think Lehman) that caused another and much larger financial institution to fail (think AIG). As news spread, depositors across the nation became nervous and began withdrawing their funds from all types of institutions (think of the mass exodus from money market funds after The Reserve Fund, a money market fund with a small position in Lehman, ‘broke the buck’.) From there, the entire system began to unravel.

John Pierpont Morgan, the wealthiest and most prominent banker of the day (before the Federal Reserve Bank existed) stepped into the fray by making capital injections into several prominent banks (think Bernanke/Paulson with their Maiden Lane loans to AIG and the $250 billion TARP injections into the largest U.S. financial institutions.)[i] John D. Rockefeller, the wealthiest person in America at that time, made a large deposit into Citigroup’s predecessor (think Warren Buffet investing in Goldman Sachs and GE Capital). After these initial injections, over the next few weeks, and through some serious banker wrangling, Morgan was able to pony up enough bankers and money prevent the total implosion of the financial system (think of the $500 billion in the 2^nd round TARP, as well as the TALF, CPFF, PPIP).[ii]

Past Performance Does Not Predict Future Performance

The economy did shrink in 1908, but it grew again until it was stymied by the outbreak of World War I in 1914. And in the aftermath of the 1974 ‘Great Bear Market’, the economy grew until 1980 despite double-digit interest rates and double-digit inflation during that time period. It is hard to say if the Panic of 2008 was any worse than the Panic of 1907. Or the economy of 1975 was more resilient or in better shape than the economy of 2009. Whatever the case, unprecedented is not a word I would use to describe the events of the last year or so.

Looking forward, a belief that America is permanently broken, or on the wrong path, or is an empire in decline is generally a bad bet in my view. In 1989, the Nikkei would peak at 38,000. Japan was on a roll. It had a vibrant economy, great manufacturing acumen, they were buying up the most precious real estate in America, and everybody wanted a Sony Walkman. In America, our financial system was in shambles as we shuttered thousands of S&Ls, Citigroup fell to less than a $1, Michael Moore made his first movie about a dying U.S. auto industry, and Apple’s first portable computer was a piece of crap.[iii] Over the course of the next decade, the Nikkei would lose 66% of it value and U.S. stock market would rise 450%. Do you think most pundits were betting on Japan or America in 1989? Perhaps I am wrong, but I caution those that think it is different this time.

DISCLAIMER: Information, data and attachments contained on this website are from sources considered reliable but their accuracy and completeness is not guaranteed. Investing entails risks, including possible risk of principal. An investment in any equity, bond, fund or other financial instrument may be speculative and involve significant risks. We do not offer tax advice. Individuals should consult their personal tax advisor before making any tax-related investment decisions. Past performance is not a guarantee of future results.

Securities offered with and through First Allied Securities, Inc., a Registered Broker Dealer, Member FINRA/SIPC. First Allied Securities, Inc., is not affiliated nor endorses Portland Private Wealth Management or any other affiliated firms.

If you would like to contact us feel free to email as at jason@portlandprivatewm.com or we can be reached at 503-703-4067. Thank you.

© 2010 All Rights Reserved Portland Private Wealth Management Group.

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[i] TARP - Trouble Asset Relief Program

[ii] TALF (Term Asset-Backed Loan Facility), CPFF (Commercial Paper Funding Facility), PPIP (Public-Private Investment Program)

[iii] The Citigroup low is a split adjusted number. Source: Goldman Sachs

Unprecedented - Part I

One editorial writer for Bloomberg suggested that unprecedented was the most overused word in 2009. I think she was probably right. 2008/2009 was a year of tumultuous financial events. But was it unprecedented?

This year is ending with much of the nation in a state of deep anxiety over the course of the economy. Wall Street is flooded with red ink, but some of the biggest investment banking houses in the country are nevertheless paying year-end bonuses.[i] The recession will represent the longest slowdown since the 1929 – 1933 experience.[ii] There has been nothing like the present degree of apprehension since 1930. The question on everybody’s mind is whether years like 1931 and 1932 lie ahead. If the nation is to avoid another Great Depression, it has to face up to the real problems and dangers that lay ahead.[iii]

Feeling the Pressure

Many individuals are cutting their expenditures because their pocket books are pinched, they don’t have the means to dip into their savings, and unemployment rolls are lengthening. Businesses see new orders shrinking, unsold inventories piling up, costs rising and profits eroding.[iv] Last week, the largest airline in the nation said it would be forced into bankruptcy without a federal subsidy.[v] The Mayor of New York City has launched the toughest austerity measures since the Depression laying off thousands of employees and is seeking help from Washington.[vi] The depressing economic news has sent the stock market to the lowest levels in more than 12 years, as the government’s index of leading business indicators fell to its lowest level in 24 years and the unemployment rate reached its highest level in 13 years.[vii] [viii] [ix]

Negative Wealth Effect

There is a real sense of wealth lost from the roughly 40% drop in the stock market since last year. To the extent is impossible to quantify, this loss of wealth cuts into consumer spending, therefore total demand and production in the economy. The drastic decline in the price of stocks (which some argue started at the beginning of this decade) eventually has an effect on the process of ‘capital formation’ in the American economy. This is the means by which savings is transformed into the creation of new businesses and increased investment in plant and equipment.

Prognosticating

There are some people on Wall Street that recommend investors should stay away from stocks all together.[x] One of the President’s top economic advisors suggested the recession would continue into the middle of next year.[xi] Another prominent economist said his personal view was that a new bull phase in stocks would not occur until spring at the very earliest.[xii] On the flip side, gold prices have soared. This clearly reflects a wave of private demand by people worried about the state of the world economy and particularly about inflation. Some people regard gold as the only safe store of value at a time of global inflation and depreciating value of paper money.[xiii]

So Goes The Auto Sector, So Goes The Economy

Automakers have been under heavy pressure as new car sales have slumped.[xiv] The problems with the auto industry are not limited to Detroit. Employing some 750,000 people directly, it is estimated that indirectly the industry creates another 13 million jobs in steel, aluminum, glass, fabrics, electronics as well as a whole host of other industries. One automotive executive said the biggest deterrent to new car buying has been the sharp rise in the cost of vehicles because of federally mandated safety and emission standards. On the other hand, some experts have argued that auto companies would be more profitable if they simplified their offerings and made fewer kinds of cars.[xv]

Politics in Flux

The country is eagerly seeking Presidential leadership, not more of the same rhetoric it has ceased to believe or respect.[xvi] The President has said he would be willing to revise the current economic program he has presented to Congress if economic conditions worsened.[xvii] The Administration should have the courage to stimulate the economy through tax cuts and socially desirable expenditure increases.[xviii] What inhibits the present Administration is the double fear of increasing the budget deficit and regenerating inflation.[xix] The Chairman of the Ford Motor Company has suggested a gas tax to benefit those hit hardest by the recession – the poor and unemployed.[xx]

Energy Policy: Getting Off Foreign Oil

Measures to strengthen the domestic economy will require a strong national energy policy, whose centerpiece should be to conserve energy and reduce uncertain foreign oil supplies. Doing without foreign oil supplies will reduce our trade deficit and avoid another Middle Eastern war. As abundant as the supply of petroleum may seem, it is ultimately a wasting asset that will ultimately vanish. It is time to consider new technologies like solar, wind and hydrogen.[xxi]

Don’t Know How Good You Have It

Despite the economic gloom in America, foreign observers ask – ‘Why should so vast an economy such as ours, which depends to such a relatively small degree on exports, be more nervous than its trading partners who are wholly dependent on foreign trade to survive?’ The United States has immense natural wealth and requires only minimal discipline to regain its self-sufficiency.[xxii]

Plagiarizing

The paragraphs above have been cobbled together directly from newspaper articles written during the last months of 1974 with minimal change except to improve the readability. It has been just over one year since I printed out and highlighted these articles, but it is still a worthwhile exercise to examine these writings as though they were current news to potentially help investors gain a deeper understanding of market psychology. In early 1973, the stock market peaked and fell over 45% over the next two years. It was a slow, grinding bear market called the ‘The Great Bear’ that ended in December 1974 around the time the articles referred to above were written. The economy would contract the first quarter of 1975, but it started growing again until the recession in 1980 (the last great housing bust in the U.S.). And the stock market would find a bottom in first week of December, 1974, and rally 73% returning to its the old highs by 1976. While we do not know what may lay ahead in 2010, listening to the media or pundits may not help very much. What we do know is that the events of recent months were not unprecedented and it is difficult to predict the course of future events.

DISCLAIMER: Information, data and attachments contained on this website are from sources considered reliable but their accuracy and completeness is not guaranteed. Investing entails risks, including possible risk of principal. An investment in any equity, bond, fund or other financial instrument may be speculative and involve significant risks. We do not offer tax advice. Individuals should consult their personal tax advisor before making any tax-related investment decisions. Past performance is not a guarantee of future results.

Securities offered with and through First Allied Securities, Inc., a Registered Broker Dealer, Member FINRA/SIPC. First Allied Securities, Inc., is not affiliated nor endorses Portland Private Wealth Management or any other affiliated firms.

If you would like to contact us feel free to email as at jason@portlandprivatewm.com or we can be reached at 503-703-4067. Thank you.

© 2010 All Rights Reserved Portland Private Wealth Management Group.

---

[i] Cole, Robert J., Wall Street in Red, But Bonuses Flow, The New York Times, December 18, 1974.

[ii] The Economic Threat, Recalling the 30s, What to Do About It, The New York Times, December 18, 1974.

[iii] The Economic Threat, Recalling the 30s, What to Do About It, The New York Times, December 18, 1974.

[iv] The Economic Threat, Recalling the 30s, What to Do About It, The New York Times, December 18, 1974.

[v] Stocks Decline in Heavy Trading, The New York Times, August 29, 1974.

[vi] The Major Events of the Day, The New York Times, November 23, 1974.

[vii] Hammer, Alexander, Dow Stock Average Drops 9.46 Point to a 12-Year Low as Volume Increase, New York times, December 7^th, 1974.

[viii] Sears, Roebuck Planning Layoff, New York Times, November 6, 1974.

[ix] Dow Soars 25.5 as Volume Rises, The New York Times, October 30^th, 1974.

[x] Vartan, Vartanig, Analysts Pick Some Winners for 1975, December 29, 1974.

[xi] Hammer, Alexander, Economic Gloom Weakens Stocks, The New York Times, October 27, 1974.

[xii] Vartan, Vartanig, Will 525 Be the Bottom?, December 8, 1974.

[xiii] Dale, Edwin, Gold for Sale: It Probably Will Make No Difference, December 29, 1974.

[xiv] Dow Soars 25.5 as Volume Rises, The New York Times, October 30^th, 1974.

[xv] Mullaney, Thomas, What Will Help Detroit?, November 3, 1974.

[xvi] The Economic Threat, Recalling the 30s, What to Do About It, The New York Times, December 18, 1974.

[xvii] Hammer, Alexander, Ignoring the Bad News, Market Advances on Broad Front, October 30, 1970.

[xviii] The Economic Threat, Recalling the 30s, What to Do About It, The New York Times, December 18, 1974.

[xix] The Economic Threat, Recalling the 30s, What to Do About It, The New York Times, December 18, 1974.

[xx] The Major Events of the Day, The New York Times, November 23, 1974.

[xxi] Sulzberger, C.L., Let Them Eat Petroleum, November 13, 1974.

[xxii] Sulzberger, C.L., The Gods That Are Failing, The New York Times, December 1, 1974.

A Casino? Really?

It has been exactly one year since Lehman Brothers declared bankruptcy and sparked a financial panic that substantially changed the trajectory of the already sluggish U.S. economy. The spillover effects rippled through global markets and global trade came to a virtual halt. The U.S. economy contracted by roughly -6% in the 1^st quarter and U.S. imports fell by 34%. (Source: JPMorgan / www.imf.org). The repercussions to our trading partners were substantial. During the first quarter Taiwan’s economic activity (GDP) fell -10.2%, Japan -11.7%, German – 13.4%, Hong Kong -16.1%, Mexico -21%, Russia -33.6%. (Source: JPMorgan)

So what was the series of events that precipitated this shock?

I. The Real Estate Peak, Subprime Collapse & Stock Market Peak

In August of 2006, the real estate market peaked. Falling prices put pressure on lenders and by the summer of 2007 the subprime lending market collapsed. In October 2007, the stock market (S&P 500) peaked.

II. Bear Stearns, Freddie & Fannie

By March 2008, reverberations of falling estate prices led the failure of Bear Stearns, a large Wall Street investment bank. Over the summer of 2008, it became clear that the government would need to support mortgage markets as lending was drying out. The stock market was down over 20% signifying a bear market in equities. By September, Freddie Mac and Fannie Mae, two government sponsored lending giants, were placed into government conservatorship.

III. Merrill, Lehman & AIG

As summer came to a close, several investment banks were desperate for cash. Trust among big institutions was eroding and the spigots of capital were shut off. On September 15^th, Merrill Lynch sold itself to Bank of America, the largest bank in the country at that time, and Lehman Brothers, another large investment bank, failed as it could not find a suitor. The next day, to prevent imminent collapse, the government extended a loan of $85 billion to save AIG, the world’s largest insurance company at that time. That same day, a large money market fund ‘broke the buck’ due to its exposure to Lehman. The failure of this money market fund was significant in spreading panic throughout the financial system.

IV. Financial Shock & Capital Injections

What had begun as a housing bust / credit crunch morphed into a full-blown financial shock. Over the next 6 months, the stock market would fall 57% from the peak in October of 2007, representing one of the worst bear markets in history. The government would take extraordinary actions in an attempt to restore confidence in the financial system and inject significant amounts of capital into U.S. banks. The impact of the financial crisis caused economic activity to contract considerably. It now appears that the U.S. economy is on the mend.

V. Aftermath: Impact on Efficient Market Hypothesis

The impact of this event on investors, bankers, regulators, policy makers and academics has been substantial. Alan Greenspan, a former Chairman of the Federal Reserve told congress last October – “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.” (Alan Greenspan, Testimony to Congress, October 23rd, 2008).

I was taught in school (I majored in business economics) that financial markets are efficient, rational and inherently stable – a concept commonly known as EMH (Efficient Market Hypothesis). This concept was essentially handed down to me as cutting edge thinking about the way financial markets truly operated. I, among others, thought it was generally correct given the evidence produced by Nobel Prize winning formulas. Some now maintain that the application of these formulas encouraged excessive risk taking (meaning utilizing massive amounts of leverage to purchase mountains of debt instruments) because the data used in these models ignored the possibility of highly catastrophic and unpredictable events, like the collapse of Lehman Brothers which would set-off panic selling of money market funds, a seemingly irrational behavior, or that liquidity might dry up completely in mortgage markets, and not just the market for subprime mortgages.

However, before EMH, a guy named John Maynard Keynes (1883 – 1946), the highly influential economist of his time, believed that speculators dominated markets, were prone to exuberant mood swings and the whole shebang was essentially a giant casino. (Krugman, NYT, 9/6/09)

One of most interesting things about Keynes was he was well known as a speculator as well as a respected academic. I think if anything results from this crisis is that people will dust off some of Keynes’s old books and see if he still has anything to add to the conversation.

Written by Jason McMillen, Chief Investment Strategist, PPWM

Prognosticating

I watch Bloomberg television everyday. It is something that plays in the background as I work. The primary reason is because I like to know what is going on with the economy and financial markets, and I like to hear what other professionals and pundits are saying about the markets. It is called infotainment.

After thirteen years in this business, what I have learned is most people do not have any special insight on the direction of economy or financial markets. In fact, many so-called experts are either too bullish or too bearish. However, there is an old adage on Wall Street that ‘If you say the same thing for long enough you will eventually be right.’

When I sit down with clients many of them want me to look into a crystal ball and tell them what I see. What I tell them is few people, if any, can accurately predict the future. If there are any absolutes, it is to ‘Expect the Unexpected’ which is a magnet on my refrigerator (next to my ‘Take a bath in the real estate market with Mr. Hou$ing Bubble’ magnet).

So why make any predictions or forecasts if it is a seemingly futile exercise? When it comes to investing all of the old pros provide the same advice which is -- 1) develop your own ideas, 2) have some convictions, 3) admit when you are wrong.

Below we have developed some of our own ideas that we often discuss with our clients. Please take them with a grain of salt as the following disclaimer warns:

All estimates, opinions and views expressed are our own and constitute our best judgments as of the date of this podcast or email and may be subject to change at any time without notice. These opinions and views are made under conditions of great uncertainty and there is a good possibility that our judgments could be completely wrong. However, we hope for your sake and ours that we are more right than wrong of which there is no guarantee.

The PPWM Outlook Fall 2009

A) The global economy is nearing a trough in the business cycle marked by the early phase of a cyclical bull market in financial markets.

B) Coordinated global fiscal and monetary stimulus provides a positive environment for investors.

C) Global interest rates will remain low for a significant period of time as central bankers work aggressively to stimulate risk taking behavior and economic activity.

D) We are in a long-term bull market for commodities, driven by new demand from emerging markets.

E) The developed economies will grow slower than emerging economies.

F) Companies in the developed world that can sell products into the developing world are attractive.

G) The rest of the world is geared toward selling consumer products to the U.S. consumer. They have a huge stake in the revival of U.S. consumption.

H) The U.S. economy and the consumer are resilient and will be highly adaptive to the headwinds they face, despite opinions to the contrary.

I) When (assuming) the global economy starts growing robustly again, inflation will come back quickly.

J) U.S. unemployment rates may not come back down in the near-term as the U.S. economy must make a tectonic shift from the hyper-activity of building automobiles, houses, condos, strip malls and office buildings – to doing something else – at least for the next 5 to 10 years.

K) The fiscal deficits of the U.S. government are unsustainable and highly problematic without serious sacrifices.

L) Industrialized governments have made significant promises to their retirees that are significantly underfunded.

M) Higher taxes are on the horizon.

N) Financial markets still have significant negative exposure to commercial real estate assets that could be disruptive to economic expansion.

O) The government may to have to make additional capital injections into financial institutions in order to absorb future losses due to write-downs associated with commercial real estate (which have not yet been taken). Such injections may destabilize financial markets once again.

P) A multi-year bull market may take stock market indices back to old highs, but a return to the good old days like the 1980s and 1990s where indices rose 15-fold is probably not in the cards until the ‘structural headwinds’ mentioned above have been addressed. This may mean another decade of volatile markets similar to the 1960s and 1970s.

Investment Implications

Based on the outlook above, we believe investors may need to be more proactive and nimble than they have been in the past. This may require considering new investments ideas, timing strategies and examining yield as an important slice of total return. We will continue to make investments in companies with exposure to basic materials (commodities) and emerging markets, either through the purchase of fixed income or equity instruments. In addition, we want exposure to investments that benefit from an improving global economy or can benefit from an inflationary environment. If you want specifics, we encourage you to contact us. These are our prognostications -- for now.

Written by Jason McMillen, Chief Investment Strategist, PPWM

Waiting for Gisele

On November 5, 2007, it was reported that Gisele Bundchen, the world’s richest super model, told Bloomberg News that she would no longer accept payment for her modeling gigs in U.S. Dollars – she was only taking Euros. It was said Ms. Bundchen, who was 27 years old at the time, earns about $30 million a year peddling products like Pantene shampoo for the likes of Procter & Gamble and perfume for Dolce & Gabanna. The headline at Bloomberg was Supermodel Bundchen Joins Hedge Funds Dumping Dollars.

A few days later Gisele’s manager said she had never made any such comments. But the story sparked a furry of negative comments about the old Greenback and brought a story mostly confined to the financial media into the mainstream. That same month, a popular rapper named Jay-Z flashed Euros in his new video. The basic drift was Dollar days were over and it was time to make way for a new world order. From government officials to currency traders, from economists to academics – America was over. Back in those days, everyone was a real estate mogul and hedge funds were the smart money. We now know that the real estate boom was a bubble built on poor lending standards and too much leverage, some high profile hedge funds have closed their doors after severe losses, and one of the biggest and most exclusive hedge funds was just a Ponzi Scheme.

When financial news becomes general news, it can often mark an important turning point. Negative dollar sentiment climaxed right at the end of a long decline (-42%) in the U.S. Dollar Index. The Dollar peaked in 2001 after a long rally (+51%) that began in early 1995. Five months after Gisele’s comments, the Euro Index ($XEU) peaked and then declined (-23%) into the October 2008 lows. The Dollar Index ($USD) bottomed around that time and rallied (+27%) through March of 2009.

One method of investing, called ‘contrarian investing’, means doing the opposite of the herd. For instance, when every other commercial on TV is an infomercial for buying real estate it is probably not the best time to be buying real estate. This analysis can also apply to market bottoms. A couple of months ago, I was getting calls from people who said they had heard the Dow Jones Industrial Average (DJIA), an index made up of the 30 largest companies in the U.S., was going to 5000, maybe even 4000. The DJIA peaked just over 14000 in March of 2007. These calls were coming in March of 2009 when the index was under 7000. Contrary to general sentiment, the market went 2000 points in the other direction.

There is an old saying on Wall Street that ‘When the market goes on sale nobody wants to buy.’ It is a natural human behavior to be afraid when we sense danger. But a contrarian investor understands that the fear factor creates opportunity. Now I am just waiting for Gisele to say she will no longer be contributing to her 401K because the stock market and economy are so bad. That could be a good contrarian sign.

Written by Jason McMillen, Chief Investment Strategist, PPWM

What would Friedman do?

Milton Friedman (1912 – 2006) is possibly the most influential economist of all time. His ideas have been woven into the DNA of American economic and political life by the likes of Barry Goldwater, Ronald Reagan and Alan Greenspan. In a nutshell, Friedman is among the great advocates of free markets, deregulation and arguably his influence has been very beneficial.

In 1963, Friedman co-authored a book titled the Monetary History of the United States:1867-1960. In this book, he laid out his argument that the Great Depression began as a typical business cycle recession and mutated into major depression because the Federal Reserve Bank contracted the money supply between 1928 and 1933.

In an interview in 2000, Friedman said:

“We have to distinguish between the recession of 1929, the early stages, and the conversion of that recession into a major catastrophe…. What happened is that [the Federal Reserve] followed policies which led to a decline in the quantity of money by a third….And that extraordinary collapse in the banking system, with about a third of the banks failing from beginning to end, with millions of people having their savings essentially washed out, that decline was utterly unnecessary. At all times, the Federal Reserve had the power and the knowledge to have stopped that. And there were people at the time who were all the time urging them to do that. So it was, in my opinion, clearly a mistake of policy that led to the Great Depression.”^

In the late 1920s, the Federal Reserve believed that speculative excesses of the ‘Roaring Twenties’ needed to be purged. Any government intervention to the contrary would only slow a necessary and natural process. In terms of the banking system, weak banks needed to close and the strong would survive. That was the policy prescription that carried the day. But in retrospect, allowing the banking system to fail caused the economy to collapse. By 1933, roughly 1 in 3 Americans were unemployed. In some places it was 1 in 2.

Friedman strongly believed that the government should tinker as little as possible in the private sector except for controlling the supply of money. When asked if he supported the policies of Franklin Roosevelt and the New Deal, he answered:

“Because it was a very exceptional circumstance. We'd gotten into an extraordinarily difficult situation, unprecedented in the nation's history. You had millions of people out of work. Something had to be done; it was intolerable. And it was a case in which, unlike most cases, the short run deserved to dominate.” ^

On nearly a daily basis I am told that government should let the banks fail and the government’s stimulus plan is a waste of money. People ask why should we (the taxpayers) borrow massive amounts of money to bailout irresponsible investors, bankers and borrowers? That answer may lay in the thoughts of Milton Freidman. We can go the route of Great Depression II or we inject the billions, probably trillions needed to stabilize the banking system. I hope that the powers that be in Washington do what needs to be done.

^ Source: www.pbs.org, Commanding Heights, 10/01/00.

Written by Jason McMillen, Chief Investment Strategist, PPWM

Financial Pandemonium

Metastasis

What began as a housing bust and credit crunch has metastasized into a full-scale financial meltdown. Banks have found that the securities they bought with depositors’ money are now worth far less than they could imagine. Bank write-downs have reached $792 billion offset by $826 billion in capital raised. ^ $380 billion of the capital raised represents public monies. ^

Lender of Last Resort

Several first-round investors, including sovereign wealth funds, billionaire financiers, private equity and hedge funds have lost their investments. It now appears no one will give financial companies any more money. As a result, the taxpayers, through their proxies – the Treasury and the Fed – are the ‘lender of last resort’.

Shouldn’t We Just Let Them Fail

The alternative to the lender of last resort is to allow the financial system to implode and see what rises from the wreckage. This solution may not be particularly palatable as the adjustment could be harsh (riots, populism, massive layoffs, deflation, hyperinflation) and what could emerge on the other side is a much smaller economy, lower incomes, higher unemployment, and potentially a much different political landscape.

Seizure and Liquidation

When a bank’s reserves fall below a certain level we have instructed the FDIC to seize those banks and liquidate the assets. When this happens to our biggest banks, we have to decide if this liquidation process would heighten the level of anxiety, induce further financial pandemonium and potentially compound the problems in the economy.

Capital Injections and Nationalization

The alternative to seizure and liquidation is for the taxpayer to inject capital into these institutions. Nationalization is the process where the taxpayer takes ownership stakes in systemically important financial firms. The dilution of the existing shareholders is good because it essentially makes them pay dearly for their foolishness.

Eatin’ Boiled Crow

Hopefully, we are getting closer to the beginning of the end of this mess. A healthy and efficient financial system enables our economy to be far more productive than otherwise. To return to health will likely mean that the so-called toxic assets are quarantined. The quicker we ‘eat crow’ – i.e. the banks clean up their balance sheets -- the sooner the economy can begin a recovery.

Written by Jason McMillen, Chief Investment Strategist, PPWM

^ International Monetary Fund, Global Financial Stability Report, Update, January 2009, Updated as of January 26^th, 2009.