Friday, April 30, 2010

"The Senate Budget - Is the Individual Being Marginalized?"

Sydney M. Williams

Thought of the Day
“The Senate Budget – Is the Individual Being Marginalized?”
April 30, 2010

Keeping with the partisan atmosphere in Washington, last week the Senate Budget Committee passed a fiscal 2011 budget resolution on a party line vote of 12-10. While this is a non-binding proposal, it suggests the direction the Administration wants to travel and it raises taxes dramatically on dividend income for those in the highest tax brackets, which will have consequences for those in lower brackets.

The report prepared by the majority staff highlighted the expectation that the deficit, as a share of GDP, will drop from 9.8% to 3.0% – a 70% decline over five years. It also emphasizes that the budget provides net tax relief of $780 billion over the next five years, “targeted largely to the middle class.”

Senator Judd Gregg, ranking Republican Senator on the Committee, had a different take: “Both Social Security and Medicare go into negative cash flow in the term of this budget. For the last twenty years (and more), we’ve used the Social Security funds and Medicare funds to fund the general operations of the government, rather than borrowing from the public. We can’t do that again.” Taxes will go up, not down. Using the data from Wikipedia, entitlement spending (Social Security, Medicare and Medicaid) will amount to $1.168 trillion in 2010. Social Security and other payroll taxes will generate $940 billion, implying a shortfall of $228 billion. Instead of generating cash that could be used to purchase Treasuries, the data suggests payments will have to be made with borrowed money.

Interest expense on the national debt is forecast to be $164 billion, implying an average annual interest cost of 1.26% on debt of $13 trillion. Does anyone believe that interest rates will not rise over the next year or so? It is hard to imagine such a scenario, unless we are headed back into recession and corporate and individual demand for money shrinks materially. It is more likely that inflation will result from a cheapening Dollar and interest costs will rise materially.

To pay for these entitlements – and the newest entitlement, the new healthcare plan – taxes will go higher, most likely significantly more than we have been led to believe. On Thursday, the Wall Street Journal, in an editorial, pointed out that the tax on dividends, as proposed in the Senate’s budget resolution, for those in the highest brackets, will rise to 43.4% – the top rate of 39.6% plus the 3.8% surcharge on all investment income resulting from the recently passed healthcare bill – versus the current 15% rate. As I wrote on Wednesday, the tax code needs to discourage consumption, not investment. A 189% increase in taxes on dividends will serve to dissuade companies from raising dividends, thereby impacting the income of the retired and those in lower tax brackets.

Despite protestations by the Administration to the contrary, it begs credibility that a new entitlement – universal healthcare – will not add costs. Outside of rationing and improved technology, the elimination of waste is the only way in which costs will be reduced, and government has never been known for efficiency.

There is no question that there are inequities in our democratic, capitalist society: income disparities are too high; not enough children have access to good education and too many people survive with inadequate healthcare. These areas need to be addressed – incomes because of fairness; education because of opportunity and healthcare because of decency. But on balance our system has served our nation and its people well. Immigrants, for the most part, come to this Country for its freedoms and opportunities, not for its welfare. To create an environment that fosters dependency on the State ultimately dooms that State to failure. In a world in which our competition comes from around the globe, we need to encourage innovation, entrepreneurship and investment at home. We must leave behind the culture of consumerism and xenophobia, and recognize that markets are global. Our opportunity is to serve a rising middle class, in places like China, Brazil, India, Vietnam, Indonesia and Eastern Europe.

It is individuals, risk-taking, creative persons that grow and expand GDP, not the State. A sense of personal responsibility must be recognized and encouraged. Government should set the rules and umpire the games, but the athletes should be the people, free to succeed and free to fail.

I worry that the direction we are headed leads toward Statism and away from individual freedom, opportunity and prosperity.

Thursday, April 29, 2010

"The Commission on Debt Reform - A Way Out of the Morass?"

Sydney M. Williams

Thought of the Day
“The Commission on Debt Reform – A Way Out of the Morass?”
April 29, 2010

There is an irony that the non-partisan National Commission on Fiscal Responsibility and Reform has been created by the most profligate and partisan President this Country has ever known. I hope he is serious and that any recommendations will be considered seriously, for there is no doubt we face a difficult future, in terms of financial obligations. An improving economy will lessen the immediate magnitude of the problem, but the underlying cause – too much spending and too little savings – remains.

The President proposed and Congress passed an $800 billion Stimulus Bill that produced debatable results. Billions of Dollars have been poured into Fannie Mae and Freddie Mac, but they have been removed from a proposed Financial Reform Bill, despite their obvious role in the collapse of mortgage markets. (Goldman may have traded these mortgages, but most were created/packaged at either of the two GSEs.) The President proposed and Congress passed, purely along Party lines, an overhaul of the health care system – 17% of the U.S. economy, the consequences of which no one knows, but, like all entitlements, will cost far more than anyone expects. The President is proposing and Congress will be considering an energy bill, which he has been careful to no longer call cap-and-trade legislation. The legislation may well help the Country become more energy independent in future years, but in the short term will raise prices. A Kilowatt of energy produced today by wind or sun costs more than that by oil or gas.

As a candidate, Mr. Obama talked of a bi-partisan “movement for change” in which citizens would organize and agitate their Congressional representatives to pass legislation. As President he has out-Roved Karl Rove. Congress and the people have rarely been in such a partisan mood.

Nevertheless, the President has created a Commission of eighteen members, which comprises six selected by him, no more than four of whom can be from one political party:

Alan Simpson – Co-Chair – former Republican Senator from Wyoming
Erskine Bowles – Co-Chair – Clinton White House Chief of Staff
Andy Stern – former President Service Employees Int’l Union
Alice Rivlin – Brookings Institute
David Cote – Chairman and CEO Honeywell
Ann Fudge – former Chairman and CEO Young & Rubican

House Republicans:
Paul Ryan – Wisconsin
Jeb Hensarling – Texas
Dave Camp – Michigan

House Democrats:
John Spratt – South Carolina
Xavier Becerra – California
Jan Schakowsky – Illinois

Senate Republicans:
Judd Gregg – New Hampshire
Tom Coburn – Oklahoma
Mike Crapo – Idaho

Senate Democrats:
Richard Durbin – Illinois
Max Baucus – Montana
Kent Conrad – North Dakota

Any recommendation from the Commission must have the backing of at least fourteen of the eighteen members, thereby guaranteeing a bi-partisan conclusion. (I would love to be a fly on the wall, as Paul Ryan and Andy Stern go at it!)

While I hope that this Commission will be able to do what no other has done, Peter Orzag comments to the Commission yesterday raise doubts: “Reining in the deficit [will] require significant changes in policy that builds on what we have done.” (Italics are mine.) If we continue down the path we are on, we are headed for fiscal wonderland. Unlike Alice, however, we will not awaken to realize it was only a dream.

Howard Gleckman, writing in yesterday’s Christian Science Monitor, said that he was “skeptical” and that it reminded him of what Dr. Johnson said of second marriages: “a triumph of hope over experience.” More seriously he suggested that the issues that need to be watched include:

1) Republicans being willing to raise taxes.
2) Democrats being willing to raise taxes on those earning below $250,000.
3) Social Security problems will have to be dealt with.
4) Medicare costs (and, I would add, those that will be incurred by the new healthcare entitlement) will have to be addressed – most likely in some form of care.
5) The “Atmospherics” – an indication that the mood will permit consensus.

Yesterday the Commission met for the first time. Co-Chairman Erskine Bowles characterized debt as a cancer that destroys what it inhabits from the inside. He pointed out that the Congressional Budget Office projects that our federal debt is on a trajectory to reach 90% of GDP by 2020, which would put us not far off the situation in Greece. And, if anything, projections from the CBO are generally more benign than reality. The Fed Chairman, Ben Bernanke, told the Commission that the consequences of failure (to put forward and execute on a plan) would be “substantial”. And Alan Simpson, the laconic former Senator from Wyoming and Co-Chairman admitted to the difficulty of the task ahead: “It’s going to be like giving dry birth to a porcupine.”

A risk, in my opinion, of the Commission is that President Obama may use any recommendations to move the economy toward a state-building enterprise rather than a free market one. However, for most of us, and certainly those of us in the investment business, we must deal with the world as it is, not the way we would prefer. Lines toward the end of John Marquand’s novel, Point of no Return, have pertinence: “…but his profession was investments which in the purest sense was only an endeavor to cut the cloth according to the situations which radicals and liberals created.”

Wednesday, April 28, 2010

"Retirement - Is There One in Your Future?"

Sydney M. Williams

Thought of the Day
“Retirement – Is There One in Your Future?”
April 28, 2010

After a day in which the Dow Jones declined 2.0% – the first decline in excess of 1.5% since February 4th and the longest period between such declines in three years – largely because of Greek debt concerns, it is worth considering the desperate situation of our own unfunded pension liabilities.

Writing in yesterday’s Wall Street Journal, Washington correspondent, Gerald Seib, wrote that just as the American government is addicted to debt, so are the American people. In a survey released yesterday, Putnam Investments of Boston found that 40% fewer Americans expect to fully fund their IRAs this year than last year and that “62% (believe) their savings are unlikely to provide them with a sizeable retirement nest egg.” With total retirement assets in the U.S. at about $18 trillion, that works out to around $175,000 per worker – nowhere near what will be required.

Two years ago, Roger Lowenstein wrote While America Ages. In the book he suggested that total cumulative retirement deficits are approaching one trillion dollars. Given a recent study by the Stanford Institute for Economic Policy Research, that number must understate the real situation. The Stanford study reviewed the unfunded liability for California’s three largest pension funds – CalPERS, CalSTRS and the University of California’s Retirement System – and determined that those three funds alone were underfunded by more than $500 billion. (The group at Stanford used a discount rate of 4.14% – a rate tied to the Ten-Year – versus discount rates of between 7.5% and 8% used by the three pension giants. Using the higher discount rate, the unfunded liability shrinks to $55 billion, but that discount rate seems extremely aggressive in today’s world.)

An estimated 78 million baby boomers will begin turning 65 in 2011, creating a further pressure on an already over-burdened Social Security System. Two years ago the federal government estimated that by 2017 Social Security would be paying out in benefits more than it was taking in. Four years ago the estimate had been 2019. It is now expected that more money will be paid out this year than the System will collect.

In the mid and late 1940s, the concept of a pension was an agreeable enticement and an attractive amenity for the young who had returned from the War. Society was less mobile than today. Families tended to be larger. And actuaries knew that life expectancy was in the late 60s and early 70s. For the most part pension assets were invested in Treasuries and High Grade Corporates. Typically, the discount rate used was the Ten Year Treasury. Given life expectancy, population growth and the safety of the investments, it was analogous to floating down a gentle stream on a comfortable raft. As the years went on, the current grew swifter. Baby boomers had fewer children and life expectancy increased. Pension managers began to seek higher returns and discount rates became more aggressive – thereby reducing corporate contributions.

By the late 1970s, corporate pension managers and consultants began to realize that future liabilities threatened the viability of their businesses; so they began converting defined benefit programs to defined contribution plans – 410Ks and the like. The onus for saving fell to the individual. But in a world in which consumption (conspicuous or otherwise) trumped savings, millions of aging baby boomers chose to live in the present and let the future take care of itself. Now, they are beginning to realize that the dream of a retirement for millions is turning into a nightmare. Reality is staring them in the face. Those still in defined benefit plans – today almost the exclusive purview of the public sector – risk bankrupting their cities and states. The only answer will be reduced benefits and more years at the wheel, as the price for promises that were easy to make but have proven impossible to keep.

Keeping with the river analogy, we are now in the midst of the rapids and the roar of the falls can be heard above the din of the deniers.

Can something be done? Of course; it will have to be so. Retirement age will be increased. Benefits will be reduced. The President has on staff a number of behavioral economists and he will need them to alter the tax code to discourage consumption and to increase savings. President Obama has done the right thing in establishing a bi-partisan National Commission on Fiscal Responsibility and Reform, headed by Alan Simpson and Erskine Bowles. Their first report is scheduled to be delivered in December, after the mid-term elections, and that is a positive thing, for their recommendations may well be harsh (and should be). In fact, if the Commission takes its mission seriously – and I am sure they will – many of their suggestions will appear draconian. But that is what it will take, if we are to avoid the fate of the Greeks.

The question, from where I sit: will Congress, which has shown a unique proclivity to excuse itself from any responsibility for the credit collapse, also do the right thing and have the courage to implement needed reforms, or will they follow the path of least resistance, a way that leads toward inflation and depreciation of the Dollar?

Tuesday, April 27, 2010

"In Today's World, Does Character Matter?"

Sydney M. Williams

Thought of the Day
“In Today’s World, Does Character Matter?”
April 27, 2010

We live in a world where trades are executed in milliseconds for gains that are unrecognizable without a microscope, yet the participants can make millions, because hundreds of millions are involved. We live in a world in which investment managers can write insurance on investments in which they have no economic interest. We live in a world in which banks trade securities that create no economic value. We live in a world that seemingly has no time for “character” or “judgment”.

We have come a long ways – and perhaps not completely for the better – from a time when John Pierpont Morgan went before the Pujo Committee in 1912. Representative Arsene Pujo (Democrat from Louisiana) was investigating the crash of 1907. The Committee’s counsel, Samuel Untermyer was interviewing Mr. Morgan.

Mr. Untermyer: “Is not credit based primarily upon money or property?”
Mr. Morgan: “No, sir. The first thing is character.”
Mr. Untermyer: “Before money or property?”
Mr. Morgan: “Before money or anything else. Money cannot buy it.”

Goldman Sachs’ executives, led by CEO Lloyd Blankfein, will be marched before Senator Carl Levin’s (Democrat from Michigan) Permanent Subcommittee on Investigations, this morning. The leaking of e-mails prior to the session and Mr. Levin’s comment that Goldman “dumped toxic mortgages into the system” has set the tone. While the purpose allegedly is to determine the root causes of the financial meltdown of 2008, there is little question that the upcoming mid-term elections play a role. Wall Street is a convenient punching bag, and knocking the Street plays well in populist politics. Democrats (who in 2008 extracted twice as much money as Republicans from Wall Street) are anxious to make those same Republicans appear as agents of the monied classes.

There is a second agenda on the part of Democrats in the circus we will all be watching this morning, and Walt Kelly’s Pogo provides a clue. He once declared: “We have met the enemy and he is us!” Mr. Levin may accuse Goldman of “dumping toxic mortgages”, but it begs the question as to who created the mortgages? The answer to that question leads directly to Fannie Mae (FNM) and Freddie Mac (FRE) – sensitive subjects to Democratic leaders, especially Senator Chris Dodd and Representative Barney Frank. It reminds us that, while reform is needed – particularly in terms of increased capital requirements along with greater regulation and visibility in terms of derivatives – reform that excludes FNM and FRE and provides advantages to large banks at the expense of smaller ones is not reform that addresses the root cause of the credit collapse. Like the Health Care Bill, obfuscation appears the hallmark of the new Administration.

While there is little question in my mind that Goldman can be accused of ethical lapses, it seems uncertain as to whether it will be proven that they broke the law. A broker is, after all, a broker. The clients with whom they were dealing were “sophisticated”. Losing money is not an excuse (no more than making money is evil) and does not necessarily warrant restitution. At the time of the trades – in early 2007 – most people were still positive on housing, including, I might add, Fannie Mae and Freddie Mac.

Wall Street firms do gain intelligence, however, from their clients. When a broker acts purely as an agent (as opposed to acting as principal) patterns in customer trading can be detected. Such intelligence is not always accurate, for “smart” clients can make “not-so-smart” trades and “not-so-smart” clients can make “smart” trades. But over time, and particularly applicable to large brokers, such intelligence can be gained and will influence activity. It is natural and inevitable.

So this morning, expect some sparring, but not much contrition, or answers. As in most other endeavors, location is important and Congressional members seated on a dais, looking down at their victims, creates a disadvantage to the witnesses. It is the character and judgment of both inquisitor and those seated before them that we will observe. As well, Congress is expert at destroying reputations and in that regard I am sure they will succeed.

Monday, April 26, 2010

"A Resurgence in the Fight on Hunger and for Clean Water May Yield Opportunities"

Sydney M. Williams

Thought of the Day
“A Resurgence in the Fight on Hunger and for Clean Water May Yield Opportunities”
April 26, 2010

Opportunities often appear in unexpected places. An op-ed in last Thursday’s Wall Street Journal by Timothy Geithner and Bill Gates spoke of the launch of a Global Agricultural and Food Security Program (GAFS). They point out that, in terms of dollars spent as a percent of official development assistance world-wide, spending on agriculture fell by two-thirds over the past twenty years. The Fund was launched on April 22 with an initial funding of $900 million by the Gates Foundation, along with the United States, Canada, Spain and South Korea.

Six months ago an obituary marked the death of Norman Borlaug, an American agronomist who won the Nobel Peace Prize in 1970, who died at the age of 95. Via technology in seed and land use, he was credited with saving more lives – literally millions of them – than any other person. While most hard commodities rose in price during the first quarter, most food commodities declined, so that corn and soybeans are selling about where they were a year ago, whereas wheat sells 25% below where it was at the end of 2008. Fertilizer stocks such as Potash (NYSE: POT) and Mosaic (NYSE: MOS), while up 100% from their March 2009 lows are still 52% and 65% below their 2008 highs. Chemical companies with large ag-chemical businesses, such as Monsanto and DuPont (MON and DD – both rated at Neutral by MCH), have not fared much better, though DuPont has done better than Monsanto. Water companies, such as Veolia Environmental (NYSE:VE), Clean Harbors (NYSE:CLH) and Aqua America (WTR) show chart patterns similar to the fertilizer stocks.

There are just over 6.8 billion people in the world and we add about 75 million annually. It has been estimated that a billion or more of the world’s population are undernourished and that almost half of humanity has difficulty accessing clean water; yet, as Mr. Geithner and Mr. Gates write, only 5% of world-wide development assistance went to agriculture in 2008 versus 18% in 1979.

The decline in assistance is inexplicable, but I suspect in part it is due to an increasing consciousness (and spending) on environmental and climate-related concerns, areas that are more socially popular and have achieved a status of political correctness. Bjorn Lomborg, a controversial Danish academic and environmentalist, in 2001 published a book, The Skeptical Environmentalist. The main thesis of the book is that most claims and predictions on environmental issues have been wrong; the book, as one can imagine, that was not received well in the politically correct, man-created-global-warming world of Al Gore and Michael Moore. Nevertheless, he has written convincingly that most of the impoverished world is far more concerned about clean water and adequate food than the possibility of rising temperatures – whether natural or man made. Certainly, those of us in the developed world cannot forsake climate concerns, but to ignore the food and water problems is to worsen a situation in which it is estimated 24,000 children die every day due to starvation and/or contaminated water.

According to the World Development Report, 23 members of the Development Assistance Committee, the European Commission and non-DAC members spent $121 billion in 2008 on assistance to developing nations, about one quarter of one percent of those countries GDP for 2008. Assuming the Geithner/Gates numbers are correct, it suggests that something like $6 billion went for agricultural purposes. In contrast, over the last 20 years the United States alone has spent $79 billion on policies related to climate change. In 2008, carbon trading reached $126 billion – more than was spent in all global development assistance. Squeaky wheels get grease and very few wheels squeak louder than Al Gore and Michael Moore, both of whom have made millions of dollars personally in their pursuit of addressing man made global warming.

It is not that there are too many people. Malnutrition in the impoverished world is due to the lack of access to technology and irrigation systems that improve per acreage crop yields. For decades Norman Borlaug was worried that the growth in world-wide population would outstrip the ability of the earth to sustain its people. By 2000 he had changed his position: “I now say that the world has the technology – either available or well advanced in the research pipeline – to feed on a sustainable basis a population of 10 billion people. The more pertinent question today is whether farmers will be permitted to use this new technology? While the affluent nations can certainly afford to adopt ultra low-risk positions and pay more for food produced by the so-called ‘organic’ methods, the one billion chronically undernourished people of low income, food-deficit nations cannot.”

The world’s population growth rate has been slowing, as poor countries gradually emerge toward a middle class status. More people means more demand for food, and, as wealth increases, diets improve. So, assuming Mr. Borlaug is correct – and the doomsayers on population have always underestimated the ability of man to adapt – we have half a century to prepare. The Global Agricultural and Food Security Program (GAFS) launched by the Gates Foundation and a handful of countries may well provide a stimulus to help solve the food and water needs of a billion or more people, and that spending should allow for exciting growth in food, water, farming and ag-chemical industries. While more acreage may be tilled, the real opportunity means increased yields. The average African farmer, on a per acre basis, reaps about one fifth that of his American counterpart.

I recognize that I sound dismissive of climate change. I am not. The world’s climate has changed thousands of times over millions of years. It will continue to do so. We should do what we can to limit man’s impact, but with less shrillness and recognizing the costs. The Icelandic volcano that exploded out of the Ejfjalllajokull glacier was a clear manifestation of nature’s power. It is the implicit arrogance of so many in the vanguard of “global warming” that I find off-putting.

Last Friday was the 40th anniversary of Earth Day. While the papers were filled with the continued need to clean our water ways – in fact, there are those in Congress who are seemingly more fixed on removing the word “navigable” from the Navigable Clean Waters Act – but little was written about the plight of millions of underfed people around the world. The GAFS Program, besides being humanitarian, is demonstrable of the recognition of a far greater and more immediate need. It should also serve as a catalyst for an increase in funding to this sector of the economy.

Thursday, April 22, 2010

"An ex-President Stoops Low for Political Mileage"

Sydney M. Williams
Thought of the Day
“An ex-President Stoops Low for Political Mileage”
April 22, 2010

Unbecoming to an ex-President, Bill Clinton wrote an op-ed in Monday’s New York Times – essentially an abridgement of a speech he gave on April 13 before the Center for American Progress, a left wing think tank in Washington, D.C. His subject was appropriate and the timing was correct, but what made it unbecoming were his allusions, omissions and innuendos that were more politically partisan than simply informative.

The op-ed was titled, “What We Learned in Oklahoma City”, and the date the piece appeared was, appropriately, fifteen years following Timothy McVeigh’s deliberate and horrific bombing of the Alfred P. Murrah Federal Building in Oklahoma City, which resulted in the death of 168 people, including 19 children. The piece also appeared, as Mr. Clinton notes, exactly seventeen years after the siege ended on the Branch Davidian compound in Waco, Texas, a siege begun by the Bureau of Alcohol, Tobacco and Firearms (BATF) and carried out by the FBI, who were accompanied by U.S. Army tanks. The siege lasted 51 days and resulted in the fiery deaths of 76 men, women and children, including the leader David Koresh who was killed the first day, on February 28. The Oklahoma bombing was a direct consequence of the Waco massacre.

Mr. Clinton’s op-ed is replete with more hedges than would be known to a Goldman derivatives trader: “Criticism is part of the lifeblood of a democracy;” “No one is right all the time;” “Civic duty can include harsh criticism, protest and even civil disobedience. But not violence or its advocacy. That is the bright line that protects our freedom.” And, in his op-ed, he never specifically referred to the tea party movement, though he did mention it in his speech.

The ex-President wrote that we should never forget that what drove the bombers, in Oklahoma City, was an “ultimate extreme”, an idea advocated by “an increasingly vocal minority.” But he added toward the end of the piece, “We are again dealing with difficulties in a contentious, partisan time.” There is little question that he was alluding to the tea party movement, a focus of concern to Democrats, as we head toward November’s elections. (Of course, if one listens to the tea party people, most incumbents are at risk.)

In Washington, Mr. Clinton spoke of a “sort of fever in America in the early 1990s…a time, like now, of dramatic upheaval.” “…in the decade of the 90’s, and really beginning in the 80’s, there was a run-up of much more demonization of the government and its employees and a whole effort to legitimize violence.” Emmett Tyrrell, in response, wrote on the New York Sun’s website that he recalled no “fever” in the early 1990s. Neither do I. The former President said that by the 1980s “…we began to have the rise in violence from the fringe I suppose you could call it right-wing but it was basically uncritical hatred of the government and beliefs that all taxes were illegitimate.” Again, I am not sure to what he was referring; however, earlier violence resulting from left-wing organizations such as the SDS, or the Weathermen, founded by Bill Ayers and his wife, Bernadine Dohrn (acquaintances of President Obama) and who were involved in bombings in Chicago, New York and Washington, D.C. in the early 1970s, received no mention. Or, what about the reverend Jeremiah Wright, former Pastor of Trinity United Church of Christ in Chicago? Were his words not inflammatory when he shouted from his pulpit, “God damn America!”?

Mr. Clinton properly noted that “we can’t let the debate veer so far into hatred that we lose focus of our common humanity” and that there is “a basic line dividing criticism from violence or its advocacy.” That is an ideal worth seeking, but history is replete with violence from both the right and the left and it is likely those tendencies will persist.

But suggesting that today’s tea party movement has characteristics in common with the Branch Davidians would stretch the imagination of even the most creative Goldman swaps trader. The Branch Davidians, a religious group, descend from Seventh Day Adventists and, as such, are fatalistic, in that they believe there is a forthcoming “final judgment”. The Davidians had very few members, even in 1993 and were very much on the lunatic fringe. The tea party movement, on the other hand, even according to that instrument of impartial reporting, the New York Times, have support from 18% of the American public, according to a CBS/NYT poll. (An AP-GIK poll, conducted at the same time, suggests that 31% of Americans consider themselves supporters of the tea party movement.) No matter which poll is accurate, one can assume that dissatisfaction of Washington is felt by millions of Americans. Moreover a recent New York Times article (April 14, 2010) indicated that “…while Tea Party supporters are more conservative than Republicans on some social issues, they do not want to focus on those issues: about 8 in 10 say they are more concerned with economic issues, as is the general public.” (My italics.)

Moreover, the article had some revealing general observations – more than 50% of the public feels Mr. Obama is moving the Country toward socialism and 60% of the public think the Country is headed in the wrong direction. Personally, I disagree with the tea party movement on social issues like immigration and their emphasis on religion, but I agree with them on most of their fiscal preferences and in their desire for less intrusive government. And, as I wrote yesterday, there are a lot of people living on fixed income who are distraught with low yields, the prospect of higher taxes and curtailments to Medicare. They feel isolated, in our politically-correct world.

In attempting to trivialize the tea party as a “fringe element” movement, Mr. Clinton comes across as a political hack, spouting political balderdash, and not as a serious, senior statesman standing above the fray, the proper role for ex-Presidents.

………………………………………………………………………..

On Friday I will be attending an important, non-financial meeting in Greenwich – grandparent’s day at Julian Curtis.

Wednesday, April 21, 2010

"Short Rates - A Boon for Borrowers, A BUst for Savers"

Sydney M. Williams

Thought of the Day
“Short Rates – A Boon for Borrowers, A Bust for Savers”
April 21, 2010

Janus was an ancient Roman god, noted for his two faces, one looking toward the future, the other facing the past. He has, one might argue, a duplicitous personality – giving to one party while taking from a second. Something Janus-like is going on in the short term interest rate market. Borrowers, especially banks, have benefitted enormously from low rates. Whether it is payments on customer’s deposits, CD’s, or borrowings from the Federal Reserve, bank liabilities have been noted for their low rates and the concomitant interest income they can earn while taking very little risk.

The results have been spectacular. From facing extinction eighteen months ago, just four banks – Citigroup, Goldman Sachs, Bank of America and JP Morgan Chase – generated about $14 billion in the first quarter. The loser, the flip side of this Janus, has been the saver – mostly elderly and retired. They, as much as the government, are funding the enormous profits being made by traders on Wall Street, and getting very little in return.

Banks are in liability Heaven. Money market rates are de minimis. Member banks can borrow from the Federal Reserve at 75 basis points (0.75%); one-year CD’s pay about 1.5%; savings accounts pay around 1.0%. Interest bearing checking accounts pay 10 to 20 basis points. This cheap money can be invested in Five-Year Treasuries and earn 2.5%. It can be put out to earn 3.25% at prime, though most loans are prime plus. A fifteen year mortgage will return 4.4% and a home equity loan 4.6%, for someone with excellent credit. With borrowing costs so low, especially in comparison to Treasuries, banks can generate attractive returns while taking very little risk.

But savers are in income Hell. There are about $7.5 trillion in short term deposits – interest bearing checking accounts, saving accounts and CD’s. Middle class retirees, who often rely on income from savings to augment Social Security and pension benefits, have suffered significant declines in income. For example, a CD which earned 5.5% in December 2006, pays 1.5% today –a 75% drop in income. Little is written about the plight of these savers, but they have been the unsung heroes of this crisis – lending money for little return and no words of appreciation. The President speaks of the risks taxpayers assumed in guaranteeing loans to the banks a year and a half ago, but he has been silent on the matter of those millions of seniors who rely on interest from savings. A steep yield curve suggests banks do not have to make riskier loans, but the opposite is true for savers. The low payments they receive means, to supplement their meager returns, they have to take on more risk – again the reverse of what should be happening, the elderly assuming risk, while the young and strong were able to reduce risk, though we know that is not what they have done.

The collapse we faced in the fall of 2008 was unprecedented. The Federal Reserve and the Treasury from both administrations deserve credit for saving the financial system. We did not collapse, banks survived (or most did) and the economy is now in its third quarter of recovery.

No one doubts the importance of keeping the recovery going. No one wants the economy to slide into a double-dip recession. But the plight of savers deserves more attention than it has received. On December 16, 2008 the Federal Reserve lowered Fed Funds to a range of 0.0% to 0.25% and the Discount Rate to 50 basis points. On February 18, 2010 the Fed did raise the Discount Rate to 75 basis points, but it has kept Fed Funds at the same level for sixteen months, despite noticeable improvement in both credit markets and the economy. Mr. Bernanke’s greatest fear is the possibility of deflation, similar to that which ripped through our economy during the 1930s and something none of us want to revisit. But the problem is that much of the low cost money has gone to fund speculative bets at bank trading firms, generating returns that benefit a few with extravagant bonuses. And the concern of savers is that their income has dwindled, as they read of these Wall Street traders making enormous profits; their taxes are rising, their Medicare benefits are scheduled to be reduced and huge Federal deficits risk rising inflation, further demeaning their savings.

Much has been written about transfers of wealth – in inheritance from one generation to another, from tax payers to recipients of government’s largesse, but this has been perhaps the largest transfer of wealth on record – certainly the least recognized.

Tuesday, April 20, 2010

"Is the Market's Non-reaction to the Goldman News Sending a Message?"

Sydney M. Williams

Thought of the Day
“Is the Market’s Non-reaction to the Goldman News Sending a Message?”
April 20, 2010

As fascinating as all the commentary has been on Goldman’s alleged commitment of fraud – which has quickly become overanalyzed – has been the reaction of the financial markets, or, rather, the lack of reaction. It could be, since the SEC was divided along Party lines in bringing the charge, that investors expect the charge will fail. Or it could be that investors are simply comatose; perhaps they have become so inured to the nefarious behavior of those on Wall Street that they feel there will be no lasting consequences – that the alleged perpetrators will remain in their Park Avenue apartments and Greenwich homes untouched by the financial pain inflicted on their “innocent lamb-like” customer. (I recognize that is a gross hyperbole – most institutional investors are not victims. They are savvy and do their homework; the phrase is used to make a point.)

Despite the Goldman news, the Dow Jones closed down only 126 points, or 1.13%, on Friday. The last time the DJIA closed down more than 1.5% was February 4th. The last time those averages closed up or down more than 1.5% was February 16th. Volume and volatility have been declining for months. The VIX between February 16 and last Thursday declined 28.6%. It rallied 15.5% on Friday, but sold off 5.6% on Monday. Volume on the NYSE spiked to its third highest level of the year on Friday, but on Monday returned to the somnambulism which has increasingly come to characterize the Exchange.

Not only did we have the Goldman news on Friday, but we had the eruption of a volcano in Iceland, which lies under the unpronounceable Ejfjalllajokull glacier. That blow-out has caused the cancellation of 81,000 flights and the loss of millions, if not billions, of dollars for exporters around the world and devastating for a Europe struggling with recovery. China, an increasingly critical global participant, over the weekend took steps to cool a surging residential real estate market by raising rates and limiting capital. On Monday, the markets yawned. (China didn’t, but Europe and the United States did.)

Treasuries gained on Friday, as fear gripped markets, but then sold off yesterday, as fear dissipated. Gold, normally a commodity investors rush to in times of peril, declined on Friday and continued its modest sell-off on Monday. The Dollar has been a modest beneficiary of recent news.

A consequence of the Goldman news will likely be a hastening of increased financial regulation, but instead of scaring markets, as such news historically would have done, they seem to be comfortable with the concept of more regulation – an opinion with which I am in agreement.

Economically, things continue to improve and whatever the ultimate decision about Goldman it will have little impact on the economy. Keep in mind, the growth of the financial services industry over the past couple of decades, with its proliferation of myriad derivative products, outstripped the real economy. In other words, a substantial portion of the debt created by Wall Street – the reported $450 trillion in notional value of derivatives – did very little to augment real, lasting economic value. A downsizing of those products and markets will have little long term economic impact, except to those immediately affected.

An old adage says, never short a dull market and this market certainly qualifies for that adjective. But investors would be wise to remain alert that dullness does not become complacency. It is not where we are at this time, in my opinion, for skepticism persists, but one should be vigilant. There are other risks out there. Federal debt and the Federal deficit, relative to GDP, are at levels not seen since World War II; the risk of reflation cannot be dismissed. Fed Chairman, Ben Bernanke, a student of the Depression will do everything to avoid deflation (as well he should), so the risk, in my opinion, becomes one of inflation. Growth in deficits will lead inexorably to rising taxes. There is a (unquantifiable) political risk of Congress relinquishing power of the purse strings to the Executive branch.

Treasuries and Investment Grade Corporates provide very little return should the Fed misread the strength of the economy and inflation returns. Value stocks with low P/Es and decent dividends look attractive. Increasingly, I am being told that cash makes no sense, as it returns nothing, but neither does it lose value – except in an inflationary environment – and it permits opportunity. Risk always lurks, usually in dark corners, as some Goldman clients discovered to their dismay; so the watchwords to heed are caveat emptor.

Monday, April 19, 2010

"Fraud Charge Against Goldman - The First in a Series? Was the Timing Coincidental?"

Sydney M. Williams

Thought of the Day
“Fraud Charge Against Goldman – The first in a Series? Was the Timing Coincidental?”
April 19, 2010

Whether Goldman and its executives get indicted and/or convicted of fraud remains to be seen, but there is little question in my mind that what they did – illegal or not – was certainly unethical. At the same time, the timing of the accusations was no coincidence, again, in my opinion.

The President and Democrats in the Senate are trying to push through Senator Chris Dodd’s Wall Street Reform Bill, a bill about which Main Street should have serious reservations, as it appears to do very little to prevent a repeat of what created the mess in the first place. Wall Street, it should not be forgotten, serves Democrats in two ways. First, it is an attractive target as a symbol of wealth, greed and corruption. Second, when they doff their populist hat, it is a source of substantial funding for Democratic coffers. By day, they attack the malignancy of banks and all they stand for; by night, they return, palms outstretched furtively soliciting and pocketing dollars. (To be fair, Republicans do the same, but it is the Democrats who are now in charge.)

The events that led to the fraud charges against Goldman, as I understand them, are as follows:

1) In late 2006, John Paulson, manager of the eponymous hedge fund, was looking for ways to short what he determined to be an overheated housing market.

2) Mr. Paulson approached Goldman Sachs (and likely other firms) with the idea of creating a collateralized debt obligation (CDO) comprised of residential mortgage backed securities (RMBS) that he would select based on his research, which suggested a likelihood they would be downgraded by the rating agencies.

3) Goldman agreed, for a fee, to create such a structure using the RMBS that Paulson selected.

4) Goldman named the CDO Abacus 2007-ACI, and agreed to sell it to institutional investors, allegedly without disclosing that Mr. Paulson had selected the RMBS or that he would be betting against those same securities. (Saturday’s New York Times reports that Abacus 2007-ACI was one of 25 such vehicles.)

5) Once the mortgage securities had been bought, Goldman then hired ACA Management, a well known manager of CDOs and a financial insurance provider, to manage the vehicle. A second allegation is that Goldman did not disclose to ACA Mr. Paulson’s role in selecting the RMBS, nor his intent to bet against the CDO.

6) Once the CDO had been created, Mr. Paulson then purchased through Goldman Sachs a credit default swap (CDS), betting that the mortgages, now owned by Abacus 2007-ACI, would decline in value, and some, if not all, would in fact default.

7) Goldman was paid $15 million for structuring the CDO and marketing it to their clients. (They have alleged that, in fact, they lost a total of $90 million on the whole deal, but I say, “so what”.)

8) A few months later the mortgage business imploded; Goldman’s clients purportedly lost $1 billion, while Paulson & Co., also a Goldman client, pocketed a similar amount.

No one can predict the ultimate legal outcome, but certainly the allegations do not place Goldman in a favorable light. And, while no one can predict if this is the first in a series, certainly I don’t believe it was the only such incident. Once the camel gets his nose under the tent, the rest of him generally follows and that holds true for the S.E.C. While there is an instinctive reaction among many Americans to view unfavorably anyone who bets against something as American as home and hearth, Mr. Paulson, it would appear, earned what he made by being right on an over-heated market and in his willingness to make the bet. Short sellers, often vilified, in fact serve as a governor on run-away speculators – the canary in the coal mine, if you will. (It is also important to remember that in late 2006 most investors did not believe that we were on the precipice of a residential real estate collapse.

Despite SEC spokesman, John Nester, saying (according to Saturday’s New York Times) that the timing of the charges filed against Goldman were unrelated to the finance reform under discussion, I find myself agreeing with an observation of Elie Wiesel. What he said about Jewish history, “that there are no coincidences”, also holds true for Washington politics. Whatever the coincidence, though, there is little question that the President will use the negative publicity surrounding Goldman’s behavior to push for reform. And I, for one, am in favor of reform, as I have written on numerous occasions.

While it is impossible to anticipate the next crisis – Wall Street traders and analysts are nothing if not clever – it does make sense to correct those factors that abetted the last, and that includes relegating most derivative trading to exchanges, ensuring that credit default swaps be treated as the insurance they are and that sun shines in on products such as CDOs, so that buyers have a clearer perspective of what they own, or may be considering. Off balance sheet items should be moved on to balance sheets, and leverage, for deposit taking institutions, should be limited to a more reasonable ten or twelve times. Officers and directors of banks and financial firms should be held personally and financially liable. In my opinion, certain to be opposed by many on the Street, proprietary trading desks should be spun off from desks dedicated to customer business, ala the Volker Plan. Certainly banks should be able to hedge customer orders and be able to take what remedial action may be deemed necessary to protect their assets and that of their clients, but putting their own account ahead of a client’s should be prohibited. And, if a bank is too big, it is too big. It was heartening to read, for example, that Victor Pandit of Citigroup no longer feels that his bank should be a “supermarket” within the financial industry.

The ridiculous notion, put forward by Democrats, that a $50 billion fund should be set up – paid for by banks and managed by the Federal Reserve – is akin to hiding an old hag beneath a flimsy nightgown. (Apparently, the President has nixed this recommendation of Senator Dodd’s.) Keep in mind that the recent crisis caused a commitment on the part of government for an amount measured in trillions, not billions of dollars. Senator McConnell may not be correct that such a fund would not only permit “taxpayer funded bailouts, but actually encourage them”, but he is right that such a proposal would be favored by banks and diverts attention from the more stringent recommendations of the Volcker Plan, which would separate commercial and investment banking functions from proprietary trading operations. Excluding Fannie Mae and Freddie Mac from any such bill seems absurd, given the role they played in the collapse.

The protestations of the banks against such proposals, reminds me of the story from Uncle Remus: You will remember Brer Rabbit had been caught by Brer Fox, who wanted to do him harm, “please, Brer Fox, don’t fling me in dat brier-patch.” So Brother Fox threw him into the brier-patch, which is where Brother Rabbit had been born and where he wanted to go in the first place.

I believe the President is right when it comes to demanding full disclosure on derivative instruments and the manner in which they are traded, but be wary of any bill in which the devil is in the details – and Senator Dodd’s, at 1336 pages long, has enough room to harbor a lot of details and a lot of devils. As I wrote last week, I believe there is a deliberate attempt on the part of both parties to not collaborate – they both feel it is in their best interest. That may be so, but it is not in the Country’s.

The events of last Friday may provide the catalyst the market needs to get a well-earned respite after its thirteen-month, 79% rise, but I doubt that it does much to derail the economy or the longer term market outlook.

Friday, April 16, 2010

"Value Stocks - Increasingly Attractive", "A Letter from Ahmadinejad to Obama", "Finally, A Sensible Answer to the Budget Crisis"

Sydney M. Williams
Thought of the Day
“Value Stocks – Increasingly Attractive”
”A Letter from Ahmadinejad to Obama”
“Finally, a Sensible Answer to the Budget Crisis”
April 16, 2010

That the economy is improving is increasingly becoming conventional wisdom. Fed Chairman alluded to that fact in recent testimony. His words were echoed by Janet Yellen, President of the San Francisco Fed and recent nominee to become Vice Chairman in a speech yesterday. Thus far, the Fed has maintained a posture of keeping Fed Funds between 0 and 0.25%. In her speech yesterday, Ms. Yellen said, “overall financial conditions have improved substantially.” She added that she agrees with the Fed’s accommodative policy, due to the economy continuing to operate below its potential, subdued inflation and persistent high unemployment. But she did say that she feels the economy will continue to accelerate over the balance of this year and through 2011. She added, toward the end of her speech: “At some point though, as the economy continues to expand, the Fed will have to pull back some of this extraordinary stimulus.”

Byron Wien, in his Market Commentary, agrees: “The Federal reserve may respond to the renewed strength of the economy and begin to tighten.” He also points out that our, “borrowing needs are huge [and] our savings rate is low”, suggesting higher rates may be necessary to attract investors.

An improving economy, with bond prices looking relatively less attractive, should be positive for stocks, especially for those in the “value” category. According to a recent note from Jim Cullen of Schafer-Cullen, thus far in the thirteen-month rally, companies with earnings have underperformed those without and the bottom 20% of stocks based on P/E ratios have underperformed those with higher P/Es. In his note, “Time for Value?”, Jim also points out that the earnings yield on the 20% of stocks with the lowest P/E is now 8%. And that premium over the Ten-Year Treasury has only been higher two times in the past seventy years. A similar argument was made at a recent portfolio manager dinner in Boston.

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In a front page article yesterday, the New York Times headlined a story, “Obama Speech Signals a U.S. Shift on Middle East”. Their argument is that events in the Middle East are interconnected and that our travails in Iraq and Afghanistan, and the growing risk of a nuclear Iran, are creating a fissure in relations between the U.S. and Israel. In referring to the impasse in negotiations, Mr. Obama said they “create an environment that [contributes] if you will to the overall environment within we operate.”

On Wednesday, Stratfor reported that Iranian President Ahmadinejad is sending a letter to President Obama suggesting that only an understanding with the Iranians will allow the U.S. to achieve its goals in Iraq, Afghanistan, the Palestinian question and Iran’s nuclear ambitions. Stratfor does not totally dismiss this communication as the ravings of a madman and points out the comparison of Richard Nixon and China in 1972 – the visit of a notorious anti-communist to the cradle of communism. It is an attempt by Mr. Ahmadinejad, in the words of Stratfor, “to use American weakness to its advantage.” The odds are that the note will be ignored, but no one can doubt the complexity of the problem and it is worth watching.

In the past, we have made compacts with the devil. In my opinion, the more apt analogy would be the decision of Churchill and Roosevelt to enlist Joseph Stalin as a partner/ally in the bid to defeat Hitler. Hitler was defeated and Nazism died, thank God. But the price paid included the lives of millions of Eastern Europeans, as well as the enslavement of the survivors for two generations. Any agreement with Ahmadinejad would extract an even higher price.

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In what is probably America’s best newspaper, The Onion, the headline in this week’s issue read, “U.S. Government To Save Billions By Cutting Wasteful Senator Program”. The article points out that last year $450 billion was “funneled into the chamber, an amount considered fiscally unsound considering how few citizens actually benefit from its existence.” The reaction so far, to the concept of eliminating that august body, “has been overwhelmingly positive.”

It is amazing that it takes “America’s Finest News Source” to come up with the first practical suggestion for reducing the budget deficit.

Thursday, April 15, 2010

"Financial Regulation - Less Sniping and More Common Sense"

Sydney M. Williams

Thought of the Day
“Financial Regulation – Less Sniping and More Common Sense”
April 15, 2010

I was in Boston last night, so apologize for the tardiness of this note.

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Why is it that Washington and common sense are mutually exclusive? Yesterday the President had House and Senate leaders to the White House for a meeting to discuss the proposed financial regulation bill. The talks, as the Financial Times reports today, are a result of a pledge President Obama made in his State of the Union to hold more bipartisan meetings. Today’s New York Times reported: “Mr. Obama urged Congressional leaders to reach a bipartisan deal. But Mr. Obama also pushed back forcefully against Republican criticism.” Those observations lend credence to Daniel Henninger’s characterization of the President in today’s Wall Street Journal: “Mr. Obama by instinct is a man of feints. He finds value in seeming to be ‘open’ to any point of view, proposal or fix.” But “seeming” open and being open are two different things.

Meanwhile, as the Parties snipe at one another, reminiscent of school children at recess, Wall Street and Washington have returned to their old ways; the environment that created the crisis goes unchecked. By excluding Republicans from the proceedings the Democrats can make them the Party of “no”. Republicans, in refusing to negotiate, attempt to make the Democrats appear to be the Party that railroads through legislation. The public is getting fed up with them all.

The legislation concerns banks that abetted the crisis and are deemed “too big to fail.” Among the proposals would be the establishment of a $50 billion fund to “essentially dismantle companies that are so big their failure would endanger the economy.” Republicans think such a fund would encourage bailouts. Democrats feel such a fund would be prudent. Common sense suggests such a fund is OK, but that first officers and directors must be held financially accountable and personally liable. One is always more careful with his own money than with that of a stranger.

Democrats feel that swaps should no longer be permitted to be traded by banks. Republicans disagree. Common Sense suggests swaps – particularly credit default swaps, which are really insurance – be regulated as an insurance product and that the size of an issue should not exceed the nominal value of the underlying security. Who trades them is less important than regulation.

Senator Chris Dodd, an important factor in encouraging mortgage lending to those with limited or no means (and who has never explained his close ties to the disgraced former chairman, Angelo Mozilo, of Countrywide Credit) chose to denounce Senator McConnell’s criticism in what the New York Times described as “an angry floor speech” – no mea culpa from Connecticut’s senior Senator!

What is needed is a system that encourages entrepreneurial activity and intelligent risk taking, but without putting at risk depositors, shareholders or tax payers. Officers and directors should be held personally liable. Commercial banks should maintain a reasonable level of leverage, of ten to twelve times. They should not be permitted to trade against their customers, except for purposes of hedging. Commercial banks should consider spinning off their proprietary trading desks, perhaps to private partnerships. Private partnerships, it should be recalled, are the progenitors of today’s global banks and were more prudent when it came to speculating with their capital, because the money they risked belonged personally to them and they were each individually held liable for losses. We need regulators who regulate and Congressional members who take responsibility for their policies. The latter is probably never possible, but it should be.

Jamie Dimon, chairman of JP Morgan Chase, is right; increased regulation is a “punitive” tax, but one well worth paying for providing protection to investors and shareholders. And he doesn’t have to worry. He will pass on all costs to his depositors and shareholders. He and his employees will do just fine with tightened rules. Big egos, political infighting and the desire to make history are natural to those who serve in Washington, but those characteristics often stand in the way of doing what is right. Treasury Secretary Geithner said that he was confident the bill would be approved. “This is going to be the most sweeping legislation since those put in place after the Great Depression.” While I believe he meant during the Great Depression, it is not soaring rhetoric or historic legislation that is needed, as much as common sense solutions to problems obvious to the majority of Americans.

Wednesday, April 14, 2010

"The Nuclear Summit - A Step Forward - I Hope"

Sydney M. Williams

Thought of the Day
“The Nuclear Summit – A Step Forward – I Hope”
April 14, 2010

According to Richard Burt, former Ambassador to Germany and State Department official, writing in yesterday’s Wall Street Journal, President Obama has not abandoned “his long-term goal of Global Zero: the elimination of all nuclear weapons world-wide.” Others, like James Schlesinger, disagree. “The Nuclear Posture Review indicates that a sizable nuclear deterrent will remain essential for the foreseeable future.” Certainly, the goal of a nuclear-free world is, to borrow a line from Hamlet, “a consummation devoutly to be wished.” But, in my opinion, it is a wish born in naïveté and unlikely to be realized.

The President is correct when he suggests that the single greatest threat to our – and the world’s – security is the possibility of nuclear weapons falling into the hands of terrorists. He said, “…the risk of a nuclear confrontation between nations has gone down, but the risk of a nuclear attack has gone up.” That may be true, but try telling that to Israel, a country that lives with the very real threat of a nuclear empowered Iran. Ironically, the summit did not touch on the two most combustible nations, Iran and North Korea. Instead a non-binding agreement was signed to secure prescribed amounts of nuclear material or convert nuclear reactors that use highly enriched uranium to less dangerous fuel. Additionally, specific agreements were made with Vietnam, Ukraine, Mexico, Chile and that hot-bed of terrorism, Canada.

The Bush administration sat back and let North Korea achieve nuclear capability. To let that happen a second time in Iran brings to mind that old saying, “trick me once, shame on you, trick me twice, shame on me.”

For sixty-five years the world has lived with nuclear weapons. During the first ten or fifteen years we built bomb shelters to save us at home, while at school we had drills requiring us to hide under our desks, in what would have proven a vain attempt to escape a nuclear holocaust. However, the Cold War did have the positive effect of maintaining a balance. The leaders of each side kept their respective allies/satellites in check. We learned to live with the concept of deterrence. An unanticipated effect of the fall of the Soviet Union has been the greater threat of proliferation, as former Soviet satellite nations have decided to go for the bomb – countries like North Korea.

It is a different world and the President is right in recognizing that a changed environment requires different policies. But the power of deterrence was and is powerful and should not be forsworn. And, as important are defense systems, including missile defense. Establishing such a shield is in the interest of all parties, including Russia. There is little question that both Putin and Russia are interested in re-claiming land lost as the Soviet empire disintegrated. Eastern Europeans want the missile defense shields as much against a resurgent Russia as against a possible nuclear empowered Iran, and Russia knows that. (The recent death in an air crash inside Russia of the President of Poland, Lech Kaczynski, and 96 other Polish officials is providing Mr. Putin, according to Stratfor, a rare opportunity to express sympathy for a man noted for his anti Russian feelings.)

World War I cost 20 million lives and after the war, in January 1919, Woodrow Wilson went to Paris to sign the Treaty of Versailles and promote his dream for a League of Nations, so that the war just concluded would have been “the war to end all wars.” It was the right dream, but it was only a dream and did not take into consideration the natural behavior of man. The concept of a world without nuclear weapons is also, unfortunately, only a dream and success in deterrence requires a level of cynicism that man is also driven by greed and a desire for power.

The immediate problem we face is Iran and the disruption to the Middle East, and in fact the entire world, that their successful development of a bomb would bring. Mr. Obama is hoping that his signing of an arms reduction with Russia last week and the attention this summit brings will strengthen his hand at the U.N., as he asks, once again, for sanctions. He feels, I suspect, somewhat like Stuart Little, as the eponymous book ends: “But the sky was bright, and somehow he felt he was headed in the right direction.” I hope he is, and that he finds his version of Margalo.

Tuesday, April 13, 2010

"Bonds - Is The End of Their Rally in Sight?"

Sydney M. Williams

Thought of the Day
“Bonds – Is The End of their Rally in Sight?”
April 13, 2010

As investor despair deepens, the rush to safety intensifies. As despair dissipates, investors reverse course and assume more risk. This has been our experience over the past two years. 2008, which will be long remembered as the year credit markets collapsed, 2009 as the year of redemption. As problems intensified, Treasuries rose in price, with the yield on the Ten-Year declining form 4.04% to 2.24% over the course of 2008. During that year, the yield on the Bloomberg-FINRA Index High Yield Bonds rose from 10.45% to 17.43%. The S&P 500 was down 38.5%. It is the behavior of investors that can be seen in these numbers.

The nadir of the 2008 crisis occurred between Sunday, September 7 when the government took control of Fannie Mae and Freddie Mac and Monday, October 13 when revisions to TARP prompted a huge intraday rally – the DJIA rose 11.08%. On Friday October 10 the TED Spread (the spread between 3-month LIBOR and 3-month T-Bills) widened to 460 basis points, versus a pre-crisis level of around 50 basis points. (Today that spread is 12 basis points.) It is unsurprising, then, that the U.S. Treasuries along with gold and the Dollar were the only asset categories to enjoy gains in 2008.

Investor preferences reversed in 2009. In fact, investor’s behavior, mirrored in markets, had already begun to change in the final weeks of 2008. On November 18 of that year, in my TOTD, I wrote that LIBOR was “261 basis points lower than it had been on October 10th.” Corporate bonds, both Investment Grade and High-Yield, troughed in November of 2008 and actually showed positive returns for the 4th Quarter of 2008. In contrast, all stock indices continued to decline and, as we all know, did so until March 9. Despite money still flowing to Treasuries, the natural forces of a willingness to increase risk was already apparent in the corporate bond market. Markets had already assumed that the credit crisis was being resolved and we were left dealing with its aftermath – a severe recession, typically a deflationary event.

2009 saw the Ten-Year Treasury decline in price, as the yield rose from 2.24% to 3.84%. Gold continued to rally, but the Dollar fell. The positive trend in corporate bonds continued throughout the year, so that by the end of 2009 Investment Grade Corporates, at 5.07%, were yielding less than they had been before the crisis began in July 2007. Today, the spread between Investment Grade Corporates, at 105 basis points, is less than it was on June 30, 2007, a remarkable turn of events and an indicator of a willingness to assume more risk. Investment Grade Bonds have continued to rally into 2010, yesterday yielding 4.88%. As well, and even more dramatically, High-Yield Corporates rallied in 2009 with the yield declining from 17.43% at the end of 2008 to 9.57% at the end of 2009 and 8.46% today, below the yield of 8.51% these bonds sold at on June 30, 2007.

The rise in bond prices has been accompanied by strong flows into bond mutual funds and ETFs. (Stock mutual funds, in contrast, experienced outflows throughout 2009 and have only turned positive in the past two months.)

A corollary of the decline in yields has been an improvement in corporate balance sheets. The improvement in balance sheets, obviously, has more to do with reductions in employment, increases in outsourcing and enhancements to technology, but every bit helps. Zach Karabell, former President of Fred Alger and President of River Twice Research, points out in a recent piece in the Wall Street Journal that corporate balance sheets have about $2 trillion in cash – funds that could be used for, among other purposes, mergers and acquisitions. Reflecting this improvement in balance sheets, along with better than expected earnings, investors continue to extend out the risk continuum. Stocks have rallied 79% since the March 2009 lows, but they remain, unlike their bond cousins, 20% below their June 30, 2007 level; in fact, the S&P 500 is still 5% below where it was when Lehman filed for bankruptcy.

There are two ways to make money in bonds. One, you simply collect and reinvest the coupon, hoping that inflation remains below the interest rate level to provide a reasonable return. Second, one can make a bet that inflation will decline and the price of the bond will appreciate, giving the owner a capital gain along with the coupon. In a deflationary environment, secured bonds will provide attractive returns, though one must be particularly wary of credit risk as deflation and recession are often bed partners.

In the first quarter of 2010, domestic general stock funds outperformed general bond funds by a factor of almost two to one. Yet flows into bond mutual funds were more than double the level into stock funds. It suggests to me that, going forward, flows into stock funds are likely to exceed those going into bond funds. This is not an argument to suggest stocks are cheap, but only that they look more reasonably priced than bonds, especially those companies with attractive balance sheets and with the prospect of increasing dividends.

Bonds become less attractive, as Bill Gross makes clear in his April “Investment Outlook”, during periods of rising rates and ultimately higher inflation. The conundrum for investors is that draconian reductions in government spending may be necessary in order to reduce deficits that threaten to choke growth. The last time we went through such a period was in the early 1980s when the Federal Reserve, with the compliance of the Reagan administration, induced a recession by raising rates dramatically in order to kill inflation. The question becomes, does the current administration have the will to reduce spending in such a forceful manner to bring fiscal sanity back to Washington? Given the insatiable appetite to spend, it is difficult to answer in the affirmative.

Monday, April 12, 2010

"The Angelides Commission - A Mea Culpa from Congress - Don't Bet On It"

Sydney M. Williams

Thought of the Day
“The Angelides Commission – A Mea Culpa from Congress – Don’t Bet On It”
April 12, 2010

Who will regulate the regulators? The Angelides Commission (the Financial Crisis Inquiries Commission) threatens to provide cover for the role Congress played in the downfall of Fannie Mae (FNM) and Freddie Mac (FRE) and the $126 billion of tax payer money those two enterprises have consumed, since entering receivership on September 7, 2008. It raises the ageless question posed by the Roman poet, Juvenal, 2000 years ago: “Quis custodiet ipsos custodes?” (“Who will watch the watchmen?”)

The financial meltdown of late 2008 has many parents – consumers caught up in rising home prices, shady mortgage and real estate brokers, bankers greedy for fees and trading profits, rating agencies who put fees ahead of responsibility and Washington politicians who implemented policy initiatives without regard to financial costs. Consumers have paid dearly. Home prices have declined and millions of homes seized. Jobs have been lost. Shareholders have paid dearly with banks like Lehman disappearing and Merrill and Bear Stearns sold for a fraction of what they had sold at months earlier, and dividends eliminated or reduced by those that survived. While a few traders on Wall Street continue to make millions, a far greater number have lost their jobs. The rating agencies are chastened but remain conflicted, and have become far quicker to downgrade most any piece of paper. But those in Washington, both members of HUD (Department of Housing and Urban Development) and Congress who had the job of regulating and overseeing the two agencies continue unrepentant.

In 2000, HUD mandated that half the mortgage portfolios of FNM and FRE should comprise high-risk, low-income loans. These “affirmative action” credit quotas were raised even higher during the Bush administration. According to Investor’s Business Daily, Commission member and former Reagan Treasury official, Peter Wallinson commented this past week: “HUD was pressing you to continue to make more investments in these affordable housing loans.”

While the former head of the Office of Federal Housing Enterprise Oversight (OFHEO), the agency with direct responsibility for FNM and FRE (1999-2005), Armando Falcon, Jr., made a compelling case in testimony before the Commission that the collapse was “clearly a failure of management and reflected a deeply rooted culture of arrogance and greed”, there is little question that the relationship with Congress was symbiotic. In 2004 hearings before a Congressional Committee, Connecticut Congressman, Chris Shays stated that the two G.S.E.’s not only hired lobbyists to work on their behalf, but they paid others to not lobby against them.

James Lockhart, Director of OFHEO at the time of the collapse of FNM and FRE, in testimony before the Commission, said, as quoted in the New York Times, “that heavy spending (lobbying members of Congress) by the two mortgage companies allowed them to head off most Congressional attempts to raise their capital requirements.” “The G.S.E.’s structure allowed them to be so politically strong that they resisted the very legislation that might have saved them.” In 2004, Republican attempts to reform FNM and FRE and to punish Franklin Raines, Chairman of FNM failed: at the 2004 hearings, Representative Frank Barney, “There is nothing wrong;” Representative Maxine Waters, “We do not have a crisis” and “Our goal of 100% loans has been reached;” Representative Gregory Meeks, “I’m pissed off! There is nothing wrong.” Franklin Raines, between 1998 and his resignation in 2003 received $90 million in compensation for his role as CEO of Fannie Mae, more than half of which was in bonuses that were based upon falsified earnings reports. The Washington Post, headlined a story on May 24, 2006, “Study Finds Extensive Fraud at Fannie Mae.” Two years later, on April 18, 2008, Mr. Raines admitted to accounting fraud during his tenure at FNM and paid a multi million dollar fine, though far less than what he received from taxpayers.

The last CEO of Fannie Mae, before going into receivership, Daniel Mudd, tried, in testimony before the Commission to delineate the inherent conflict between meeting financial goals and attracting capital while, at the same time, adhering to his Congressional mandate. We had, he said, “to maintain a fine balance between financial goals and what we called mission goals.” Mission goals were designed to broaden the homeownership class, by requiring little or no down payment and permitting low-doc or no-doc mortgages.

What they did, instead, was to destroy the dreams of millions of homeowners and nearly bring down the financial system.

While both Fannie Mae and Freddie Mac carry plenty of guilt and their managers deserve the fines and beratings they have received, they had accomplices in Congress and within the last two administrations that, for payments to PACs friendly to their re-election bids, were willing to overlook responsibility to the electorate. Mr. Falcon wrapped up his testimony: “A publicly traded and privately chartered firm does not work.” Peggy Noonan, in the weekend edition of the Wall Street Journal, commenting on the Commissions efforts last week, wrote: “In fact they weren’t dramatic but a tepid affair, gentle and genteel.” Perhaps that was so because the Commission is congressionally appointed, and concerns that a quest for the truth might lead back to Congress. Is there any wonder that the focus thus far has been on management and their immediate regulator, not their overseers in Congress? Is it any wonder that the people of this country have become so cynical about those who supposedly represent them in Washington? Even before Juvenal, Socrates had asked the same question: who will watch the watchmen? The question hangs over us.

Friday, April 9, 2010

"Debt Bomb Looms - Is a VAT in our Future?"

Sydney M. Williams

Thought of the Day
“Debt Bomb Looms – Is a VAT in our Future?”
April 9, 2010

Gregory Mankiw, Professor of Economics at Harvard and former Chairman of the Council of Economic Advisors under President Bush, wrote in the February 14, 2010 issue of the New York Times: “From 2005 to 2007…budget deficits…averaged less than 2% of GDP.” Those numbers were within the norm for the last forty years. An estimated $1.6 trillion deficit, forecast for 2010, would proximate 10.6% of GDP, the highest level since 1945 – and frighteningly close to Greece’s 12.8% deficit. (The previous post-War peak for the U.S. deficit, as a percent of the budget, was during Reagan’s defense build-up in the 1980s when it peaked at 5.03% in 1985.)

We know “a crisis being a terrible thing to waste” implied an excuse to expand the role of government and to add entitlements. The answer to the looming “debt bomb” will be taxes, not fiscal restraint. Income taxes will rise next year when the Bush cuts expire, but as Glenn Hubbard, Dean of Columbia Business School, wrote recently in the Wall Street Journal, “the top 1% pay well over one-third of federal income taxes.” The “rich” can and will, one is assured pay more, but serious deficit reductions will have to come from a broader tax source. Hence, the growing talk of a European style value-added tax.

There is one positive, in my opinion, to such a tax; it would serve to discourage consumption. But that only works if simultaneously taxes are lowered on investments. Discouraging consumption and encouraging investments are twin goals desirable for a healthy economic future. But the disadvantages of a V.A.T. are first, that it is regressive – it impacts the poor and middle class more than the wealthy. Second, it will depress economic growth and raise consumer prices.

The VAT was first introduced in France in 1954, initially directed at large businesses. Today, according to Wikipedia, it accounts for nearly 50% of French state revenues. The way it works is that it taxes the value added at each stage of production; so that, assuming a 15% VAT, a mine which sells ore to a smelter for a $1000 will charge his customer $1150. If the mine had bought tools valued at $200, they would have paid $230. The mine would then send the government a check for $120 – $150 less the $30 already paid. The process continues until a final product is sold to the consumer. Because of this process, it does not suffer the weakness of a typical sales tax, which, if deemed too high, is subject to avoidance, either by buying on-line or via another state. It has been called, fairly in my opinion, a stealth tax and today largely supports a significant portion of the social programs that have come to symbolize Western Europe.

“Everybody on the right seems convinced that a value-added tax is on its way,” wrote Ross Douthat in the April 7th issue of the New York Times. Assuming the statement is true, it may be a way of attempting to head off such an eventuality. But as early as last October, Nancy Pelosi said that a value-added tax was “on the table.”

No matter the tax rate, over the most of the post-War period, tax revenues averaged about 18.5% of GDP. When taxes rise, the wealthy shield their income and alter their behavior. During the same time, government spending as a percent of GDP has averaged about 20%. Today, spending is about 25% of GDP; expectations are that it will stay at that level for the foreseeable future – an expectation that seems reasonable given the bigger role for government Mr. Obama envisions. It will have to be paid for. Speaking recently at the New York Historical Society, former Fed Chairman Paul Volcker allegedly said: “If at the end of the day we need to raise taxes, we should raise taxes.” A VAT is appealing to Washington because a 10% tax would raise an estimated one trillion dollars.

However, in their book, How Capitalism Will Save Us, Steve Forbes and Elizabeth Ames refer to a value-added tax as , “insidious because it imposes an invisible layer of taxation that inflates the cost of living…increases the cost of doing business and hits all consumers.”

Gerald Seib, columnist for the Wall Street Journal, writes today: “There is a growing disconnect between the services Americans want and the taxes they are willing to pay.” In similar vein, Ross Douthat, writing recently in the New York Times, believes it unlikely that the government will be successful in passing a value-added tax (a middle class tax hike). However, should advocates for more government entitlements win the day, it seems to me such a tax may be in our future. And government will get even bigger and people will become more dependent – not an attractive outlook in my opinion.

Thursday, April 8, 2010

"Greece - The Chickens Have Come Home to Roost - A Lesson for the U.S."

Sydney M. Williams

Thought of the Day
“Greece – The Chickens Have Come Home to Roost – A Lesson for the U.S.”
April 8, 2010

Greece has been described, aptly it seems to me, as a slow motion train wreck. Predictably and reminiscent of Richard Fuld, Greek Prime Minister, George Papandreou, was quick to blame the crisis on “traders and speculators.”

The cost of insuring $10 million of Greek bonds against default for five years has risen from $124,000 at the end of 2009’s third quarter to $466,000 today. Any buyer of Greek bonds today, with any sense of prudence, would insure them against default. This means that if one were to buy $10 million 10-Year Greek bonds today and receive $710,000 in annual interest, he would have to pay out $466,000 for a net return of $244,000 or 2.4%. That does not appear an adequate return for tying one’s money up for ten years. Of course, if there were no CDS market, interest rates would be substantially higher.

Contrary to the complaints of politicians like Mr. Papandreou, the CDS market serves investors and governments well. Since the product is a form of insurance, it seems to me that it should be subject to insurance regulation and the insurers should be required to carry adequate reserves that are adjusted to reflect changing prices. But the product has a useful and economic role. A rise in the cost of insurance should serve as a warning signal to the company or country affected. Money and investments, except on rare occasions, are apolitical. They simply look at risk adjusted returns. Attempts to politicize or demonize these products will prove disastrous for investors or taxpayers, as well as for markets.

The Greek problem stems from social programs that were far too generous, in terms of entitlement programs – too early retirement, too generous benefits and inadequate reserves against future demands. Here in the U.S. we see those same problems. California pensions have assumed returns of 8%, a number almost four hundred basis points above Thirty-Year Treasuries, and a return substantially below ten year actual returns. A recent Stanford study indicated that if California used a more realistic discount rate of 4.7% (the current rate on Thirty-Year Treasuries), underfunding in their pension plans would rise by almost half a trillion dollars. Illinois has similar problems and so does the United States, as we continue to add entitlements that are inadequately funded.

Between 1966 and 2006, spending in the U.S. on Social Security, Medicare and Medicaid, as a percent of the federal budget, rose from 16% to 40%. At current rates, those three programs will, by 2050, consume 100% of the federal budget. Any rational person knows that the new Health Care entitlement will only add to the problem.

There are only two answers to this upcoming financial crisis – increase government revenues or spending cuts. There are only two methods to increase government revenues – raise taxes, or grow the economy. Since no government in recent memory has reduced spending, and such a possibility seems particularly alien to the current Administration, the answer will lie in raising revenues. Unfortunately, the two methods are usually at odds – higher taxes tend to inhibit growth. At some point, cutting spending has to be the answer. The coming home to roost of this problem can be seen visibly in Greece today, but it is a problem with widespread implications. As Governor Chris Christie is demonstrating, the answer must lie in cutting entitlements. The same will have to happen in Greece and, at some point, it will have to happen in Washington.

In the next few weeks the Greece Finance Minister, George Papaconstantinou, will do a road show in the U.S. attempting to sell bonds. There are about 1.1 million people of Greek origin living in the United States (about 10% of the population of Greece). Perhaps they should keep in mind an old saying, which dates to the Athenians when attacking Troy in c. 450 BC and their false gift of a wooden horse, beware of Greeks bearing gifts.

Wednesday, April 7, 2010

"The Tea Party Movement - For Good or For Evil?"

Sydney M. Williams
Thought of the Day
“The Tea Party Movement – For Good or for Evil?”
April 7, 2010

It is not so much liberalism in Washington – though taxing and spending certainly played a role – that prompted the Tea Party movement, it is the arrogance of those in charge who appear to disdain the sense of the people. Political movements are often born in anger and frustration. The Boston Tea Party was a response to taxes imposed by a distant government intent on bringing to heel a rebellious commonwealth. In 1828, Andrew Jackson spoke out against “economic royalists”. Henry David Thoreau, in 1849, published Civil Resistance to Government, which, in its urging of civil disobedience, struck a chord with the people. At The 1896 Democratic Convention, William Jennings Bryan called out the “idle holders of idle capital.” It was anger at an embedded system of racial discrimination that was behind the Civil Rights Movement of the 1950s and 1960s. The MoveOn organization was a response to the Clinton impeachment trials.

And it was Rick Santelli of CNBC, angered at President Obama’s recommendation – in a precursor of parsimonious Germans being asked to come to the aid of profligate Greeks – that fiscally responsible citizens should bail out their recklessly wasteful brethren with mortgage assistance, who yelled out, “President Obama, are you listening?” The President may not have been, but millions of Americans were.

Attempts to trivialize the movement were made. Nancy Pelosi dismissed the significance of “right-wing” activism. Others attributed the movement to Glenn Beck. Frank Rich, columnist for the New York Times, dismissed the group following the defeat of Douglas Hoffman in New York’s 23rd District last election day with a headline reading, “The Night They Drove the Tea Party Down.”

Like all its predecessors, the Tea Party is not a cause of anger, it is a consequence, a reflection of the anger formed because of the increasing distancing and arrogance of those in Washington. President Obama, in a Fox TV interview before the House vote, could not understand Brett Baier’s insistence on focusing on the “process”, when he (the President) wanted to talk about the “substance” of the health care bill. This conviction, on the part of Mr. Obama, that ends justify the means indicates a misunderstanding of the democratic process, as people understand it.

It was the “Ancien Regime”, a social and aristocratic group of the privileged elite that had lost all connection with the people, which precipitated the French Revolution. A comparison with late 18th Century France may be unfair, but today’s arrogance in Washington of people divorced from the problems of their constituents should be reason for concern. The health care bill was an example: a 3000 page bill, difficult to interpret and certain to impair coverage and raise taxes, will apply to all citizens – except those in Congress and those in the Executive branch. If this bill is so good, why won’t it extend to those who voted for it and signed it into existence?

Wall Street also bears responsibility for the anger that exists in the Country. Washington – both Bush and Obama – did a terrible job of explaining to the people the need to bail out the banks in the fall of 2008. All that is known is that a few hundred billion were lent to the banks, banks who politicians subsequently bashed If Washington had clearly explained the necessity of saving the banking system – the consequences of failing to act – and had returned to tax payers directly the loans as they were repaid, they might have saved themselves some grief. If banks had acted with less arrogance and more common sense and not paid out $140 billion to a few traders while millions are still unemployed, they would not be characterized as selfish institutions indifferent to the suffering of so many.

While there are certain elements about the Tea Party movement that I personally find objectionable, it does reflect the current mood of the people. For politicians to dismiss it as inconsequential is a mistake. It is hard to know exactly how large the movement is, but according to reports, more Tea Partiers were in Washington for the 9/12 march than attended President Obama’s inauguration. The Winston Group conducted a national survey between December and February of this year and found that 17% were Tea Party members. Of those, 57% were Republicans, 28% Independents and 13% Democrats. It is not, according to Winston, a “purely homogenous” group.

Movements such as these are usually positive agents for change, though the full extent of their goals is not usually achieved and it takes longer to do so than they would like. And the change this movement portends is not the change Mr. Obama spoke of during the election.

David Brooks, in yesterday’s New York Times, headlined his column, “Relax, We’ll Be Fine.” He refers to a book that I would also recommend, The Next Hundred Million: America in 2050 by Joel Kotkin. Mr. Kotkin writes that our nation will be younger than Europe, Japan and China, due to immigration and fertility. With a quarter of the world’s GDP, we expend a third of the world’s R&D outlays. He writes: “As the world gets richer, demand will rise for the sorts of products we are great at providing” and, later, in a sentence with which I am in accord: “The U.S. has always been good at disruptive change.” That, I believe, we can expect. So, while the Tea Party movement brings concern to some, the change it portends, over the longer term, should be positive for most.

Tuesday, April 6, 2010

"The Economy - Things are Improving"

Sydney M. Williams
Thought of the Day
“The Economy – Things are Improving”
April 6, 2010

Like all of you, I read a lot. Besides newspapers, there are multiple reports sent regularly by those concerned about my lack of knowledge, or attempts to convert (or pervert) my opinions. There are blogs, magazines and e-mails. As one friend put it, it is like placing your mouth over the end of a garden hose and having someone turn the taps wide open. How much information can we take in, let alone digest?

That is why it was such a revelation (and a pleasure) to read Dennis Gartman’s concise take on recent economic data: “Things are getting better, and that’s that.”

We tend to parse every number. We look for nuances in every statement. But there are times when clarity stares us in the face, yet we weave and we bob, looking for the exception. Answers are often simple, not complicated, similar if you will to the fable of the emperor’s new clothes. Complexity sells, but is often wrong.

The economy is improving. It is, therefore, not surprising that yields on Treasuries have been rising and Corporates will, at some point, follow. Tax rates, we know, will be rising. Will increases in rates and taxes stall economic growth? Probably, at some point. But rates always rise as economies improve. And at this point, markets seem unconcerned. The advance in stock prices, year to date, has not been one of “irrational exuberance.” They have risen despite forebodings by analysts and pundits. Bob Farrell writes, in his recent note, that cash flow into U.S. equity mutual funds finally turned positive by $4.1 billion for the first 29 days of March.

In like vein, in his most recent issue of Reminiscences, Laszlo Birinyi points to a number of recent headlines: “Worries Rebound on Bull’s Birthday” (WSJ); “Stocks Soar, But Many Analysts Ask Why” NYT); “Is Another Market Pullback Near?” (Barron’s); “It’s Time to Question Whether this Rally Can Go On” (FT).

Nevertheless, as certainly as the sun will set this evening, the market will have a significant pull back. Only its timing is unknown. In the meantime, for the Bears, waiting for the correction has been like waiting for Godot.

Despite the “unknowability” of such a correction, I read every day (and have been for a year) strategists and technicians who convincingly, with charts and statistics, write of an imminent decline. Everybody has to make a living, so I begrudge none of these pundits the omens they see in their brew; besides, they provide the market a level of equanimity.

In the meantime, in terms of the economy, things are improving. The recovery may not prove to be as robust as those in the past. Unemployment may linger at relatively high levels. Consumers may save more and devour less. But the economy is getting better.

Monday, April 5, 2010

"Corporate Pay/Hedge Fund Pay - Are the Differences Warranted?"

Sydney M. Williams

Thought of the Day
“Corporate Pay/Hedge Fund Pay – Are the Differences Warranted?”
April 5, 2010

Among the more fascinating business articles last week was Thursday’s Wall Street Journal’s entitled: “Occidental Chief Tops Pay List.” What made the piece particularly interesting was its juxtaposition against an article in the same day’s New York Times: “Hedge Fund Pay Roars Back.” The immediate conclusion one draws is that one would rather manage a hedge fund than be the CEO of a public firm, as the former paid about one hundred times more than the latter.

I have written in the past of the habit of boards of public companies appearing to have greater allegiance to the managements they are charged with overseeing rather than the shareholders they represent, in rewarding mediocre performance with excessive pay.

I have also written that capitalism provides unlimited opportunities for creative individuals willing to take risk on themselves, on markets, or on both. The hedge funds cited in the Times article are proof of that fact. And, while a few dozen have provided enormous rewards to those willing to accept the risk of starting such a business, there are thousands that have disappeared, disappointing both their founders and their investors.

Nevertheless, the contrast in pay, using the top five businesses in each category, is significant. The five public companies mentioned in the Journal article – Occidental Petroleum, Disney, Travelers, IBM and Johnson & Johnson, in aggregate, paid their CEOs $132.4 million; whereas the managers of the five hedge funds, in aggregate, earned $13.5 billion. Given the multiplier effect of economics, in terms of contribution to GDP, the differences are equally compelling. The five public companies employ 700,000 people and they generated $230 billion in revenues last year, numbers far different from the hedge fund industry.

Certainly the hedge fund industry makes contributions to the economy in terms of the allocation of capital, both in terms of equity investments and in terms of keeping interest rates lower than they would otherwise be, but their contribution to GDP is far less than their counter parts in the public arena.

In a capitalist society, entrepreneurs have the opportunity to either succeed extraordinarily, or to fail miserably. Managers of hedge funds are entrepreneurs. On the other hand, most managers of public corporations are hired guns. They assume little risk and potentially extract large returns, some times fore dismal performance. There are obvious exceptions such as Bill Gates and Paul Allen of Microsoft and Larry Ellison of Oracle, men who took a shot on a concept.

The publicity of the huge pay packages at hedge funds has already generated problems for the industry, besides the obvious disadvantage of having one’s wealth broadcast. The Administration has deemed carried interest to be treated as ordinary income, as opposed to a capital gain, a decision with which it is difficult to disagree. Increased regulation and a SEC requirement for greater disclosure in terms of investment positions will raise costs for the industry.

So, while hedge fund pay may seem excessive, in my mind it is not as harmful as pay for failure which has too often been the case at public companies. Boards of Directors of public companies need to take seriously their duty to represent shareholders, not management, and should be liable for mistakes.