Wednesday, June 30, 2010

"The Debt Problem - Is Government a Help or a Hindrance?"

Sydney M. Williams

Thought of the Day
“The Debt Problem – Is Government a Help or a Hindrance?”
June 30, 2010

Growing up in northern New England in the 1950s, two of my favorite characters were “Bert and I”, recorded by Marshall Dodge and Robert Bryan, both students at Yale Divinity School. Bert, considered “dumb as a hake”, once when asked how to get to Millinocket, responded: “Come to think of it, you can’t get there from here!”

That is how many of us feel looking at the extraordinary debt load of our federal, state and local governments. Is there a way out? The answer must include a combination of reduced spending and increased revenues. Printing our way out, a possibility for the federal government, would have devastating consequences as we well know from reading the history of the Weimar Republic.

To assume Congress will reduce spending is about as likely as my seeing sixty again. Nevertheless the resulting deficits are unsustainable and, unless addressed, will lead to an extended period of stagflation or inflation. Spending won’t be cut, so the focus must be on revenue growth. The question becomes, how best to grow revenues.

Again, there are two choices: raise taxes or generate economic growth. The immediate temptation is to increase taxes, especially on easy and soft targets like the “rich” and corporations. The problem, though, is that those two segments are responsible for most of the job growth in our economy. Common sense suggests that government should encourage businesses, especially small ones, to invest and hire – something lower, not higher, taxes will do.

The tax cuts of the early 1920s, 1960s and 1980s kicked off several years of economic growth. But when stimulus is mentioned it is generally spoken of in terms of what government can do. However, stimulus comes in many forms. Going to the barber is a form of stimulus; an auto company investing in a new factory line is another. A study done by the U.S. Office of Management and Budget in 1996, which argued there is no evidence that tax cuts increase tax collections, belied its stated conclusion. The study used the Reagan tax cuts as an example. While tax receipts, in constant dollars, did decline for two years following the cuts (1982 was a recession year), the study neglected to mention that for the following six years receipts rose – 20% higher in constant dollars and 65% higher in nominal dollars by 1988. The evidence seems irrefutable – tax cuts promote economic growth.

Additionally, the personal tax cuts of 1981 (a 25% across the board tax reduction) had the effect of increasing the share of total taxes paid by the top 10% of all tax payers, from 48% in 1981 to 57.2% in 1988. A similar experience occurred in the 00s. By 2006, three years after the Bush tax cuts, tax receipts were at 18.4% of GDP, above the 20-year, 40-year and 60-year levels. Long term capital gains tax rates were reduced from 20% to 15% in 2003; three years later revenues from this source had more than doubled. Those same Bush tax cuts – purportedly benefitting the rich – had the effect of raising the share of taxes paid by the top quintile from 81% in 2000 to 85% in 2004. Tax cuts are positive for economic growth. Tax increases are not, and that is what will happen in 2011.

The stock market (the S&P 500) is at an eight-month low, down 14% from the high on April 23, having given up 173 of the 550 points gained after the March ’09 lows. Explanations abound as to why the market is behaving so abysmally – China’s slowing growth, problems in Europe, sovereign debt, inflation, deflation, unfunded public pension funds, a possible double dip in the economy, the spill in the Gulf, the U.S. housing market, tax increases and Afghanistan.

But as much as anything, the market, in my opinion, reflects concern over a spreading, pernicious and increasingly indebted federal government – a beast that exercises more control over our lives, reduces individual initiative and needs to be fed (higher taxes.) The uncertainty created by Obamanomics regarding health and financial reform, the consequences of cap-and-trade, the refusal to sign free trade agreements, the takeover of FNM, FRE and AIG and auto bailouts that ignored the rule of law is worrisome. (The irony of yesterday’s decision – a Treasury decision – to appoint as AIG’s compliance officer the former compliance officer from Lehman, a decision which causes one of those “you’ve got to be kidding!” moments, will not go unnoticed.) This apparent refusal on the part of government to acknowledge the seriousness of its rapidly deteriorating financial condition concerns investors.

Providing (temporary?) cover to the President, Treasuries have continued to rally. The yield on the Ten-Year, at 2.97% is the lowest since April 2009, while the yield on the Two-Year at 59 basis points is at a new low. The safety of a fiat currency has presumably driven investors toward the Dollar and Treasuries, but if current trends persist that will prove but a brief respite.

The answer is ‘yes’, we can get there from here, but it requires a sea-change in Washington that recognizes the limits to government and reflects the importance of the private sector to the economy. America is fortunate in its people, its laws and its resources. To restore growth, which more than anything else will re-fill federal coffers, the animal spirits endemic to our economy must be unleashed.

Tuesday, June 29, 2010

"The Dodd-Frank Act - Color it Gray"

Sydney M. Williams

Thought of the Day
“The Dodd Frank Act – Color it Gray”
June 28, 2010

My hike in the White Mountains turned out a little different than expected. Two and a half hours into our climb up Mount Madison along the Daniel Webster Trail – purportedly among the steepest in the White Mountains – a good friend who was with us experienced a pulse rate that reached 120. When the rate did not decline as quickly as we thought it should the decision was made that he should walk back out. I went with him, leaving the younger generation (including a younger brother of mine) to continue the trip, which they did. (My friend seemed tired that evening, but appeared fine the next day, and even better the day after.)


The next afternoon he and I drove up the Mount Washington auto road and met the group at the top when they emerged from a damp and cold fog, about an hour and a half later than they were initially expected. The temperature was in the low 40s with wind gusts up to 70 miles per hour. The fog was so dense that visibility was limited to no more than 15 or 20 feet. That last mile of their hike was one that my grandchildren (and their father and friends) will not soon forget.

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The compromised version of the financial reform bill, now termed the Dodd-Frank Act, voted out at 5:45AM on Friday morning, reflects the late-night strategies of the many participants, but may prove to be the best that 535 idiosyncratic, egotistical individuals could do. Of course, with many provisions not being implemented for several years and at 2000 pages, it provides a lot of hiding places; the full ramifications of this bill will likely remain undiscovered for some time. In the meantime it will prove a lawyer’s delight.

Bank earnings will take a hit, as proprietary trading desks will be curtailed, investments in hedge funds and private equity funds will be limited to 3% of Tier 1 Capital and most derivative products will be traded on exchanges – providing some sunlight on the dark recesses of these markets –requiring more margin (capital), resulting in less profitability. Of course, increased transparency may permit these markets to expand, thereby benefiting exchanges, such as the CME (Chicago Mercantile Exchange) or the ICE (Intercontinental Exchange). Concerns of job losses for New York City are exaggerated in my opinion, as banks will spin off operations and new firms will fill the voids created as banks curtail or sever departments. But I agree with Gretchen Morgenson, writing in Sunday’s New York Times, that “the nation’s financial industry will still be dominated by a handful of institutions that are too large, too interconnected and too politically powerful to be allowed to go bankrupt…” The concept of too big to fail has not been deterred.

(Limiting the banks proprietary desks to primarily investing in U.S. Treasuries may be consigning those operations to investing in junk, given that our Federal debt at $13.1 trillion represents 92.3% of 2009 GDP and that the Federal deficit is about 10% of GDP – both numbers would normally place the U.S. in the intensive care units of financial prudence. Even Michael Milken would likely deem these securities as too risky.)

There is much that remains unclear. Its deliberately gray areas have been deemed by some wags as a “job creation bill for lawyers.” Fannie Mae and Freddie Mac, both beneficiaries of the two “dignitaries” whose names this bill carries, remain unmentioned, despite the fact that their debt alone, if added to the Federal debt, would swell that $13.1 trillion by 38% to $18 trillion, or 127% of GDP – far above that of Greece! The rating agencies will be able to be sued – a surprising win for trial lawyers (he wrote, cynically), but an even-closer relationship with government will provide an even deeper government imprimatur than heretofore – making worse an already bad situation. (As an aside, I still don’t understand why we need the current system of rating agencies. Public and private financial firms would fill any gap created by their absence. Equity research has always been paid for by buyers, not issuers. The same is generally true in high yield. The conflict of interest inherent in the current bond rating system, in which the issuer pays to be rated, provides too much opportunity for fraud, monkey business and disingenuous opinions.)

The $20 billion dollar fund (paid for through taxing certain financial organizations) that Congress hopes to establish to serve as means of preventing future taxpayer funded bailouts is mistaken on two counts: first, it rewards the prodigal at the expense of the frugal (a bad message), and, second, $20 billion is nowhere near enough, given that the last crisis required at least $700 billion.

The SEC, which was notably absent from duty in those days leading up to financial Armageddon, as the Bernie Madoff case most explicitly screams out, is rewarded with increased authority over rating agencies. In the recent past, it was not so much a lack of regulatory authority as it was a failure to enforce the rules. On the positive side of the ledger, the Federal Reserve, despite its role in augmenting the housing bubble by keeping interest rates too low for too long, remains the one truly independent agency (or the least political.) Under the proposed bill it will stay independent and, in fact, gain powers, housing what is expected to become a Consumer Protection Agency. While there is no question that consumers should be protected against willfully fraudulent hucksters, I often wonder how smart it is for the government to persist in protecting people against their own bone-headed decisions. Perhaps politicians simply want a more dependent electorate?

I have been a believer in the notion that commercial banks have become too big, especially since the demise of Glass-Steagall, and involved in too many conflicting operations; at least this bill trims their sails. But I believe that merchant and investment banks serve different markets and customers than their commercial cousins, so should be separate. The principal assets of a commercial bank should reflect the fact that their principal liabilities are deposits, now to be insured up to $250,000. The businesses of merchant and investment banks, by definition, entail greater risk, so should either be set up as partnerships – where the liability for loss is carried by the general partners, jointly and severally – or, if set up as large, public corporations, they should be subject to very strict capital rules. Fear of loss and financial pain, however, is always the best regulator.

While having some positive attributes, in general the bill seems, to me, to move us toward a collective good and away from individual responsibility. Behind its pleonastic language, the bill risks taking us one more step down Friedrich Hayek’s “Road to Serfdom.”

Wednesday, June 23, 2010

"Financial Reform, or Another Reason to Dis Bankers?"

Sydney M. Williams

Thought of the Day
“Financial Reform, or Another Reason to Dis Bankers?”
June 23, 2010

Congress is intent on getting a financial reform bill on the President’s desk before the 4th of July. It is ironic that the day we celebrate our Independence may well be spent tightening regulations under which we live. Of course, there is little question that bank reform is needed. In the course of the financial crisis, a few banks fell into the abyss; others only peered over the precipice. Bank’s required capital ratios did not include off balance sheet assets, nor were they able to fully reflect their myriad derivatives operations. Raising bank’s capital requirements makes good sense. Borrowing short and lending long is, of course, the business of banks, but with narrow spreads the temptresses of proprietary trading desks became impossible to ignore.

At the same time, shareholders, managements and employees all demanded more money, so risk levels were lifted, for we were living a Panglossian life where nothing ever went wrong – until it did.

We now have financial reform bills that have, separately, passed the House and the Senate and must be reconciled before being presented to the President. In another bit of irony, the Senators and Representatives who have responsibility for shepherding the bills are generally those who have been the principal beneficiaries of the lobbying efforts of the banks and financial institutions effected. (As an aside, these all-too-comfortable relations between regulator and regulated are, in my opinion, another compelling argument for term limits. An apple for the teacher is one thing, a sack full of cash quite another.)

According to yesterday’s New York Times, there are three remaining unresolved issues: How to regulate derivatives trading; restrictions (if any) on banks investing or trading their own funds, and whether stronger “buffers” should be required against unexpected losses.

Derivatives, in my opinion, should be traded on sun-lit exchanges, with counter-parties clearly delineated. In terms of the second issue, personally I am a fan of reinstating Glass-Steagall, but that seems unlikely. Of course that problem and the third would not be issues if management were required to have substantial ownership in their banks – stock not options – and if the banks were deemed not too big to fail. Government should make the rules, which should be clear and concise, and they should enforce them. Businesses (including banks), investors and speculators should be allowed to succeed and/or fail. A bank that is too big to fail is too big.

An article in Tuesday’s Wall Street Journal reported that the Federal Reserve on Monday adopted rules that will give regulators power over the compensation for thousands of bank employees from senior management to traders. The rationale is to prevent bank employees from taking undue risk, placing the bank at risk. Since the Federal government insures deposits, they should set parameters as to how those particular liabilities are invested. But as for the banks own assets, could not the same end be achieved, as mentioned in the previous paragraph, with requiring significant management equity ownership in their bank and explicit guarantees that the bank would not be saved, should it fail through self-inflicted errors, either ones of omission or of commission? When the boss’s capital is on the line, rogue traders, knowing they would be watched more closely and fired more quickly, would exercise more caution.

Deals have apparently been reached for issues such as debit card fees, which are collected by merchants and rebated to banks – about $15.8 billion last year according to Tuesday’s New York Times. However, the Fed has decided that the fees would apply only to those banks with more than $10 billion in assets – about 120 banks who control about two-thirds of debit card transactions. While smaller banks will undoubtedly take more share, the impacted banks are sure to offset the decline in debit card fees by raising fees for other products. Whatever happens, the consumer is unlikely to be a winner.

White House officials have said they do not want special, one-off deals, such as the one Senator Blanche Lincoln is attempting to arrange for Arvest Bank in Arkansas, largely owned by the Walton family. The Administration should stand fast.

The President sees himself as the author of sweeping social legislation – a man for the ages who will bring redemption to millions of Americans who have suffered, during the past decade, from a miasma of capitalism. A health care bill, the consequences of which are making people increasingly nervous as they learn more of its impact, has been signed into law. Financial reform looks like it will be next and, like the health care bill, is of sufficient length most people, including legislators, will be unable to anticipate its consequences. BP’s disastrous spill in the Gulf will be used to hasten a cap-and-trade bill. The complexities of these bills are such that they primarily serve to make large headlines, provide job opportunities for lawyers, while generally restricting individual freedom and choice.

Greed dominated the actions of too many bankers over the past few years, but it should not be forgotten that much of what they did was under regulators who chose not to regulate, and Congressmen who looked piously toward the sky while extending outward their palms toward these same bankers. To treat the industry as a Jezebel from Sodom or Gomorrah risks losing many of the industrious and creative people who populate the industry. Reform should truly make things better and safer, not just add another layer of regulation. As David Brooks put it so well in his column yesterday in the New York Times: “If your policies undermine personal responsibility by separating the link between effort and reward, voters will punish you for it.”

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I will be out until Tuesday of next week, hiking in New Hampshire’s White Mountains with one of my sons, two grandchildren and a few friends. If all goes well, weather and legs permitting, we will climb the northern Presidentials. Hiking a steep and rocky trail, placing one foot in front of the other, will consume my daily thoughts.

Tuesday, June 22, 2010

"Fannie and Freddie - From Privatization to Nationalization in Forty-Two Years?"

Sydney M. Williams

Thought of the Day
“Fannie and Freddie – From Privatization to Nationalization in Forty-Two Years?”
June 22, 2010

Last Wednesday, Edward DeMarco, acting director of the Federal Housing Finance Agency (responsible for both Fannie Mae and Freddie Mac), stated: “A voluntary delisting at this time simply makes sense and fits the goal of a conservatorship to preserve and conserve assets.” While a delisting does not mean there will no longer be public shareholders, it has meant that their shares are worth less – about half of what they were valued on Tuesday.

In a sense, Fannie Mae (Federal National Mortgage Association) is reverting to its origin. The company was established in 1938, as part of the New Deal. Like today, the collapse of the housing market during the Depression discouraged private lenders from offering home loans. Fannie Mae was set up to provide local banks with federal funds to finance home mortgages – known as conforming mortgages. As the secondary market developed for these mortgages, Fannie Mae grew, borrowing at low rates (with U.S. Government guarantees) and lending at a rate high enough to earn a reasonable ‘spread’.

The system worked well. Home ownership increased. Mortgages were simple affairs, usually twenty to thirty years in duration. Down payments were generally 20% of the value of the house and mortgages were typically no more than three times the borrowers’ annual income.

As home ownership rose during those post-War years, so did the balance sheet of Fannie Mae. In 1968, President Lyndon Johnson, encumbered domestically with the war on poverty and internationally with the war in Vietnam, chose to privatize Fannie Mae, so as to remove the Company’s debt from a ballooning Federal deficit. Two years later Freddie Mac (Federal Home Mortgage Association) was created to provide competition for Fannie Mae.

Though privatized, both GSEs (Government Sponsored Enterprises) enjoyed the continued benefits of exemption from state and local taxes, exemption from oversight by the SEC and their bonds traded with an “implicit” guarantee from the U.S. Government – permitting them to borrow at lower rates than private competition.

A combination of developments took place. In 1977, the Community Reinvestment Act was passed and signed into law by President Carter (and strengthened by the Gramm-Leach-Bliley Act of 1999). It essentially encouraged (required) FDIC compliant banking institutions to meet the needs of all segments of their communities, including low-and moderate-income neighborhoods. Secondly, declining interest rates from about 1982 forward had the beneficial affect of raising asset prices. Third, technology introduced complexity into mortgage offerings – adjustable rates, balloons, interest-only mortgages and myriad others. Significant, but selective political donations provided a cover from Congress. So, despite being public and without SEC supervision, the potential for extraordinary riches proved too tempting for managements, as the tale of former Fannie Mae CEO Franklin Raines relates.

In 2006, when a $10.6 billion accounting scandal broke – manipulating financial reports to allow earnings that would trigger bonuses for senior executives – an attempt at reform by the Bush Administration was blocked by Democrats who claimed that the real victims would be low-income borrowers made unable to buy homes. Reform failed.

When the credit crisis boiled over in the fall of 2008, Fannie Mae and Freddie Mac were placed, almost immediately, in conservatorship and the government became an 80% owner of the equity.

In last Sunday’s New York Times, Binyamin Applebaum reported that thus far, “the tab [for the two GSEs] stands at $145.9 billion and it grows with every foreclosure…The Congressional Budget Office predicts the final bill could reach $389 billion.” The bill may be substantially higher. The two companies, with a combined market capitalizations of $750 million, have total debt of just under $5 trillion, offset by mortgages held. (To put that $4.8 trillion in context, total residential mortgages in the U.S. are about $10 trillion.) The question, without a known answer, is what is the value of the underlying mortgages? Given the number of foreclosures over the past couple of years and the fact that a number of mortgages exceed the collateral value of the houses mortgaged – perhaps 25% of all mortgaged properties, according to some estimates – it is fair to assume the two GSEs are technically bankrupt.

Mr. Applebaum, in his Times article, also makes the point that the two companies owned 163,828 homes at the end of March, and that, in foreclosure sales, on average the company’s recoup less than 60% of the money the borrower failed to repay. While 164,000 homes is a large number, it should be placed in the context that there are, according to U.S. Census data, 105 million households in the U.S. and that existing home sales are running around 5 to 6 million a year. (Existing home sales are due out today and are expected to be around 6.15 million.)

Despite all the noise, though, most homeowners continue to pay their mortgages, hoping, over time, to build equity. Nevertheless, the government is between a rock and a hard place – they cannot allow the two entities to fail and, given the size of the Federal debt - $13.1 trillion – they do not want to take on another $5 trillion in debt, so a re-nationalization seems unlikely at this time. Given the fraud and the corruption that permeated these two entities and the unhealthy ties they had to the Congress of the United States where millions of tax payer dollars went into the coffers of Senators like Chris Dodd and Chuck Schumer, it is hard to believe that both Fannie Mae and Freddie Mac appear to have been left out of the financial reform bill. But perhaps that too-cozy relationship and recognition that the problems are too monumental provided an exemption? Regardless, Congress should, once the crisis has ebbed, revisit its relationship and prevent such an occurrence from happening in the future.

Monday, June 21, 2010

Three Bites: "China and the Yuan, BP and the 'Shakedown' and Hedge Funds - a New Book"

Sydney M. Williams

Thought of the Day
Three Small Bites

"China’s Currency Move – Giving in to the U.S., or Simply a Smart Move?”
“Twenty Billion Dollars – A ‘Shakedown’?”
“Hedge Funds – ‘Pure as Slush’, but less Flawed than Other Financial Institutions”
June 21, 2010

China’s announcement that they had removed the Yuan from being pegged to the Dollar sent markets soaring overseas this morning. Twenty months ago, during the global financial crisis, the Chinese linked the Yuan to the Dollar – a fortunate decision, as the Dollar, becoming the world’s safe haven, rose. Against the Euro, it should not be forgotten, the Yuan has already appreciated 16% this year. It will now float versus a basket of currencies, similar to the policy they had in effect from mid 2005 to mid 2008, but will be limited to moves of +/- 0.5%.

The Wall Street Journal points out this morning that during the years 2005-2008 the Yuan appreciated 21% against the Dollar. They did not mention, though, that during that same time the Dollar Index fell 18%. With the Dollar now at highs, the decision to remove the peg to the Dollar makes sense. It strikes me that that the Chinese may simply be better currency traders than many of their counterparties.

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Republican Representative, Joe Barton, created a sensation when he apologized on Thursday to officials from BP for the actions of the Administration. It was a stupid thing to do. As a Friday Wall Street Journal editorial put it: “Everyone agreed they hate CEO Tony Hayward.” But the $20 billion “shakedown”, as Mr. Barton described the fund, is a different matter. The fund may allow claims to be paid more quickly – and BP now says they have already paid out $2 billion – and that is a good thing, but actions have consequences. Not surprisingly, the Financial Times questioned the fund. There are normal judicial procedures that are typically followed. They write that the fund “smacks of confiscation.” But they also make an important point: “…And it makes it hard for the U.S. – the biggest owner of foreign assets in the world – to resist other nations’ extrajudicial imposts.”

Tony Hayward, who was relieved of his duties on the Gulf, was widely criticized for sailing this weekend in a race around the Isle of Wight. However, very little was made of President Obama’s decision to spend four hours on the golf course on Saturday with Vice President Biden. To the best of my knowledge, the President is still on the job. Personally, I don’t object to either one’s activities, but this seems like Press favoritism.

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In what appears to be a fascinating book (I have ordered the book, but have not yet received it), Sebastian Mallaby, a fellow at the United States Council on Foreign Relations and a columnist for the Washington Post, has recently written More Money than God – a look at the hedge fund industry. He makes the point that capitalist societies have out-shone state-run economies and the reason is largely attributable to the fact that in capitalist-driven economies responsibility for allocating capital lies with the private sector. Mr. Mallaby now fears that governments across the developed world are trying to set back the clock.

With the exception of a handful, hedge funds are not, as James Mackintosh in the Financial Times wrote, “’too big to fail’, as the demise of 1500 such institutions in 2008 caused barely a ripple.” Mr. Mallaby’s twin conclusions are, according to the FT’s review, “governments must encourage hedge funds and don’t regulate (he would relax this decree for the very largest, leveraged funds).”

While the reviewer found some objections, it is refreshing to read that not everyone is demonizing hedge funds.

Thursday, June 17, 2010

"Long Term Problems - Short Term Answers, So Far"

Sydney M. Williams

Thought of the Day
“Long Term Problems – Short Term Answers, So Far”
June 17, 2010

Eleven years ago John Bogle, founder and former chairman of the Vanguard Group, had an op-ed in the New York Times in which he referred to the casino nature of the market. Putting aside the obviously self-serving aspect of his piece – defending index funds – he pointed out the significant increase in trading activity. Mr. Bogle pointed out that in 1960 the annual turnover on the NYSE was 12%. By 1999 it had risen to 95%. He wrote: “These trends show no sign of abating.” They have continued to accelerate, so that today turnover is approaching 200%.

Yesterday, I received a bulletin from my friend Laszlo Birinyi entitled, “Market Frustrations,” indicating that since the market’s peak on April 23rd, the correlation of stocks in the S&P 500 to the Index has risen 62%, from 0.48 to 0.78, indicating that there have been very few places to hide as the market collapsed. Mr. Birinyi provided a second chart indicating the rolling 200-day correlation of stocks to the Index over the past ten years. That chart indicates a rising correlation over a ten year period, confirming, in my opinion, the growing importance of quantitative programs, be they Index Funds, trading relationships that are correlated or uncorrelated, ETF’s, high frequency trading platforms, dark pools, or whatever.

This trend toward treating stocks as little more than casino chips has been abetted by a financial press, especially TV programs like CNBC and Bloomberg with their emphasis on the short term. Jim Cramer, who I am sure is a very smart man, cannot seem to make a point without screaming. Alas, he is not alone.

It might all be amusing were it not so serious. Baby boomers born in 1946 will reach 65 next year. And the numbers of retirees will accelerate over the next twenty years. Social Security is already on life support with more money going out than coming in. Since its early days, it has never been a savings system; it is a transfer system – from workers to retirees. Medicare is in equally bad shape. The combined unfunded liability is approaching $50 trillion. The recently passed health bill will only add to the burden. In the meantime, on a price basis, the S&P 500 is 23% below where it was ten years ago. Interest rates are abnormally low, penalizing savers while aiding borrowers. Since the average mutual fund underperforms the Indexes, investors must sympathize with Mike Tyson: “Everybody has a plan until you get punched in the face.”

Wall Street is still characterized and cartooned as populated by greedy, fat, white men, while the reality is that over half the population own stock, either directly, or indirectly through mutual funds, IRAs or 401Ks. There are very few remaining defined benefit programs, suggesting that virtually all workers will have to rely on their own savings. Nevertheless, neither government nor Wall Street seems to have fully acknowledged this changed landscape. Wall Street worries about the next quarter. And government will increase taxes next year on investment income and capital gains.

We live during a time when people demand instant gratification. Long term has become, for most people, next week, not thirty years in the future. And today the Country faces a number of very visible problems from the War against Terrorism (if we dare call it such), to a recession from which we are slowly exiting, to the oil spill in the Gulf. The problem of adequate capital that allows people to retire is not so visible, but is just as serious, perhaps more so. The tax code is a powerful tool government has available to encourage or discourage behavior. It has long been used for just such purposes, from encouraging home ownership to discouraging smoking. There are actions government could take now to nudge people toward saving more and consuming less. Higher taxes could be used to discourage short term trading and reduced taxes would encourage long term investing. Unfortunately, government reacts and does not anticipate. The patient must be in the ICU before Washington pays attention. Let’s hope this time will be different.

Wednesday, June 16, 2010

"The Oil Spill - The President's Speech"

Sydney M. Williams

Thought of the Day
“The Oil Spill – The President’s Speech”
June 16, 2010

On the day the President spoke to the Nation from the Oval Office, the estimate as to how much oil is leaking into the Gulf was raised to a range of 45,000 – 60,000 barrels per day, about 15,000 of which is being captured through the containment cap on top of the well. (Lost in the horror of the spill is that this is one big well – 60,000 barrels per day, a mile beneath the surface of the water and another three miles into the bedrock, suggests a well capable of producing 22 million barrels a year!)

The 18 minute speech was designed to show a President in charge. Interestingly, Mr. Obama said that the government had been in charge from the beginning – a curious admission, as the recovery appears to have been badly bungled. (My own opinion is that the government was not in charge at the beginning, BP was, but that was not something the President wanted to admit to the American people.) He never mentioned that no call had been made to experts on spills in Norway, nor a suspension of the Jones Act to aid in the clean up. He mentioned that Admiral Thad Allen was in charge and that immediately following the spill he assembled a covey of scientists including a Nobel winner to advise on the clean up, a process the New York Times has termed as having been “botched.” Using terms such as “fight”, “siege”, “war” and “battle plan”, he sounded like a First Lieutenant leading troops over the barricades.

While not demonizing BP (a good thing, in my opinion), he left no question that they would be responsible for the clean-up and that, when he meets today with the Chairman and CEO, he would demand the establishment of a fund, but mentioned no dollar amount last night. BP certainly deserves to be penalized for the spill – this incident has already cost them $1.5 billion – but House and Senate politicians should restrain their anger, recognizing that a viable BP will better serve the people of the Gulf than one tossed into bankruptcy. It should also be mentioned that we all, in our desire for big houses, big cars and big vacations, bear a responsibility.

The President defended the six months moratorium he had imposed on the industry from deep water drilling, without acknowledging the cost to consumers or, more importantly, to those along the Gulf who make their living from such activity. A commission he has established, not unlike the ones set up after Three-Mile Island and the Challenger explosion, will study the accident and provide advice for Minerals Management Services, an organization with oversight over all oil drilling (and who failed miserably), which will now be under the directorship of Michael Bromwich, a former Federal Prosecutor.

But it was in the last third of the speech, with Mr. Obama’s leaning forward with the enthusiasm he reserves for favorite subjects, that he made his most impassioned plea – in this case for clean energy, to rid ourselves from the clutches of dependency on foreign oil and to pass the legislation proposed by Senators John Kerry and Joe Lieberman. He wants to invest billions in renewable resources such as wind power and solar energy, this time mentioning China, as a country creating thousands of jobs in clean energy, but without mentioning his former favorite country, in that regard, Spain. (He did not mention that China is also building one new coal plant a week and that they plan to do so for the next ten years!) There was no mention of clean coal technologies, despite the fact that the United States is the Saudi Arabia of coal and that half our electricity generation comes from that source. He concluded, invoking the image of his White House assistant, Rahm Emanuel, that we must “seize the moment.”

In fairness, the President did say there would be costs associated with abandoning fossil fuels in favor of nuclear, wind, natural gas, solar and water, but there was no attempt to quantify those costs – perhaps an impossible task, but especially painful to consider as we exit recession in a feeble recovery. On a per person basis, we consume more than ten times as much energy as do the Chinese, but I know of no one who would want to exchange our standard of living for theirs. The fact of the matter is, regardless of a cap-and-trade bill, over the next couple of decades, our per capita consumption will decline due to preservation and efficiencies, while that of the Chinese will increase. That will happen no matter what the government does. It is a trend that began toward the end of the 1970s and continues today.

There is nothing wrong with the President’s idealistic vision for a country dependent upon renewable energy sources, but it is one that must be tempered with realism and should make use not only of the talent, but of the natural resources we possess – especially natural gas and coal. (We do have a lot of wind, especially in the halls of Congress, so the steps leading to the Mall might be ideal for a number of wind turbines!) Over the past thirty years efficiencies have improved in terms of better home insulation, auto mileage, appliances and factory systems, and in myriad other ways. That process toward preservation and efficiencies has been evolutionary. Government might hasten the process, but it is underway because it better serves the people.

Certainly the goal of becoming less dependent on those whom Senator Lieberman calls “not our friends” is admirable, but the weaning process has to be a gradual one. We have carbons easily accessible (on shore and in the ANWR region of Alaska), which we should tap in the meantime. The suspension of drilling in the Gulf will only serve to raise prices for consumers here, increase our dependency on foreign oil, which will benefit dictators in places like Venezuela and Iran.

This President has a desire to do “big’ things. He wants to be known as one who revamped our Nation, seemingly forgetting that for all our faults there is no country that has achieved so much for ourselves and for people all over the world. That success is largely due to the initiative of individuals, most of whom play according to the rules; it does not derive from a more powerful central government.

Seventy-six years ago my grandfather hosted his fortieth reunion from Harvard. It was in the midst of the Depression – June 1934 – and he quoted a poem he had written, with one stanza that seems especially relevant today:

I’d like to live a hundred years
So I can know for sure
If Roosevelt makes the poor all rich
Or makes the rich all poor?

Tuesday, June 15, 2010

"Risk Homeostasis - Does it Apply to Stocks at Present?"

Sydney M. Williams

Thought of the Day
“Risk Homeostasis – Does it Apply to Stocks at Present?”
June 15, 2010

Risk and stocks are inextricably intertwined. Anybody who has ever invested in stocks, bonds, commodities or any derivative thereof is aware of risk. We have all experienced our personal “Black Swan” moments. Risk is ubiquitous. The Gulf of Mexico has proven risky beyond expectations for British Petroleum. Last week we hosted a lunch for the management team of W.R. Berkley. Managing an insurance company, Bill Berkley makes his living evaluating risk. The Wall Street Journal, on Monday had two articles on the risks of municipal bonds – one article and one op-ed piece.

When I get in a cab, as I do each morning, I take a risk. Of course so does the cab driver who picks me up; while I may look harmless, he has no idea what surprises may be in store for him. Risk is everywhere.

In the investment business, we often measure risk against Treasuries – Three-month T-Bills, as longer dated ones carry the risk of inflation. Quantitative analysts measure with mathematical precision (or they claim to) risky investments versus their riskless cousins. Those of us who are quantitatively challenged try to make similar distinctions through analysis, observation and anecdotal evidence. Jim Grant, in the most recent issue of Grant’s Interest Rate Observer, for example, deems there is less risk in owning a list of thirty-two large U.S. companies than there is in Five-Year Treasuries.

A problem with risk is that it is not constant. It changes as people and conditions changes. For example, a study of taxicabs in Munich determined that the crash rate for cabs equipped with anti-lock brakes was identical to those without. The reason had to do with the fact that those using ABS took more risks, presuming the brakes would protect them, than those that did not have the new braking system. To explain this propensity to risk-adjustment, to bring risk back into the individual’s equilibrium has been called risk homeostasis by Dr. Gerald Wilde, a professor emeritus of psychology at Queen’s University in Kingston, Ontario, Canada. We compensate for changes that affect us. Going forward, weekenders in Arkansas will be more conscious of the rivers along which they camp.

One might argue that British Petroleum’s explosion in the Gulf was a result of risk homeostasis. (On the other hand it might simply have been due to a too-close relationship between BP and the Minerals Management Service of the Department of Interior – the regulatory body with responsibility for off-shore drilling activity!) Something like 30,000 deep water wells have been drilled in the Gulf. While none were in water as deep as this one, nor had any of them gone so deep into the bedrock as the Tiber Prospect, there had been no problems until April 20th. In determining risk, as drilling began, adjustments were undoubtedly made by BP engineers for the fact there had been no earlier problems – risk homeostasis was at work.

Regarding the space shuttle Challenger, which blew up over Florida on January 28, 1986, sociologist Diane Vaughn wrote in her book, The Challenger Launch Decision, “No fundamental decision was made at NASA to do evil. Rather a series of seemingly harmless decisions were made that incrementally moved the space agency toward a catastrophic outcome.” As humans, we gain comfort in our understanding of failure by placing blame. We see a similar chain of events developing in the Gulf. Whether the explosion was a product of regulatory, mechanical, or human error, or was unavoidable, the pointing of fingers seems to have superseded the search for what actually happened.

In speaking about the disastrous oil spill in the Gulf, Charles Krauthammer said, “We respond to crises because history shows us what is risky.”

But to return to stocks; as Dr. Albert Wojnilower wrote yesterday: “The tangible brighter business outlook is grossly at variance with the financial market mood.” Unfortunately, we as always, are victims of extrapolating our most recent experiences. Stocks have been a poor place to invest money over the past ten or twelve years. As investors, we appear subject to the phenomenon of risk homeostasis; we find comfort in gold, the Dollar and Treasuries, suggesting to me that the risk embedded in many stocks is overstated.

Monday, June 14, 2010

"Free Trade Agreements - Green Shoots in California"

Sydney M. Williams

Thought of the Day
“Free Trade Agreements – Green Shoots in Colombia?”
June 14, 2010

It is commonly assumed that the Great Depression was made worse because of three decisions: the Fed’s decision to lift interest rates, the decision to increases taxes and the unintended consequences of the Smoot-Hartley Tariff Act of 1930. (There is a fourth factor, in my opinion as important as the first three, but about which there is less consensual agreement, and that is the decision by the Roosevelt administration to intrude in an unprecedented manner into the private sector.) We are, in my opinion, fortunate in that our current Fed Chairman, Ben Bernanke is a student of the Great Depression, so is more likely to guide us safely through these uncertain times, at least in the area in which he exerts some control – interest rates. Unfortunately, unless dramatic steps are taken, taxes will go up next year, as the Bush cuts expire; so it is of the trade situation I want to write. Last week green shoots may have appeared in Colombia.

This has been an Administration that, despite the multicultural image it has cultivated, has been singularly xenophobic when it comes to global trade. In a report dated March 2009, Craig VanGrasstek of Harvard’s Kennedy School of Government stated that President Obama’s approach to trade “might be best characterized as passive free trade.” In fairness, most of the opposition to global trade emanates from Congressional Democrats who have long, deep and dependent (financial) ties to labor unions, the scourge of free trade advocates.

As a candidate, in a March 2008 speech in Ohio, Mr. Obama proclaimed that NAFTA had cost the United States one million jobs. He later vowed to withdraw if terms weren’t renegotiated. However, it is generally conceded that NAFTA, encompassing 450 million people producing $16.5 trillion in goods and services annually, is the world’s largest free trade area and, according to estimates, adds 0.5% (about $70 billion) to our GDP every year. But, bending to union lobbyists, no matter the benefits of NAFTA to the Country, President Obama signed a bill denying a Bush-era provision allowing transborder trucking between the U.S. and Mexico.

President Obama has neither actively encouraged nor discouraged Free Trade Agreements. When House Democrats inserted the provision “Buy America” into the stimulus package, the Administration waffled. Claude Barfield and Philip Levy wrote in August 2009, “The European Union, Canada, Mexico, Australia and Japan threatened to launch World Trade Organization (WTO) cases against the United States,” not an auspicious start for a man who vowed to rebuild international bridges allegedly blown up by his predecessor. But, rather than remove the language altogether, as John McCain urged, the agreed-to-amendment stated that the “Buy America” provision should not violate existing U.S. trade commitments.

Free trade agreements between the U.S. and South Korea, Panama and Colombia were negotiated by the Bush administration, but have been bogged down in a Democratic-led House. Mindful of his financial backers, the Obama administration has made little attempt to push them through a union-sponsored Democratic Congress.

Last week, however, the log jam may have been released, or, at least, eased. On the third stop of her Latin America tour, Secretary of State, Hillary Clinton, assured the Colombians of her and President Obama’s commitment to the Free Trade Agreement. On RCN Television she said, “We are going to continue to work to obtain the votes in Congress to be able to pass it.” Perhaps more importantly, she demonstrated that the streets of Bogotá have become safe. She met her peripatetic husband, ex-President Clinton, for cappuccinos and a steak dinner in a restaurant across the street from their hotel, a move that delighted President Alvaro Uribe, as a manifestation of the safety of the city. As President, not only was Mr. Clinton the author of NAFTA, but shortly before the end of his second term, in 2000, he launched Plan Colombia, the policy that has allowed Colombia to ascend from a drug -infested terrorist state to one of the few examples of a foreign aid success story.

As an editorial in the weekend edition of Investor’s Business Daily puts it, who better than Mr. Clinton, fresh from a successful endorsement of Blanche Lincoln in Arkansas’ Democratic primary – a victory she won despite $10 million being spent for her opponent by big labor – to shepherd the Colombian Free Trade Agreement through Congress? Unions have been the problem, in terms of getting Democratic support, so the former President would seem an ideal choice.

Unions have become an albatross around the neck of progressive Democrats. The world continues to evolve, becoming increasingly global, yet many unions are mired in the past. Their influence exceeds their numbers and is based almost solely on the dollars they provide to fund campaigns – virtually exclusively Democratic ones. Unions, especially the public ones, are the largest dollar contributors to any national campaigns, Democratic or Republican. Despite waning numbers, private sector unions’ influence remains ubiquitous.

While unions in the private sector have declined in terms of numbers, those in the public sector continue to expand, creating problems for states like California, New York, Illinois and New Jersey. Nevertheless, President Obama has shown courage in his willingness to take on teacher’s unions, in his support for charter schools. If he will now take on the AFL-CIO, in urging Congress to pass the three remaining Free Trade Agreements, the economies of the countries involved – the United States, South Korea, Panama and Colombia – will benefit. The way forward was shown last week when Mr. and Mrs. Clinton dined on steak in Bogotá. It is now up to Mr. Obama.

Friday, June 11, 2010

"Lessons from the Gulf"

Sydney M. Williams

Thought of the Day
“Lessons from the Gulf”
June 11, 2010

The obvious lesson is that the consequences of imprudent or corner-cutting methods used to extract oil from very deep off shore wells can be exceedingly costly. While stricter regulation will obviously ensue, there is, for a business, no master quite so compelling as the one that strikes the pocket book. If this spill costs British Petroleum $40 billion, as some have forecast, then a $20 profit on 2 billion barrels would represent three years worth of oil consumption in the United Kingdom! Politicians, regulators and environmentalists can rest assured that any company operating in deep waters off the shores of rich countries are going to be far more careful in the future.

The second lesson (I am sure there are dozens, but I am focusing on this one) is that the threat of a dividend cut – urged by the President, Congressional members and others – provides a vivid manifestation of the link between Wall Street and Main Street. Dividends matter. It is easy for a politician to look at the $10.5 billion BP pays in annual dividends and become incensed. But, when one considers that those dividends represent 12% of all dividend income paid to pensioners in the U.K., they assume another dimension. Long term studies of stock market performance conclude that about half of all returns to stocks come from dividends. Eliminating a dividend – easily done to satisfy disgruntled (or even gruntled) politicians – has serious consequences, in terms of a retiree’s income and in terms of the value of his or her capital. When J.P. Morgan-Chase reduced its dividend 87% on February 24, 2009 – two weeks before the stock market’s bottom – they compounded the pain for their shareholders, who over the previous fifteen months had lost 64% of their capital. The decision to cut or eliminate a dividend should be that of the board of directors acting dispassionately, while balancing the needs of the company versus their obligation to shareholders. It should not result from ranting politicians looking to score a populist point.

From what I can gather, about two thirds of all equities in the U.S. are held in tax exempt (retirement) accounts – state, local and private pension plans, 401K accounts, IRA and other retirement accounts. They represent, for lower and middle income people, the majority of their wealth, away from their homes. The country is facing an impending crisis, in terms of Social Security and Medicare, as baby boomers face retirement. Private retirement accounts will be critical in aiding the crisis. Government should encourage dividend growth through tax policy, not discourage it via populist rhetoric.

It increasingly seems that this government is intent on disparaging any fix that does not emanate from Washington.

Thursday, June 10, 2010

"Shrinking Consumer Debt = Lower GDP Near Term, but Higher Longer Term - Gvernment Permitting"

Sydney M. Williams

Thought of the Day
“Shrinking Consumer Debt = Reduced GDP Growth Near Term,
But Longer Term it is what the Doctor Ordered – Government Permitting”
June 10, 2010

Tough times call for tough measures. As the financial crisis and recession deepened, corporations were quick to cut costs, so that despite one of the most devastating recessions in the past one hundred years, according to Bob Doll of BlackRock writing in Tuesday’s Wall Street Journal, real GDP should reach an all-time high by the third quarter of this year. In contrast, during the Depression, it took fifteen years for GDP to return to its previous level. In the 1970s, it took three years. Mr. Doll, in the same article, writes that corporate profits could reach a new record high in this year’s third quarter – an incredible achievement, especially when the National Bureau of Economic Research has yet to call an end to the current recession. While federal and state debt has been soaring (discomfiting, but not surprisingly), corporations have been hoarding cash. Cash on balance sheets, at close to 11% of assets, is, according to Mr. Doll, at a 60-year high.

Consumers, more slowly perhaps, have also been reducing their leverage. Speaking at the Consumer Banking Association meeting in Hollywood, Florida, Fed Board Governor made a statement of the obvious, that a positive outcome from the [financial] crisis will be that consumers are likely to be wary about taking on debt. Data released Tuesday from the Federal Reserve suggests that is already happening. While consumer borrowing rose in April by 0.05%, the real story was in the revision of the March numbers from a small increase to a decline of $5.44 billion. During the nineteen months since consumer debt (both revolving and non-revolving) peaked in September 2008 at about $2.70 trillion it has declined in seventeen of those months to a current level of about $2.44 trillion – an “unprecedented stretch,” in the words of Kelly Evans writing in the Wall Street Journal, “in the series’ 67-year history.”

During the Bush years, total mortgage debt rose from $6.9 trillion to $14.6 trillion, an increase of 110%, while GDP rose 33% - implying a substantial portion of GDP growth could be attributed to increased home ownership and rising prices. Two factors acted as principal accelerants: an accommodative Fed and federal policy which actively encouraged home ownership. The result, as we all know, was an overleveraged consumer who ran out of places to hide.

The bad news is that total consumer debt remains uncomfortably high and future economic growth will reflect a continuing deleveraging consumer – and consumers represent two thirds of our economy. The good news is that the consumer, without a nudge from Congress, is addressing his unbalanced balance sheet. Revolving and non-revolving debt has been declining for the past year and a half. Mortgage debt, likewise, is in retreat. Mortgage applications have declined. As my friend, Vince Farrell, wrote yesterday, “The purchase index (as opposed to refinancings)…is now at its lowest level since 1997.” Foreclosures have set records in the past two months, not a positive sign, but further alleviating the mortgage situation. Nevertheless, in one of the great mysteries, which make economics as much an art as a science, home prices, according to the Case-Shiller Index, while down 0.5% in March, were up 2.3% versus a year earlier.

Crystal balls are not provided by my firm, so I have no idea as to the direction of home prices. What seems to be true, however, is that consumers, on their own, are addressing their own recent excesses. That will likely mean slower GDP growth, but it also suggests, in time, a healthier consumer. It is also worth noting that this trend will have been in place almost two years before any financial reform bill passes Congress. As Bob Doll wrote,”...the spirit of innovation and entrepreneurship that has defined America in past crises will prevail again…”

It is government, not corporations and not individuals that stands in the way of economic growth. At a time of crisis, it is necessary for government to step in and lend support, but as Federal debt rises to unsustainable levels we risk losing government assistance as an option should the economy falter. Federal debt now approximates 92% of GDP – the highest level since World War II. Much of the spending (while admittedly necessary in times of economic distress) has been for programs that inhibit job growth such as transfer payments, social welfare and regulation. Has all this spending been necessary? A year and a half ago, and even a year ago, the answer would have been yes. But the taste of big budgets has infected much of Washington and it remains to be seen if they can go “cold turkey” on pet projects which provide so much from so many to so few.

Thomas Friedman, in a recent New York Times op-ed, “A Gift for Grads: Start-ups,” quoted Curtis Carlson, the chief executive of SRI International, a Silicon Valley-based innovation specialist: “This is the best time ever for innovation…our global economy opens up huge new market opportunities [and] technologies are improving at rapid, exponential rates…opening up one major new opportunity after another.”

The federal government, though, persists on a contrary course. Our government is becoming increasingly mercantilist, more protectionist and overly interventionist, as the call by Congress for BP to suspend its dividend – generally the purview of a company’s board of directors.

So, while growth may slow, as the consumer weans himself from the incarcerating effects of debt, we may well be setting ourselves up for renewed and better growth from producing products and services and generating ideas that an expanding global economy needs. It will work, government permitting.

Wednesday, June 9, 2010

"BP's Containment Cap - Looking a Gift Horse in the Mouth?"

Sydney M. Williams
Thought of the Day
“BP’s Containment Cap – Looking a Gift Horse in the Mouth?”

June 9, 2010

For forty-six days the news emanating from the Gulf worsened. While there is no accurate way of measuring the volume, according to retired Coast Guard Admiral Thad Allen something like 25,000 barrels per day were spilling into the waters a mile down. On Saturday the first piece of good news appeared, to little coverage by the Press and no hockey sticks thrust in the air by politicians. Nobody wants to be seen celebrating while so many continue to suffer.

British Petroleum specialists, in a remarkable feat of engineering using remotely operated vehicles, cut the riser near the top of the blowout preventer and attached a close-fitted containment cap to siphon oil to the surface. BP is expected to slowly close the vents that are continuing to leak oil. Nevertheless, by Sunday 11,000 barrels a day were being collected. Admiral Thad Allen, who heads the Federal response, said the system is on track to capture 15,000 barrels per day. In a twelve hour period yesterday, 7,800 barrels were collected – faster than the run rate forecast by Admiral Allen the day before. However, the problem of leakage has not been resolved. While we can precisely measure the amount of oil now being collected, the amount of seepage remains unknown, though it is certainly larger than initial estimates.

At least one expert assigned to the government team charged with estimating the flow has concluded that the operation now siphoning more than 15,000 barrels a day has only made the situation worse. Dr. Ira Liefer, a researcher at the University of California in Santa Barbara, a critic of the “cap, container and flow” was given prominent coverage by the New York Times yesterday in venting his views. Despite his group’s inability to measure the leakage, he has already concluded the siphoning operation a failure.

Perhaps Dr. Liefer’s words will prove prescient, but at this point the only voice of reason, authority and an apparent willingness to accept responsibility for his decisions, in this entire mess, is that of Admiral Allen.

The President, after being criticized for failing to display appropriate rage during the first six weeks of the spill, on Monday, after a glimmer of hope appeared, said that if BP CEO Tony Hayward worked for him he would fire him. Commentators on cable networks and the internet are questioning as to whether BP should be allowed to profit from the oil they will be siphoning and bringing safely to the surface. Profiting? Andrew Ross Sorkin, writing in the New York Times, suggested that a worst-case estimate could cost BP $40 billion – more than two years net income for the entire company. (It should be noted that no one has any idea what the costs will be – the costs of cleaning the damaged coast line, the destruction of oyster and shrimp beds, the loss of a livelihood to tens of thousand of fishermen, the moratorium on drilling and the alleviation of suffering of millions of residents in the immediate area.)

Do these commentators have any idea where the money will come from to cover these costs? Regardless of the ultimate disposition of inevitable lawsuits, BP will be tied up in courts for years, so generating cash now at least provides a means by which some of the bills can be paid. The only known beneficiaries will be lawyers.

A third of the Gulf fishing waters has been affected and 140 miles of coast line have been damaged; in some cases it will take decades for nature to reclaim the marshes.

Nevertheless, good news should not go unnoticed. It is hard to believe, despite Dr. Liefer’s objections, that siphoning off an increasing amount of oil is not a positive step. In an article in yesterday’s USA Today, it was pointed out that shipping lanes have remained open in New Orleans, Mobile, Alabama and Gulfport and Pascagoula, Mississippi. Thirty cleaning stations have been set up, but at this point “Only one ship has been doused so far – and that’s because it sat in one place for three days.” While, at this point, 140 miles of coastline have been affected, they only represent 8.3% of the 1680 miles of U.S. Gulf Coastline.

This somewhat Panglossian view should not be construed that I minimize the damage done to the coastal beaches and marshes, nor that I ignore the loss of life in the initial explosion, nor that I trivialize the loss of jobs and the costs that will result to food and energy. I do not. If this is not the largest man-made disaster in our Nation’s history, it must rank among the largest. My house in Connecticut fronts the marshes at the mouth of the Connecticut River; so I am a conscious beneficiary of the abundant and extraordinary forms of life that inhabit those environments. Regardless, while looking a gift horse in the mouth is OK, it should not detract from the fact that good news is good.

Monday, June 7, 2010

"Un-Buffett Like Comments by Warren Buffett"

Sydney M. Williams

Thought of the Day
“Un-Buffett like Comments by Warren Buffett”
June 7, 2010

Warren Buffett is, deservedly, the paragon of global investors, which is why his testimony before the Financial Crisis Inquiry Commission in New York last Wednesday was so disappointing.

Mr. Buffett was subpoenaed to testify, having declined an invitation, as the largest shareholder of Moody’s – whose business model he has described as “bullet proof” and “extraordinary.” The description is apt, as the business is an oligopoly, of which three companies, Moody’s, Standard & Poor’s and Fitch have the majority share. The SEC permits investment banks and broker dealers to use credit ratings from “Nationally Recognized Statistical Rating Organizations” NRSROs, of which, as of 2008, there were ten, five in the U.S. Besides the three listed above, the other two American companies are A. M. Best and Egan-Jones Rating Company. A. M. Best works principally with insurance companies. Egan-Jones is paid by investors, not issuers.

While the business of Moody’s was “bullet proof”, according to Mr. Buffet, and that was the principal reason for his investment, he claimed that he personally does not rely on credit ratings when making investment decisions. He makes his own judgment. “What we hope for,” Mr. Buffett said, “is misrated securities because that would give us a chance to make a profit if we disagree with the rating agencies.” That makes good investment sense, but does not seem like a good reason to excuse the rating agencies for having misled other investors. His defense of Moody’s and Moody’s CEO, Raymond McDaniel that they were “among many who missed warning signs of the crisis” just doesn’t hold up. Investors rely on the rating agencies because of their supposed diligence and insight, and their quasi-government affiliation. Nevertheless, Mr. Buffett added, “In this particular case, I think they made a mistake that virtually everybody in the country made,” so removing Mr. Daniels is “not necessary.” Arguing that agencies were among the many who missed warning signs of the crisis may be a true statement, but placing “virtually everybody in the country”, on an equal setting, with the supposed gate-keeping experts, which are the rating agencies, is a flimsy defense.

Mr. Buffett went on to say, “I’m not arguing that this is a perfect model [the rating agency model, paid for by the issuers]. It’s very difficult to think of an alternative where the user pays. I’m not going to pay.” That statement is contradicted by his statement that he does not rely on the rating agencies. He does his own work, which means he is paying, either his staff or outside analysts; so he is using an alternative.

In speaking of the housing bubble, Mr. Buffett said, “Rising prices are a narcotic that affects the reasoning power, up and down the line.” Again, a true statement, but over the years Mr. Buffett has made great use of “Mr. Market” who takes advantage of emotional swings in markets; so one would think he must have seen Moody’s falling victim to just that emotion – that their persisting with AAA ratings for securities that were becoming increasingly irrational – would have caused him to question their judgment? But perhaps, since he personally ignored their credit ratings he was fine, as long as most investors continued to use them?

It seems to me that Mr. Buffett, who is as wise and plain spoken as any investor of the last half century, could have used the forum to argue that a basic problem with the system is that rating agencies are paid by the issuers, thereby establishing an inherent conflict of interest. While he claims he cannot see an alternative, he uses one himself – conducting his own independent research.

Larry Harris, in Friday’s Financial Times, suggests a contingent compensation system, whereby some percent of the fees paid to the Credit Rating Agencies (CRAs) be placed in escrow and released over time based upon the performance of the bonds. Cash flow needs of the CRAs could be had by borrowing against the escrowed funds. The lenders would, effectively, rate the raters instead of the government. It drastically would change the business model, but we know the current one does not work.

Representative Barney Frank would force credit raters to register with the SEC and allow investors to sue them for assigning recklessly high ratings. Senator Al Franken wants a new regulatory board to choose the rating agencies that analyze each bank deal. Both proposals would add to an already bloated government and would serve to give a more entrenched “government approval” to ratings – permitting, perhaps, less independent analysis and more reckless behavior than we now have. Besides which any new government agency is grist for lobbyists. The ability to sue, despite appealing to trial lawyers, should always be an option.

It makes more sense, in my opinion, to adapt what Mr. Buffett does already. Investors should be responsible for doing their own due diligence. Whatever information CRAs now receive from the businesses, agencies and governments whose bonds they rate should be available to all parties. It should be a level playing field. Investment banks should be disallowed from providing research on their own debt – on mortgages they create, or on all other products they create or issues they underwrite. Individual investors would rely on research from those that sell it, just as they do today for equity investments. On May 3rd I wrote a “Thought of the Day” entitled “Rating Agencies – Do We Need Them”. My answer then and still is “no”. Whatever void would be created by their absence would be filled by new and old firms clamoring to get into the credit research business. The new firms would represent investors, not issuers. Those that do well will thrive. Those that do not will fail.

But Mr. Buffett whom we all admire as the world’s foremost investor did not take advantage of the opportunity he had to suggest a better way. He came across as a defender of a firm, which saw 90% of its investment-grade ratings in 2007 become relegated to junk. It makes no difference that “they made the same mistake virtually everybody in the country made.” They were supposedly the experts; the ones who had done their due diligence upon which most investors depend. It seems obvious, despite protestations to the contrary, that Mr. Daniels was more interested in market share than in accuracy. In this instance, “Mr. Market” missed his opportunity. I expected more from Mr. Buffett.

…………………………………………………………………

Tomorrow I will be in Massachusetts for the Big Brothers Golf Outing – a worthy cause, but a sport at which I am abysmal. If victory were based on the most swings taken, I would be lauded and covered in roses; alas, that is not the way in which golfers are judged.

Thursday, June 3, 2010

"The Promise of Capitalism Will Return - Just Not Yet"

Sydney M. Williams

Thought of the Day
“The Promise of Capitalism Will Return – Just Not Yet”
June 3, 2010

Two years ago this evening, in St. Paul, Minnesota, Barack Obama, having just secured the Democratic nomination, gave a victory speech. He sounded like a cross between an Old Testament Prophet and King Canute, absent the modesty of either. He ended the speech, “…I am absolutely certain that generations from now, we will be able to look back and tell our children that this was the moment when we began to provide care for the sick and good jobs for the jobless; this was the moment when the rise of the oceans began to slow and our planet began to heal; this was the moment when we ended a war and secured our nation and restored our image as the last, best hope on earth.”

Now, fifteen months into the Presidency, Mr. Obama is facing challenges, most not of his making and, I am sure, not anticipated. Despite the economy gradually extricating itself from recession, unemployment remains high. In spite of extending open arms to the Muslim world, Mr. Obama has been rebuffed by Iran. The War on Terror, by whatever name, persists. Hundreds of people in Detroit and New York are alive today, not because of our government’s success in preventing terrorist’s attacks, but because of the incompetence of Umar Farouk Abdulmutallab and Faisal Shahzad. Mr. Obama finds himself helpless in an accident (preventable or not) in the Gulf of Mexico, which looks to be the greatest ecological disaster our Country has ever known. (While the government now claims they are “in charge”, it will be the engineers at British Petroleum that ultimately will fix the leak. Nevertheless, expect a dozen or more government hockey sticks to be raised when the leak is plugged.)

The Presidency must be a humbling experience. The truth is that not all problems can be fixed. Accidents happen and not every one can be prevented, or even anticipated. Nature is more powerful than anything man has created. The ability to hate, unfortunately, lies deep within the psyche of man. We should, of course, never stop trying to improve ourselves and our environment, but life is not without risk. We must weigh the obvious benefits of accident prevention against the rewards that come from innovation and development.

Thirty years ago President Reagan was elected on the claim that government was the problem, not the answer. President Obama was elected at a time when the financial system had come close to failing; government, to him, was the answer. The truth is that both sectors, left to themselves, exceed the norms of common sense. Capitalism thrives on self interest, but, when society suffers at the expense of personal greed, collapse becomes inevitable. But we also know that government’s appetite exceeds its ability. The U.S. Post Office will never get marks for efficiency and anybody who has ever been to the department of Motor Vehicles understands the futility of dealing with government bureaucracy. The Obama Administration has fewer people in its cabinet that come from private enterprise, than any previous administration. The U.S. Congress is a master of spending money, but has no concept as to how to generate revenues, other than through taxation.

Mark Steyn, a cultural critic and political commentator, recently wrote a column, “We’re too broke to be stupid.” He points out that the expansion of entitlements, which transfer money from productive sectors (taxpayers) to unproductive sectors (non-taxpayers), are, perhaps, understandable when we are “rich”, but are stupid when we are “poor”. And a nation of 300 million with $13 trillion in Federal debt ($40,000 per person) is certainly not rich.

The oil spill in the Gulf will cause drilling to be curtailed, even in areas deemed to be safe. Clean energy is a worthy ideal, and a goal worth aiming at. But the truth is we have been doing just that for most of my life. When I was born, most apartments in New York City were heated by coal, and the smell and smoke filled the skies and clung to the buildings. In the 1970s, there were many days during the summer when the beaches at Sea Bright, NJ were closed because of pollution. The Connecticut River, on which I have a home, is cleaner today than it was two hundred years ago. I am a believer in conservation and support their causes, but there is a cost to clean energy that must be weighed against its benefits.

In my view, the stock market continues its long adjustment that began in early 2000. Like the 1920s and the 1960s, the 1990s were a time of “irrational exuberance”, a period when investors priced stocks to perfection. Those halcyon days came crashing down as the tech-telecom-internet bubble imploded over two and a half years. But the speculative juices were not quenched, as the Fed kept interest rates low and speculator attention was transferred from internet stocks to home prices. The collapse of that bubble finally took the wind from the sails and with it confidence in the long term future of our capital markets. As portfolio managers struggle today, it seems to me it is best to try to view where we are within the perspective of a continuum of time.

Part of what bothers the market, in my opinion, is this tug of war between the demands of the state versus the wants of capitalism. The pendulum has only recently swung in favor of statism; it is probably too early for it to swing back toward free markets, but it will. In my opinion, it is not unlike the 1970s. The election of Ronald Reagan almost a generation ago ushered in an age of free capitalism and produced the greatest spurt of growth and wealth creation our Nation has ever known. Social welfare states do not work, even those of a benevolent nature, as we can see from the troubles in Europe. Burton Malkiel writes in today’s Wall Street Journal: “Western governments have made entitlement promises that are increasingly difficult to keep.” Socialism certainly does not work when governments are evil, as in Venezuela, or as was true in the former Soviet Union, and it will not work in America, but memories are short; so to the extent we rely on our most recent experiences, at the moment it is the problems of greedy banks, unscrupulous brokers and, now, oil companies drilling in the deep waters of the Gulf that are in the forefront of the minds of the people. However, this period, too, will pass.
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Tomorrow I have a stress test; so please do your best to make the market minimally stressful as possible. Another day like Wednesday would be just fine.

Wednesday, June 2, 2010

"High Speed Computers? Common Sense is the Answer - At Least for Markets"

Sydney M. Williams
Thought of the Day
“High Speed Computers? Common Sense is the Answer – At Least for Markets”
June 2, 2010

An article in Yesterday’s New York Times cited the fact that China’s Dawning Nebulae based at the National Supercomputer Center in Shenzan has achieved a sustained computing speed of 1.27 petaflops, the equivalent of one thousand trillion (quadrillion) mathematical operations a second, making it, in terms of theoretical peak performance, the fastest computer in the world; however, in terms of a standardized test, the machine ranks second to the Cray Jaguar supercomputer located at the Oak Ridge National Laboratory in Tennessee. I doubt my stop watch could catch the difference.

Apparently this is not good enough. The article goes on to suggest a new system is being built to compute at exascale performance – a million trillion, which would be a “1” followed by 21 “0”s. Pretty soon these machines will be fast enough to attract a new breed of high frequency traders. While the last sentence was written facetiously, there is little doubt in my mind that they (high speed traders) have been a major source of the ebbing confidence among investors.

Their activity leads to the question – what weighs upon the market? The list of concerns is well known: besides high frequency trading, Europe, Iran, North Korea, Israel and its blockade, the oil spill in the Gulf, greater government intrusion into business, deflation, inflation, high levels of debt at both state and federal levels, forthcoming financial regulation and cap and trade, insider selling, tax increases – the list goes on.

But I suspect a significant part of the problem is psychological. A year ago everything seemed possible. We had a new President who was young, articulate, bright and confident. Granted, the Country and the world were in recession, having suffered a near-fatal financial collapse, but it was one which we had survived, and recession seemed a small price to pay. Anything and everything seemed possible. President Obama provided a sense of renewal, trust and belief, as we faced the future. While there were doubters, giant steps were taken, like the stimulus package. Unemployment would recede; jobs would be created. People believed, or wanted to believe in, policy initiatives, such as health care reform, financial regulation, cap and trade. The Muslim world would become our friends. It was a case of “out with the old (anything Bush) and in with the new (anything Obama).” And the Economic Cycle Research Institute (ECRI) omnisciently predicted, in May 2009, the economic recovery that began in the third quarter.

Then things began to turn. The very size of the stimulus package began to weigh on investors and people began to question its merits. Health care reform rallied opposition, like the Tea Party, and questions arose about too much government. Just as Macbeth, upon hearing of the death of Lady Macbeth, saw his hopes turn to ashes; investors soon became concerned that the principle of Murphy’s Law would prevail – “Anything that can go wrong will go wrong.”

Recent news lent credibility to those concerns. British Petroleum’s oil spill in the Gulf is becoming one of the worst environmental disasters in U.S. history; Iran, according to some studies, now has enough material to make two nuclear bombs. The “flash crash” on May 6 spooked investors. Europe appears incapable of dealing with their crisis, which is bound to result in even more bank write-offs. According to the West Coast’s Mechanics Bank, an estimated $8 trillion in federal, state, corporate and commercial real estate debt will have to be refinanced between 2012 and 2014. Data from ECRI suggests that the economy, while still in recovery, is showing signs of slowing.

However, things change. The time and the circumstances cannot be predicted. What would be nice would be a leader in the mold of France’s great World War I general, Ferdinand Foch, who, at the Marne, wired his commander: “My center is giving way, my right is in retreat; situation excellent. I shall attack.” Regardless, to borrow another line from Shakespeare, this from Henry VI, Part 3, “the smallest worm will turn being trodden on.” Bad and seemingly hopeless situations will reverse. I recognize that that provides cold comfort to the portfolio manager dealing with redemptions from dispirited investors. So we must resort to the things we can fathom – fundamentals: the study of companies, understanding their cash flows and determining values. Fear causes emotion-filled decisions. We can either abet the volatility of the market, or we can let that volatility work for us, to use “Mr. Market” speak.

High speed and performance computers will permit great advances in medicine and defense. But, in markets, the speed of the fastest computer cannot substitute for the common sense of the individual and I, for one, would always rather invest alongside common sense.

Tuesday, June 1, 2010

"Remembering Memorial Day"

                                                                                                                                                                  Sydney M. Williams
                                                                                                                                                                  June 1, 2010

Note from Old Lyme

“Remembering Memorial Day”

“The roses blossom white and red
On tombs where weary soldiers lie;
Flags wave above the honored dead
And martial music cleaves the sky.”
                                                                                                                           Joyce Kilmer (1886-1918)
                                                                                                                          The second stanza from “Memorial Day”
                                                                                                                          Kilmer was killed at the Second battle of the Marne.

It is Memorial Day in Peterborough, NH, when I was ten or eleven, which I remember best. In part, that is because memories of World War II were so recent, it having been concluded only six or seven years prior, and in part because the Parade in a small town is so personal. In a town of 2500 people, 341 (including my father) served in the armed forces during the Second World War – a remarkable number given that there could not have been many more than 400 eligible men. (A few women in the town did serve in the WAVES and WACS.) Thirteen of the men were killed. One of those killed, Theodore Reynolds, had a brother, Rodger, two grades above me. Another who was killed, Philip Sangermano, had a brother, Tony, with whom I used to ski at Whit’s.

Many of the marines, sailors and soldiers who served were men that I knew – Perkins and Robert Bass, Kenneth Brighton, Harley Cass, Paul Cummings, Milton Fontaine, Edward Lobacki, Elting Morison and Walter O’Malley among others. Most marched in the Parade; a few, like my father, chose not to. Accompanying the soldiers and veterans were the high school band, composed of children older than I, but whose younger siblings I knew; along with cub scouts, girl scouts and boy scouts. With several others on bicycles, we trailed the Parade to Pine Hill Cemetery just north of the village on Concord Street. It was a somber moment when, after the laying of a wreath, the sound of Taps could be heard, followed by its echoing notes wafting from the hill beyond.

Of course I did not fully comprehend the symbolic significance of the bugle, repeated year after year, with its spine-tingling response, but I did realize that it represented a moment for the townspeople to, annually, pay tribute and say goodbye once again to those who had fallen in our Nation’s wars. However, I knew the moment was grave and rich in meaning.

Those of us who are fortunate to live in this Country, either through birth or adoption, owe an allegiance of remembering those who gave their lives that the principles of democracy may endure. The signers of the Declaration of Independence promised to “mutually pledge to each other our Lives, our Fortunes and our Sacred Honor.” We can do no less than recall that an estimated 1,200,000 have given their lives, since 1776.

Originally called Decoration Day, Memorial Day, which was first celebrated in the years immediately following the Civil War, and Arlington Cemetery, where more than soldiers 300,000 are buried, have come to symbolically represent all those who have fallen in our Nation’s wars. The scene on Memorial Day at Arlington, in which American flags are placed on the tombs of all veterans, and where a wreath is laid at the Tomb of the Unknown Soldier, is one in which all Presidents have participated. It is unusual for a sitting President to be absent, as was true yesterday, especially in time of war.

This year, as has been my family’s recent custom, we observed the Parade in the small town of Old Lyme. Middle school and high school bands march as do a Fife and Drum group from Deep River and a Bagpipe Brigade from New London. Scouts and Little league teams proudly march. Antique cars, fire engines and EMS vehicles wind slowly up the street, as do muscle cars, including a Ford Gran Torino and a Pontiac Trans Am from the early 1970s making their presence known with a roar of their engines. With local groups, such as the Old Lyme Historical Society, the Lions’ and the Selectmen, they all drive or march toward the Duck River Cemetery where lie veterans from every war that has been fought on this continent and in distant lands, including those from colonial campaigns, such as King Philip’s War. But the highlights are the veterans, some of whom served in WW II and today are too old to march, with others from Korea, Vietnam, the Gulf War, Iraq and Afghanistan. Taps are played, as in Peterborough, and its echoing refrain is mixed with the sound of the wind and of the cries of Osprey flying overhead. The notes remind us of our eternal debt.

"The Middle East - Tensions Intensify"

Sydney M. Williams

Thought of the Day
“The Middle East – Tensions Intensify”
June 1, 2010

The quietness of the City that greeted my return yesterday was, I hoped but feared not, an omen for a gentle June. May was the worst month since the “Annus Horribilis” that was 2008, in terms of the severity of its decline; the magnitude of its volatility was the worst since early 2009.

The “flash crash” of May 6 put the fear of God into the psyche of investors; as well it should, since the authorities have yet to lay blame. They have told us who is not responsible – fat fingers, hackers or terrorists – but have not yet determined the culprit. However, it seems to me that there is little question that high frequency traders (either through omission or commission), and their treatment of stocks as casino chips, played a significant role.

While the participation of these players must be addressed to restore confidence in our markets and to permit the markets to function smoothly as raisers of capital, of more immediate concern, in my opinion, is the heightening tensions in the Middle East – this time stemming from Israel’s boarding of the Turkish-flagged Mavi Marmara, reportedly bringing humanitarian aid to Gaza. Failing to heed repeated calls to turn back and a warning that commandos would board the ship, Israel’s naval seals boarded and were attacked by a knife and pipe-wielding crew, with at least one being tossed overboard. Subsequently Israelis opened fire and nine crew members were killed.

It has become politically correct to trash the one Democracy in the Middle East. Israel is already considered “Peck’s Bad Boy” by Europe and a growing constituency in the United States. The decision by the Turkish group, Insani Yardim Vakfi, to run Israel’s blockade was a case of “kicking the dog while it is down” and was a deliberate and provocative action designed to place Israel in a “no-win” situation. For ten years, since the Al-Aqsa Intifada broke out in September 2000, Israel has had in place a naval blockade of Gaza. Hamas, which governs Gaza, has pledged to eliminate Israel. Nevertheless, humanitarian goods are shipped daily to Palestinians in Gaza, via both Israel and Egypt. The goods are inspected for the possibility of weapons that can be used for bombardment of Israel.

Turkey has been anxious to play a bigger role in the region, as we recently saw in their (and Brazil’s) agreement with Iran for nuclear fuel. In contrast to Israel, for Turkey this looked like a “win-win” situation. If the flotilla reached Gaza, the ten-year-old blockade could be deemed to have failed. If the ships were attacked, Israel would find itself increasingly isolated. And Turkey’s standing in the world would rise.

The seriousness of the situation can be seen in Turkey’s withdrawal of their Ambassador to Israel and Israel’s statement urging their citizens in Turkey to leave. Prime Minister Netanyahu returned home, thereby delaying a planned visit with President Obama.

The U.N. Security Council met yesterday and condemned Israel’s action, but did not impose sanctions; they ordered an investigation into the matter. The United States urged Israel to conduct its own investigation.

The importance of the Middle East to our energy needs remains critical and, despite the fact that neither Israel nor Turkey is important in that regard, any flare-up will have consequences. British Petroleum’s spill in the Gulf is another visible manifestation of what will continue to be our dependency on imported crude; for it is obvious all deep-water drilling has been tabled. And with regulation tightening everywhere, all drilling is going to become more expensive. There are no free lunches. With many shallow-water wells and the Anwar Oil Fields off limits and adequate alternative sources of energy, such as solar and wind, years in the future, our dependency on imported energy will remain.

Tensions in the Middle East have again intensified – not a positive factor in a fragile global economy struggling to rebound.