July 2009

Bridges To Freedom

After taking time off from writing due to a hectic schedule, here we are back again, a couple months into a rally we first talked about potentially occurring in February.  Before we get into any real economics, first a little about a trip I just returned from.

The first week of June I was one of a small group of financial advisors. nationally to be invited to San Francisco to attend the annual due diligence meeting of Highmark Capital Management, an investment management company that provides advisory services for various investment vehicles for sale or use by stock brokers and investment

After arriving at the absolutely magnificent Palace Hotel, I decided to start my first San Francisco visit by being a sightseer.  I lit out on foot from my room and headed towards AT&T Ballpark, which was an obvious choice for me being the Commissioner of the Milwaukee Baseball League.  Along the way, I passed several pubs and bars, which made me feel right at home.  As I walked along McCovey Cove behind the stadium I was able to peak into the field and see what I believe was a workout of players the Giants were considering in this year's amateur baseball draft.  A pretty cool start to the day in my opinion.

I then walked the Embarcadero all the way around beginning in the South Beach Harbor neighborhood, with stops at the Hi Dive for a fantastic fish taco lunch and interesting conversation, every pier there including Pier 39 where the Sea Lions were holding court and by Alcatraz.  I ended a long afternoon having street crab along Fisherman's Wharf, chocolate ice cream at Ghirardelli Square and exploring just how emotionally deep it can be to be an art collector at the Franklin Bowles Gallery with Sy Sajid who was great in helping a novice begin to learn.

Throughout the day, there were two structures that stood out, no matter where I was: The Bay Bridge and the Golden Gate Bridge.  I stopped several times to think about just how these awesome structures were built.  I remembered watching the Bay Bridge sway on TV during the 1989 Loma Prieta earthquake that took place during the World Series between the two Bay cities, San Francisco and Oakland.  I could not believe that these massive man made highways did not collapse from the force of an angry earth that day.  The bridges are truly a testament to what mankind and America can accomplish with directed thoughts and efforts.

Economic Earthquake

It is easy to blame capitalism for the problems we face now as an economy.  Put as plainly as I can, capitalism is not the problem, it is the solution.  Over the past decade, it was not capitalism that ruined the economy, rather, it was a lack of ethics and quite frankly very much a criminal element that brought the system down.

In 1999, the Republican Congress led by Phil Gramm and President Bill Clinton relaxed banking safeguards and oversight by cutting back and in many cases eliminating depression era banking regulations.  While this was not on the surface unethical, it invited unethical behavior across the financial industry a few short years later, as we will once again review.

What I am about to say next is no revelation, and there are several books on the topic: During Alan Greenspan's tenure as Federal Reserve Chairman he increased the money supply by more than all other Fed Chiefs and Treasury Secretaries of the United States combined, and in turn the value of the dollar decreased by about half in eighteen years.  The effect on our economy was to create back to back bubbles, first stocks, then real estate.  Greenspan himself has said in interviews he misunderstood what was happening in real estate and securities markets.  His misunderstanding, led to two massive collapses, the second of which we are dealing with now.  While what Greenspan did was certainly not criminal, it flies in the face of common sense economics and the ethics of his job at the time.

Consider this hundred year old quote from a renowned economist which is broadly accepted: ""There is no means of avoiding a final collapse of a boom brought about by credit expansion."  No Fed Chairman should ever, by ignorance or any other reason, such as politics, help create a financial bubble by monetary policy that can only end in the misery of the citizens of the nation.  Greenspan did just that.  While my criticism might seem harsh I am hardly alone.

With the easy money then, banks relaxed lending standards in line with President Bush's "America's Homeownership Challenge" of 2002 which called for the real estate and mortgage finance industries to join the effort to close the gap that exists between the homeownership rates of minorities and non-minorities.  Some have noted that hispanics in Florida benefitted in the short run from what was going on, at least through the 2004 Presidential election.  Was there an ethical dilemma here?  Hard to say for sure, but clearly Florida became the focal point of the 2004 election.  At a minimum, banks put immediate profit and financial gain ahead of the sustainable health of their businesses, a problem that plagues many companies.

Another root cause of the financial collapse, which is almost completely and inexplicably ignored by the media, was clearly the Securities and Exchange Commission's changing of the net capital rule in 2004 that regulated the leverage that the big 5 investment banks- Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers and Bear Stearns- could employ.  In a NY Times article, it is pointed out that only one dissenter in the SEC, Harry Goldschmid, brought up that if the five firms being exempted from capital requirements had a problem "...it’s going to be an awfully big mess.”  Truer words were never spoken as three of those firms no longer are in business on their own.  The leverage that these firms were allowed to employ directly stimulated the mortgage banking industry into writing bad loans as they did not have to carry the risk of faulty underwriting- or so they thought.  This one piece of the puzzle likely made the collapse worse by a magnitude of at least double, probably triple and possibly much more, only time will tell.

Interestingly, Hank Paulson, CEO of Goldman Sachs at the time, was a major advocate for the rule change.  Two years later, he would become Secretary of Treasury under George Bush, and would preside over the initial TARP funds that were paid out to Wall Street firms.  Much of that money went to retention and other types of bonuses for employees of the failing firms.  Many of the people who received that money had been part of receiving record bonuses on Wall Street during the decade and faced few sanctions or restrictions on income even though virtually everything they had done the previous several years not only collapsed their firms prompting Federal bailouts, but were the catalysts to the American and world economies spiraling out of control.  While I hesitate to call any of the people involved outright criminals, the conflicts of interest are off the charts from an ethical standpoint.

Finally, criminality surged in mortgage origination.  From 2002 to 2004, the Office of the Comptroller of Currency, an office of the Treasury Department, effectively killed the ability of states to enforce their mortgage fraud laws.  In its 2005 Mortgage Fraud Report, the FBI showed that mortgage related fraud had more than doubled from the previous two years.  The FBI later noted that "according to a May 2006 Financial Crimes Enforcement Network (FinCEN) report, finance-related occupations, including accountants, mortgage brokers, and lenders, were the most common suspect occupations associated with reported mortgage fraud."  In essence, the foxes were in charge of the hen house.  You can find local examples of the crimes that were committed.

There are several other smaller factors involved in the collapse, but those listed are the main links in the chain.  summarizing, we had:

  1. Gramm-Leach-Bliley Bill of 1999.
  2. Easy money from the Fed.
  3. Careless underwriting at the commercial banks.
  4. No standard mortgage underwriting by the shadow banking system, i.e. mortgage corporations, structured investment vehicles (SIVs) and various offshore mortgage loan funding companies and investors issuing mortgages without verifying income or job.
  5. Over-leveraging via securitization at the investment banks and lenders taking advantage of Fannie Mae and Freddie Mac loan guarantee systems which were not equipped for the types of risky mortgages suddenly being issued.
  6. And finally, outright criminal behavior at the point of mortgage origination and issuance.

Crossing Bridges

Right now, the American economy sits at one end of a long bridge.  Unfortunately, it is the end opposite of where we want to be.  We currently have high unemployment, high debt at the household level constraining spending, high debt at the governmental level weakening the dollar and threatening inflation, a significant trade imbalance, a weak financial sector, high healthcare costs, energy challenges and a lack of productive manufacturing.  All of these issues need to be addressed over the next several years.  While some might want to address these issues slowly in a piecemeal fashion, I believe it is imperative that we move quickly and decisively on all fronts lest we risk a massive long-term economic malaise in this country which could cost us many of our freedoms.

The Obama administration seems to agree with my analysis that a go slow approach would court further economic disaster.  In general we also agree on many of the remedies.  My one huge concern is that politics takes precedent over economics- which it usually does- and we cripple the American economy long-term by squeezing out private investment and innovation, which have long been the strengths of America.  We must move quickly, but more importantly, wisely.  We must sustain capitalist incentive, while regulating unethical and criminal gluttony.  And we must do these things without expanding government to the point where it loses its effectiveness as an oversight mechanism and becomes a further bureaucratic burden on the nation- for example, if government were to actually run the healthcare system rather than just setting basic standards and rules (the most important being eliminating pre-existing clauses and underwriting), creating oversight and providing safety nets for the poor.

If we allow capitalism to be crippled and government to grow unimpeded and unchecked, we will not be solving any problems, we will merely be covering up our problems with expensive wall paper.  If that happens, we will lose our freedoms under the yoke of oppressive financial weights, intrusive government meddling and ultimately civil unrest.  While I do not think those worst case scenarios will come to pass, we clearly face decisions today that will impact our children and grandchildren immensely.

With that warning I will simply mention that with regard financial planning, it is prudent to keep extra cash, pay down debts, learn higher end job skills in your profession (or if you are switching professions consider energy and healthcare related fields) and employ a sound investment strategy.

Now, I will hit send, and say goodbye for a few weeks.  I am taking my children to Cleveland to visit the Rock and Roll Hall of Fame and to see a baseball game, Washington DC for Independence Day on the Washington Mall, a lot of sightseeing and a baseball game, and New York to see the Statue of Liberty, Ellis Island and the World Trade Center site.  Have a fantastic, safe and reflective Independence Day.


Kirk Spano