March 2009

Cars, Banks & Dollars Without Borders 

This month I get to our letter later than usual. For all the explanations of what has been going on in the economy and financial markets, I find myself getting more questions every day about my thoughts. The letter this month will offer some brief commentary on a few of the issues I have been asked about most. I must also admit, I am behind because frankly business has been good for me due to your referrals, so I sincerely thank you and hope I can continue to inspire your confidence.

A Few Issues of Note

Today we saw the resignation of Rick Wagoner of GM at the request of the Obama Administration. In watching and listening to various financial press I got the full range of opinions about the matter and the one I didn't hear was mine.  Pretty simply, nobody stood up and said, "...hey, this guy has run GM for 9 years, made tens of millions of dollars and the company is now effectively bankrupt. The guy probably should have been fired years ago."  President Obama came closest with his statement about needing to stop excusing bad decision making. The financial press was once again mostly deficient with at least one notable exception that I found in Donnie Deutsch who is awesome.

While I have already mentioned that I think the various bailouts are being handled clumsily with plenty of waste and theft going on, it is clear that the United States needs a domestic auto industry (in addition to a banking industry- to be addressed next).  This is so not only true from a jobs and product standpoint, but also a national defense standpoint, so we must make sure that GM and Ford do not simply disappear- Chrysler is less important in every respect than GM and Ford.  So far, the auto company bailout appears to have been handled about right, including dismissing Wagoner (albeit late).  It is time for new leadership at GM plain and simple. It is also time for investors, not employees, to take the balance of the brunt of the restructuring, potentially via bankruptcy. We must realize that it is ethically more right to support somebody who needs a job to feed a family than somebody who will have to take a tax write-off.

Onto banking, where talk has been of TARP, which is not a sort of fish. The banking industry is still in dire straights regardless of a few firms making noise about wanting to repay the TARP money early. My not so difficult to figure out analysis is that these firms are simply paying lip service to not wanting to be part of the TARP bailout any longer.  Virtually all of the banks that took TARP money, Goldman Sachs included, not only needed the TARP money a few months ago just to survive, but still do in order to maintain even flat lending levels.

As a point to the case, Goldman Sachs, ostensibly one of the strongest banking companies, had to cease being an investment bank last autumn and become a chartered deposit taking institution to stay in business without completely recapitalizing, they received about $12 billion indirectly from the government via AIG's bailout and they are still paying Warren Buffet a 10% dividend perpetually (that means forever if Buffet chooses) to use his money. So tell me, how strong is Goldman Sachs really? With the possible exceptions of Wells Fargo and JP Morgan, I don't believe that there are many large commercial bank that can pay back the TARP money and maintain lending at recent levels.

Of note regarding lending is that much (approximately half) of the lending for mortgages, cars and credit lines from 2002-2006 came from a non-bank entities that eluded bank regulation, such as mortgage companies, private equity funds, hedge funds, structured investment vehicles, monoline insurers and other lending firms that are no longer in existence- the so-called "shadow banking" industry.

It is important that the commercial banks not reduce lending (they are actually roughly flat as a group when small banks are counted in), because if they do, the economy will continue to contract and unemployment will grow.  As a nation we need the large commercial banks to hold onto the TARP money in order to float their balance sheets so that they can maintain lending levels. In the end, I am fairly certain that these banks will keep the TARP money because they do not want to face shrinking market share versus more aggressive competitors.

Sometime soon, we are likely to see the mid-size banks start to merge en masse as Federal money dries up for them and FDIC pressure mounts.  These mid-size banks will need to eliminate branches and employees in order to shore up their balance sheets and increase lending in order to profit from a steepening yield curve (lend long, borrow short).  Small banks will gradually fill the spaces where openings occur due to mergers of necessity at the mid-size bank level.

Of note to consider is something that the Canadian Prime Minister Stephen Harper said today, "In the name of conservatism or free markets, in some cases, (other) governments ignored very fundamental lessons we know from history. Canada itself has shown that if you have a reasonable system of regulation, there is no need for governments to be nationalising banks and directing executive compensation and trying to micromanage economic activity."  Hear hear.  He made those comments as Canadian banks apparently are planning acquisitions around the globe due to their strength.

Before I move on, I want to touch on the AIG bonuses that Congress flew into a rage about a couple weeks ago. They were right to be upset, although they are a little late to the game. The TARP program, a Paulson/Bush plan, not a Congressional one initially, should have put limits on bonuses and dividends when it authorized the first bailout. For whatever reason, the previous administration did not put those restrictions on and Congress did not demand them, even though there were many who brought the topic up at the top of their lungs. As a result, tens of billions of dollars were paid out around Wall Street in December alone for bonuses and dividends using government (our) money. 

Recently, about $160 million (with an M not a B) was paid, or supposed to be paid, to AIG employees who were mostly brought in a year ago to fix the company and oversee asset sales meant to make sure AIG paid back the government (us). I don't know about you, but there seems to be a failure of reason in certain people who did not criticize the tens of billions walking out the door at Merrill Lynch and other firms in December, but now have a gripe paying the fixers mere millions today.

Interestingly, the same critics complain about the other side of the coin, which is government intervention on companies taking government money. Either you have a problem with how the money is being spent or you don't, it can not logically be both. And yet these people run their mouths and get TV face time anyway. Sometimes I wonder if the noise coming out of Washington is simply there to distract us from the looting of the country, which apparently began in 2003 with the rampant issuing and securitization of bad debt and through the TARP and AIG bailouts of late 2008. Sad indeed. 

Of note since I brought them up, I think AIG might be a compelling investment if their insurance business reverts to mean and they can pay off their debts.

Of extreme importance this week is that the G20 (Group of Twenty Finance Ministers and Central Bank Governors) will meet to try to fix some of the global financial problems and free up credit. Although there has been posturing by Germany and some other nations, it is apparent that the major economies at least recognize the problems.  I am not certain, but it looks to me like these nations will work to free up global credit, even at the inflationary expense of printing money and issuing debt. Why is this so? Without increased capital spending there simply will not be enough trade to support the regrowth of employment worldwide. High unemployment is the most dangerous problem we face as a civilization at it would likely lead to civil unrest (my guess is there will be protests in London over the G20 meeting already). The ministers know this.

In particular, the G20 nations need to make sure that emerging economies do not fall into complete disarray as that not only affects the rest of us economically, but also likely militarily. It is not in our best interest to turn our back on the rest of the world. It appears some sort of compromise can be reached where the Europeans agree to help the emerging markets a bit more - likely through the International Monetary Fund as they have previously discussed. The U.S. should continue to fix the world's biggest economy and work with its core trade partners (i.e. U.K., Japan, Korea...), while Brazil and China continue to take more prominent roles in global finance. Such an approach should stave off depression and additional wars. The main impediment to taking actions to stimulate growth are based on the fear of inflation driven by debt. Hopefully the right balance is found.

I am going to cut off here to go bake something with my daughter that sounds like a fantastic combination of walnuts, cherries and chocolate that she found on Rachel Ray - I'm not sure if she's more excited or if I am. I plan to do a Q&A a few times per year, so if you have any questions you would like answered please submit by email or give me a call.

In April I will outline an investment strategy tied to what I expect to roughly happen over the next five to ten years. I have begun implementing the strategy and will be using some variation of it going forward for most accounts. I will also be offering a special invitation to participate for new investors.


Kirk Spano