Thursday, July 10, 2008

Risks And Follies of More Financial Regulations

It seems that our financial gurus in Washington, D.C. have finally put their brain on autopilot and left their mouths on auto “rant.” I know Hank Paulson has been doing this for a while, with his well-worn rant of "We want a strong dollar. A strong dollar is in our nation's interest.” (For those interested, there is a drinking game devised by Paul Kedrosky, based on Paulson’s strong dollar rant. Click here for the rules.)

And now, with Ben Bernanke, one of the few voices of reason in the government, calling for a consolidated oversight of investment banks, there doesn’t seem to be anyone in Washington, D.C. who is willing to face the facts that trying to heal a ailing economy with more regulatory duct tapes and rhetorical rants.

According to Bloomberg, Ben said: “Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks,” in his testimony to the House Financial Services Committee today. “He also asked for a procedure to liquidate failing investment banks and for Fed powers over payments systems.”

Mr. Bernanke, such a single federal regulatory body exists: The SEC. Perhaps, we should let the SEC do what it was founded to do: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

A Quick Romp Through Recent History Of Knee-jerk Regulatory Actions

1 – The Great Depression
Congress created the SEC in response to the Great Depression. SEC, with the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, had the responsibility to restore investor confidence in the capital markets by providing more reliable market information and clear rules of honest dealing.

I doubt that SEC is fulfilling its mandated mission if financial crises continue to occur with such regularity.

2 – S&L Crisis of 1980’s
The Savings & Loans crisis in the 1980’s led to the government adding another layer of regulation through the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). All this regulation did was to shutter existing agencies, create new ones, and shuffle existing government staffers from the old agencies to the new agencies. Change the nameplates, slap on a new cost of regulatory whitewash and everything is now supposed to be better and improved.

One of the interesting regulations that came out of this was the new capital reserve requirement that banks had to meet to ensure that they can weather the financial downturns. (FYI, this requirement was rescinded in 1990; so much for regulations.)

3 – Dot Com crash
With the blow up of Enron and other similar high-flying companies, the Congress rushed and passed the now infamous Sarbanes-Oxley Act of 2002 (SOX). Infamous in that it added such a deep layer of needless complexity, large public companies are still, to this day, trying to comply with its requirements. In a nutshell, SOX made it a criminal offense to falsify or sign falsified financial reports and held the CEO accountable. Also, it created a quasi-governmental agency, Public Company Accounting Oversight Board (PCAOB), and charged it to define the audit process and procedures.

My question on this is what really is the difference between PACOB and Financial Accounting Standards Board (FASB)? Private versus public?

What’s Changed?
Astute readers would note that another financial meltdown happened, even after all the regulatory laws and governing bodies that have been created to prevent such an event. So what has changed? Much like the rest of human development, when one side comes up with a rule, someone else will come up with a way to circumvent it. This escalation is almost instinctive. On the positive, it drives innovation, leads to new discoveries, and growth of human civilization. On the negative, it drives those bound by greed or other selfish desires to find ways to gain at the cost of others’ suffering; a zero sum game.

Ergo, the same is playing itself out in the financial market. A similar meltdown will happen. It won’t happen in the same way. However, when it does happen – a matter of when and not if – it will look similar to the past meltdowns.

Mathematics calls this The Chaos Theory. For those investors who seek to understand why and what a near catastrophic financial meltdown is happening, look at the work done in weather prediction. It is similar to that of the financial market.

Getting Back On Point And Conclusion
So what does all these historical and mathematical diversions have to do with the main point? Simple.

A direct message to Mr. Bernanke: We haven’t learned from our past mistakes and, judging from the messages being sent out from Washington, D.C., it appears that we will very likely see a similar situation in the near future, regardless of how many more additional regulations and oversights you propose to add to the already motley mix.

Ed Kim
Practical Risk Manager

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Wednesday, July 9, 2008

Downgrade U.S. Government’s Credit Rating To "A2"?

With the news out that derivatives traders are treating Fannie Mae (Fannie) and Freddie Mac (Freddie) as if they should be rated “A2”, five levels lower than the implied government backed rating of Aaa. According to Bloomberg, “Credit-default swaps tied to $1.45 trillion of debt sold by the two biggest U.S. mortgage-finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service,”

What the derivative market is saying, in essence, is that the likelihood of Fannie and Freddie being able to repay their obligations in full is in doubt. Taking this logic couple of steps further, since Fannie and Freddie have implicit backing of the U.S. Government, this implies that either (1) the implicit guaranty means nothing to the derivative market, and therefore they do not expect the government to bail out Fannie and Freddie; or (2) even with the implicit guaranty of the U.S. Government, the likelihood of being made whole is in doubt since the Government is already operating in a deep deficit.

Both scenarios bode very badly for the U.S. economy. I have stated this sort of problem in my March 19th article:

“Should losses in the 4% to 5% range occur, Fannie and Freddie will require immediate capital injection. Moreover, this would cause substantial losses in the market. After all, if Fannie and Freddie, the two truly “can’t fail” companies begin teetering, then the entire market will begin free falling.

The probability of this risk event unfolding is high given the continuing deterioration in the real estate market and with nearly $700 billion in ARM mortgage interest rate resets to occur in 2008. If the projected defaults increase substantially over the historic average, then the Federal Government will be forced to step in with tens of billions dollars in capitalization. And guess where that money is coming from.”

Let’s take some hypothetical looks at how this scenario might play itself out:

(1) Fannie and Freddie obtain capital injections from SWFs or private funds. The market will see the capital raise, as a red flag and drive the credit default spread even higher, a scenario that I think will definitely happen.

Since the cost of capital has increased substantially, the cost of the capital raise, in the capital market, will negatively affect Fannie and Freddie’s net income for years to come, if they can even obtain the capital. This too will have a long-term negative affect as more income is diverted to servicing the cost of capital. Again, the credit default spread will go even higher. This is another likely scenario, in my view. The stock prices of these two may see a little bounce; dead cat version, in my view.

(2) Fannie and Freddie fail to obtain capital injection or the funds raised are deemed to be inadequate. The market will see this as a very bad sign – double red flags – and begin abandoning their positions in Freddie and Fannie, and causing a substantial dislocation in the global market; a scenario that I hope does not happen but has an outside chance of occurring.

(3) The Federal Reserve, at the urging of the U.S. Government, steps in and provides the same short-term liquidity injection that Wall Street received (Term Securities Lending Facility). The Fed will take Fannie and Freddie’s junky bonds in exchange for UST (U.S. Treasuries), at very favorable terms. This, too, is a likely scenario, in my view.

This will increase the risks I have outlined in my March 11th article: (a) increasing the credit malaise, (b) driving away foreign investors in UST and causing the rates to rise, (c) lowering the value of the U.S. dollar, (d) driving the U.S. economy further into hyperinflation. While this move will lower the credit default swap spread, it will cause more upheaval in the bond market and drive the stocks of these two down substantially.

None of the three above scenarios are pretty. It is basically choosing the lesser of the evils at this point. It is clear at this point that the market does not believe the U.S. government’s desire to step into save Freddie and Fannie and any move by them to raise capital will trigger further widening of the default swap rate.

With the potential for housing prices to decline 10% to 20% further, the mortgages on Fannie and Freddie’s books are looking very suspect. A typical loss (haircut) given on the balance of a mortgage is 10%. Based on the $1.4 trillion in debt outstanding, a haircut of 10% results in a potential loss of $112 billion.

$1.4 trillion x 10% mortgage write-off x 80 cent loss per $1 = $112 billion in potential losses, nearly 146% of the estimated 76.8 billion in reserve capital, estimated as of December 2007.

Fannie and Freddie may not survive in their current form, after all the losses have been tallied. Batten down the hatches because here comes the other side of the hurricane!

Ed Kim
Practical Risk Manager

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Tuesday, July 8, 2008

Is There A Bright Side To The Current Economic Doom And Gloom?

Surprisingly, yes. In fact, there are lots of upside to all this doom and gloom.

The major beneficiaries of the economic downturn will be the American consumers. They just don’t realize it yet. Like a person trying to recover from a hangover, consumers are slowly realizing the high cost of their excessive lifestyle of living in a McMansion set in a former crop field miles from a major urban center.

Large ostentatious homes will be a relict of past frenzy, much like the Pet Rock craze. Consumers are also realizing that living in such a remote location is not as glamorous as it seemed at first: the long commute to work, the need to drive everywhere, trying to deal with wild creatures grazing in their yard or garbage can, etc.

The ever-increasing gas price has consumers seeking ‘green’ alternatives (or lat least more economical alternatives) to driving SUVs. Sales of bicycles and scooters are up. Electric vehicles, once derided as transportation of the ‘tree-huggers’ are now mainstream. Public transportation and car-pooling are even making a come back. Frugal is now vogue. People are driving less, downsizing their vehicles, conserving more, and seeking ways to reduce their total consumption costs.

Industries that will benefit
With consumers strongly signaling desire to reduce costs, those manufacturers that can meet the new consumer demand will benefit. And those companies are:

  • Makers of the next generation of lithium-ion batteries
  • Makers of solar energy: Electric Panels, Water Heaters, and Heat Pumps
  • Makers of Genetically Modified crops and seeds
  • Makers of Vertical hydro-farming
  • Green gas capture and trading
  • Makers of Green Construction Materials
  • The car manufacturer that comes to the market first with the economically viable 100-mpg car
I am most excited about the innovations in automotive design that should be hitting the showrooms around 2010-2011. With the advances in the next generation lithium ion batteries – no more of Li-ion batteries spontaneously combusting – we should see exciting versions of the electric cars. I can hardly wait to buy an electric hybrid car for about $20,000 that comfortably seats four, gets at least 100 miles per gallon, and still go from 0 to 60 mph in less than 5 seconds

Ed Kim
Practical Risk Manager

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Monday, July 7, 2008

Industries Primed For A Fall

We all know about the auto industry and the mess that they are in right now. I expect that in the near future, GM and Ford may have to merge to stay alive. Given how ‘cheap’ their stocks are right now, the temptation is to jump in and buy. However, in the Practical Risk Manager’s view, the risks still outweigh the reward. Firstly, there is no other automaker desiring to take over the bloated pension deficit, existing high-cost structure, and antiquated assembly plants that GM and Ford have.

The other automakers have their own problems. With increasing cost of raw materials such as steel and plastics, car manufacturers are running on fumes. If there were an investor willing to take over GM or Ford, it would be to extract the value within each firm and sell the auto operations at a steep discount. File this under “there is a valid reason why their stock prices are so low.”

GM has hidden value in its Onstar satellite communication division and its non-North American auto operations. A bold move for GM would be to (1) follow Halliburton’s move and relocate its HQ offshore, (2) sell off or shutter its North American operations (this would put a cap on its retirement fund obligations), (3) Expand the Onstar satellite communication division’s capabilities to compete with Sirius and XM Satellite, and (4) be an importer of ultra-small cars from its international operations into North America.

I wonder if any senior executives from from GM / Ford are reading this…

Another industry that will see more failures is the Airline Industry. While they have taken dramatic steps to cut costs and increase revenue – a position proposed by the Practical Risk Manager several months ago – there are still the issues of ever-increasing fuel costs and continuing trend of reduced demand for air travel. Given that consumers are traveling less and increasing the use of alternative transport means, airlines will have to have to begin offering something that they did away with a long time ago: good customer service.

Airlines need to offer something tangible without tremendous added cost. The bold move would be to raise the profile of the cabin attendants to that of air hosts / hostesses. The international carriers do this very well. In fact, most Asian airlines have one of the most rigorous training for their flight hosts / hostesses. This is clearly evident by the Skytrax’s list of six airlines worldwide that are rated 5-stars, its top rating. All six airlines are Asian: Asiana Airlines, Cathay Pacific Airways, Kingfisher Airlines (India), Malaysia Airlines, Qatar Airways, Singapore Airlines.

Where are the major American carriers? They are clustered together in the mediocre 3-star category. The U.S. airline industry seems to think that good customer service means offering free beverages, food, and onboard entertainment. Good customer service does not mean just what happens on the plane; it starts with the reservation and goes all the way to deplaning.

Currently, the airline industry has so many built-in inefficiencies that actually prevent them from providing good customer service. This is a clear risk factor in the Practical Risk Manger’s view; a clear financial and reputational risk factors.

What more can the airline industry do? Here is a sample of bold moves (I have more) that the industry can take to reverse the traveler’s view of the airline’s poor customer service:

Provide free curbside baggage loaders. The redesigned baggage loaders is capable of holding up to 5 large check-in bags and 3 carry-on bags, is electric driven, lies flat on the ground for easy loading / unloading and rises to move. Customer could use this to load their bags at curbside and guide the electrically driven loader to check-in.

I think that even with bold moves, there are certain airlines that cannot make it if the fuel prices stay high into 2009, which is highly probable. To wit, I stand by my previous assertion that American Airlines will not make it. This is even more probable since they have not taken strategic actions to reduce their reliance on their fleet of MD80s. I would file American Airlines as an investment that I wouldn’t touch with a ten-foot pole.

Ed Kim
Practical Risk Manager

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Sunday, July 6, 2008

Are We Near The Bottom Yet?

The short answer is still “Not yet.” The news continues to be grim without any signs of letting up. In fact, the major media appeared to have all climbed on to the Bear market bandwagon. As any prudent investor knows, one can make money in a Bull market as well as a Bear market. The converse of this is equally true.

My readers have been aware, several months ago, the risk factors that are manifesting themselves in current events. Hopefully, the readers have made some good and wise investments based on the risk factors, as I have presented previously. Continuing on this theme of taking prudent risks, here are additional ‘futurescape’ of the global economic condition, in my opinion, based on the publicly available data.

Will Large Banks Fail?
While it is highly improbable that many large money center banks will fail, there are certain candidates that are closer to the precipice than others. The risk manager, using a standard six-sigma approach, would note that we are currently in a ‘tail’ event economy - an economic event that typically has 0.3% or less of occurring. This means that an unthinkable can and may occur, including at least one “too-big-to-fail” bank failing. It is not a matter of “IF,” it is a matter of “When” and Which.”

In my view, the front-runners, vying neck to neck, for this dubious distinction are: Citigroup, Lehman, UBS, Merrill Lynch, and Morgan Stanley. I wonder if Ladbrokes would open betting lines on this action. If so, I would take UBS as being the candidate to fail. This is based on three factors, in addition to the general malaise affecting all banks: (a) it is still losing its high net worth clients, (b) is downsizing its investment banking division, in attempt to cut costs, and (c) the unwillingness of its senior management to admit its mistakes. With its sterling reputation tarnished, clients leaving, revenue sources drying up, it would be very difficult for it to remain independent for too long.

Banks will need to continue raising capital as more assets are reclassified to tier-2 and tier-3. The only problem is that most potential investors have already been burned and are sitting on substantial paper losses. That means that banks will have to juice up the preferred rate of return and provide a recast trigger should the stock prices drop below a threshold. Furthermore, the banks will have to go to lesser known investors and SWFs (think Brazil, South Korea, India, Taiwan, and Russia).

Ed Kim
Practical Risk Manager

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