Another Smooooth Valentine's Day

Hello everybody,

That’s right, I’m back.  The Baritone of the Box Set.  The Sultan of the CD.  The Rhymer of St. Valentiner…er, Valentine.  The one, the only, Smooooth Operator.  As he did in 2009, 2008, and 2007, my man Adam has turned over the keys to the Random Thoughts blog for a special Valentine’s edition, because Smooooth knows what you need to be freed from the everyday work’n play.  So settle in and listen to the din of the sweet sounds that Smooooth’s lined up for you today.

We’ll start out this year’s edition with a classic from that 80’s pop supergroup Hall & Oates.  Somehow, despite John Oates’ perm and glorious mustache, the crooning duo has never made the Valentine’s edition, but we’ll get it right tonight.

My friends wonder why I call you all the time, what can I say?

I don’t feel the need to give such secrets away

You think maybe I need help, no, I know I’m right (all right)

I’m just better off not listening to friends’ advice

When they insist on knowing my bliss, I tell them this

When they want to know what the reason is

I only smile when I lie, then I tell them why

Because your kiss, your kiss is on my list

Because your kiss, your kiss I can’t resist

Because your kiss is on my list of the best things in life!

Way to go, boys.  Now anyone reading this blog will have that signature song of yours stuck in their heads for the next several hours, and they’ll LOVE it!  But just in case they don’t, Smooooth knows there’s more than one way to make a woman’s heart faint and a man’s stomach queasy.  For this next little ditty, let’s check in with the men from The Eagles.

Ooh, ooh, witchy woman!  See how high she flies tonight!

You know…I’ve been screwing up the second song on this post for years.  You’d think I’d figure it out at some point.  Oh, well.  What I meant to play was:

Beautiful places in loud, empty places; look at the way that we live

Wastin’ our time on cheap talk and wine left us so little to give

That same old crowd was like a cold dark cloud that we could never rise above

But here in my heart, I give you the best of my love.

Oh, sweet darlin’ you get the best of my love.

Oh, sweet darlin’ you get the best of my love.

That’ll do, Eagles.  You always knew how to pick the slick lyrics…but you won’t get Hall & Oates out of our head.

But maybe this will: a song dragged up in a conversation between Adam and his girl a few days ago.  He’s not proud of it, and that’s why I’m playin’ it.  Men, cover your ears.

Oceans apart, day after day, and I slowly go insane

I hear your voice on the line, but it doesn’t stop the pain

If I see you next to never, how can we say forever?

Wherever you go, whatever you do, I will be right here waiting for you

Whatever it takes, or how my heart breaks, I will be right here waiting for you.

I know it doesn’t stop the pain, guys.  But then, Valentine’s Day has never been about guys, so just bear down and fight through it.  You won’t have to listen to Richard Marx again until next year.

And like always, just one final thought on Valentine’s Day.  This holiday didn’t start as a result of Hallmark cards and fancy jewelry.  It was meant to honor the patron saint living for a different kind of love, one for his Savior, and with that I leave you the lyrics I always end with.  Those about a perfect kind of love.  Hope you enjoyed the songs as much as I enjoyed bringing them to you.  All of you out there have a Happy Valentine’s Day.

Peace out,

The Smooooth Operator

LOVE SONG

By Third Day

I’ve heard it said that a man would climb a mountain

Just to be with the one he loves.

How many times has he broken that promise

It has never been done.

Well I never climbed the highest mountain

But I walked the hill of Calvary.

Just to be with you, I did everything

There’s no price I did not pay

Just to be with you, I gave everything

Oh yes, I gave my life away

Just to be with you, oh just to be with you

Yes, just to be with you.

“Greater love has no one than this, that he lay down his life for his friends.” John 15:13

Hello 2010

Okay, so it’s February, and I’m just finally getting around to my list of New Year’s resolutions…this does not bode well.  But hey, that “Bullspit” series took a lot out of me!  You try writing that much bullspit and see how motivated you are for your next blog post!

Oh, well.  Better late than never I guess, and like most everyone else, I fully intend to forget about these resolutions in approximately three weeks anyway.  Here goes nothing.

In 2010, be it resolved that I will:

1)      Watch the movie Avatar, and thus learn why Attack of the Smurfs! has become one of the biggest movies (financially and critically) of all time.

2)      Develop world-class skills in the art of origami.

3)      Convince the U.S. Ski Team I was inadvertently left off the roster for the 2010 Winter Olympics in Vancouver…try not to hurt my shoulder on a ski slope again while competing in the Men’s Downhill.

4)      Finally get my diplomas framed.  Actually, this was one of my resolutions last year, and for better or worse, it’s still valid.

5)      Fix the frame that already broke.  This was also one of my resolutions from last year.

6)      Invent the next “Why didn’t I think of that?” product to take the world by storm, like the post-it note, or American Idol.

7)      Somehow convey to Obama and all of Congress that a projected $3.8 trillion budget with a $1.6 trillion deficit is um…well…really not a good idea. 

8)      Try my hand at cattle-rustling.

9)      Somehow manage to get my hair to grow like Sawyer’s on LOST.  (The final season of the greatest show ever starts tonight, by the way.  Had to throw that in there.)

10)  Get Budweiser to bring back the Louie-the-Lizard commercials for this year’s Super Bowl.  Please?  I miss Louie. 

And speaking of the Super Bowl, I’ll go ahead and throw a prediction out there.  Let’s go with Colts 35, Saints 31.  I’m fine with either team winning, so long as it’s a good game…because I don’t think they’re bringing back Louie.

But bring it on, 2010.

Bullspit & Bear Poop - The Bloody Sequel (Part 3)

WARNING: This post is pretty long and detailed, so pace yourself.  However, I’ve tried to divide it into three sections indicated by the asterisks below.

And so now at last we come to the conclusion: What’s gonna happen and why.  Again, until the last three days, this argument I’ve been alluding to in a couple of previous posts probably seemed like crazy talk.  The market’s rallied nearly 70% since March 2009.  Just after the rally started, the government conducted its stress tests on the banks (actually, stress tests occur on a regular basis for the banks, but this time they were widely publicized since many of them were on life support).  Around June or so, we started hearing about “green shoots” in the economy.  A little later, companies started reporting quarterly earnings showing small profits or shrinking losses.  Everyone started feeling good about themselves; even Fed Chairman Bernake started intimating that the worst was over.  Through mid-January, analysts started falling all over themselves predicting the onrush of a new bull market.

Again, I don’t have any experience with illegal drugs, but based on my limited knowledge, a drug addict can often function pretty well for at least a little while after he’s had another hit.  Yes, he’ll need one again soon or he’ll go off the deep end, but until that time he’s good to go.  Well, here he goes.

Before jumping into exactly what’s going to happen, I’d like to point out a few things that the government didn’t do back in late 2008 when they had the chance.  Like I said in yesterday’s post, the government’s scheme to bailout the banks, and consequently the economy, was actually pretty brilliant.  But in the end, it put a lot more debt on the nation’s Balance Sheet, and I think it was hoping against hope.  However, remember that back in late 2008, a lot of banks much like our Big Bad Bank Corp would have gone under, were it not for the government.  Uncle Sam had them by the throat!  They would have agreed to anything to stay afloat, and yet you know how much changed in the financial industry as a result of this catastrophic situation?

Nothing.  Zero.  Zilch.  Bupkus.

There are a number of things the government could’ve changed when it had the chance to do so, and yet for all the grandstanding by the politicians, none of it happened.  Let’s pointedly discuss some of the biggies.

• Reestablish lending standards to protect MBS – As I said in Part 2 of the original series, MBS in and of themselves are not a bad thing.   However, as recently as a couple of decades ago, buying a house involved quite a bit tighter lending standards than today.  Back then, the loan-to-value ratio (amount of loan versus value of the house) could never exceed 80%.  This means that if you bought a $200k house, you had to fork over a down payment of at least $40k.  You also had to prove you actually had some income, a job, and some assets.  Suddenly you had some skin in the game.  And under this arrangement, even if you defaulted, the bank was a lot more likely to recoup all the funds it lended you after it sold the house.  Well, in the past decade, people have been able to get into a house with virtually no down payment, and after the housing market dropped, the LTV exceeded 100% in many cases, so that the loan was worth more than the house itself.  This is not good.
• Eliminate or severely reduce the use of CDS – Again, in Part 2 of the original series, I mentioned that CDS in and of themselves are not a bad thing.  They’re good when used as a cautionary way to hedge against loan defaults.  But unfortunately, greed turned these puppies into instruments for speculation, like betting in Vegas as to whether a borrower would default on a loan.  That was never their intended purpose, and they should be scaled back significantly and far more carefully scrutinized.
• Reinstate the Glass-Steagall Act – You may have heard Obama mention this last week, about three seconds before financial sector stocks went in the toilet.  Glass-Steagall was enacted in the aftermath of the original Great Depression, and it basically stated that “traditional banks are for depositors, and investment banks are for investors, and ne’er the twain shall meet.”  To spell that out, a traditional bank is essentially what I’ve described in this series so far.  They maintain a huge depositor base, and are thus heavily regulated, but also get the benefits of borrowing additional funds at the Fed Funds rate.  They primarily made money by lending the funds of their depositors to responsible people in the community.  These included such names as JP Morgan Chase, Bank of America, Citigroup, Washington Mutual, and Wells Fargo.  Investment banks, on the other hand, were not allowed under Glass-Steagall to maintain a depositor base.  This meant they didn’t face the regulation of traditional banks, but they also didn’t have all those funds from depositors, or the opportunity to borrow at the Fed Funds rate.  They simply had to rely on capital from their equity investors.  They made money primarily through expertise in mergers and acquisitions work, conducting initial public offerings (IPOs), and investments in the capital markets.  These included such names as Goldman Sachs, Lehman Brothers, Bear Sterns, Morgan Stanley, and Merrill Lynch.  For decades, investment banks looked longingly over the fence at the depositor base and Fed Funds rate enjoyed by traditional banks, whereas traditional banks looked back longingly at the lower regulation and additional revenue streams of the investment banks.  In the late 90’s, Glass-Steagall was abolished, and the result was that depositor funds (i.e. your savings account) started playing the stock market.  Again, Obama mentioned the reinstatement of this act last week, which scared all the bankers stiff.  Problem is, we should have mentioned it over a year ago when they had no chance to argue against it.
• Break up banks that are “too big to fail” – You may have noticed that WaMu’s no longer around.  Any of the good parts got picked clean by JP Morgan Chase, and the poopy parts were left for Uncle Sam to clean up.  As for Merrill Lynch, that’s now owned by BofA, which BofA now claims was a shotgun wedding forced upon it by the government.  Lehman Brothers and Bear Sterns are gone.  Goldman and Morgan got religion and suddenly decided to convert to traditional banks in late 2008 in order to get the Uncle Sam sugardaddy special (FDIC backing and Fed Funds rate).  Calling Goldman and Morgan traditional banks is about like referring to myself as a Scottish goat-herder, but anyway.  When WaMu fell apart, that sent shockwaves through the economy.  And WaMu was not as big as the other four traditional banks mentioned above.  Put simply, the FDIC backstop was never meant to handle the failure of banks this big, and believe you me, BofA and Citigroup are definitely not out of the woods.  Back in late 2008, we should have forced the hand of all these banks, established standards to keep them from getting so big that they could single-handedly collapse our economy.  When WaMu disintegrated, the government took significant measures to ensure these other behemoths wouldn’t do so, at least not yet, but that’s created what’s known as a situation of “moral hazard.”  In essence, if you’re Big Bad Bank Corp, and you believe there’s no way in hell the government will let you die, then what are you afraid of?  Why not play the market like a drunken sailor?  They can’t let you fail!  It can be argued that the FDIC (also created in the aftermath of the Great Depression) originated this mindset among bankers.  Though its presence lets depositors feel safer about their bank, it also makes the bank feel more brazen about risk-taking. 
• Enforce more stringent standards for repayment of the TARP funds – Almost all of the big banks have now paid back a substantial amount of the TARP funds stimulus, arguing that they had to in order to keep all their invaluable employees and pay them $145 billion in bonuses.  In doing so, the banks effectively stated they’re ready to play without a net.  If I’m right, and the market tanks dramatically, they’re gonna have to come crawling right back to Uncle Sam, and the American taxpayer will not be happy.  Unfortunately, at some point (maybe even now), the government simply won’t be able to help them.  

You’ll notice that in the title to this sequel series, I didn’t mention Uncle Sam’s Shovel.  That’s because I’m not sure that this time around the government will have the willpower, or maybe even the ability, to prop the banks up again. 

*******

But enough about late 2008.  Let’s look at early 2010 and what I think we’re in for.  As I stated at the end of Part 2, the government’s directives to the banks (which it now effectively owned, for a time at least) was “Go forth and lend.  Kickstart the economy.  Make everything right with the world.”  Ideally, the government did want to get back out of the banking business, but they also wanted our bank’s Balance Sheet to get back to looking like it did in Part 1 of this series.  Well, instead it looks something like this:

Assets                                      Liabilities

Cash                                 5       Deposits             80

Loans                               50      Fed funds           10

Other investments              40                  

Real estate owned               5       Equity                10

Total assets               100      Total L&E      100

On first glance, maybe this doesn’t look too shabby.  After all, at least equity’s still reflecting that healthy 10% capital ratio.  What’s the problem?

Here’s the problem.  Remember what I said about the line item for Loans in Part 1?  That they’re the bread ‘n butter of a bank?  Well, instead of this balance climbing back up to $80 million, it’s only sitting at a paltry $50 million.  The other $30 million has gone into the line item for Other investments, which as I mentioned is normally expected to be considered “safe” investments like U.S. Treasury securities.  That’s a very important distinction.

Again, Uncle Sam ordered the banks to “go forth and lend.”  It did not say to “go forth and buy T-bills.”  There’s a reason the government wanted the banks to start lending again.  Lending to the public is what unfreezes the credit markets.  Lending gets money to companies and individuals, who hopefully use that money in a way that makes them money, money which can then be taxed by the government as revenue and eventually (someday, when hell freezes over) start paying down our national debt.

However, investing in U.S. Treasuries does not help Joe Citizen, or Joe Citizen’s fledgling small business.  U.S. Treasuries are considered the safest of investments, but they don’t generate tax revenue for the government, instead they increase the national debt.

So why is it that banks aren’t lending to the public as ordered by the government?  Well, Uncle Sam also added that stipulation about lending to people who can pay you back.  Therein lies the problem.  Back in late 2008, another change happened at the banks.  As one speaker I heard put it, “the credit guys busted back into the bank, shot the sales guys, and reclaimed the Loan department.”  Banks started trying harder to make sure they were making good loans, which is a wonderful thing…but that doesn’t change the debt balances rung up in the economy to date.

Imagine you’re Joe Banker, and you shot the sales guy and reclaimed the Loan department.  Now you’ve got this mandate from Uncle Sam to lend money to people that can pay you back, and you intend to live by it, but here’s the problem.  You’re looking through the bank’s current loan portfolio and listing of potential new clients and realize some hard facts are staring you in the face.

• About those improving earnings in Q2 and Q3 of 2009, a lot of that improvement had to do with companies trimming payroll, cutting expenses anywhere they possibly could to stop the hemorrhaging.  However, those earnings didn’t show improvement in revenues, which drives the companies’ business.
• There is a lot of pain in both the commercial and residential real estate sector.  Real estate was hurting two years ago when the subprime crisis hit, but now even prime borrowers are having trouble making payments.  You think back and recall the seemingly endless list of big name companies that bit the dust over the past two years, and you realize that no one’s replaced them.  What’s more, the ones hanging on have cut their expenses, including possibly negotiations with commercial real estate borrowers to lower their lease payments.  As a result, your loan clients in commercial real estate are dealing with lost tenants and lower lease income.
• As goes the real estate industry, so goes the construction industry.  If your clients in commercial and residential real estate are the ones who order business from the construction industry, and real estate’s floundering, then guess what’s happening to construction?
• Unemployment’s skyrocketed over the past year.  Yes, you know the media claims it’s just over 10%, but you also know that’s the watered down version of unemployment according to the government’s “U-3” calculation.  It excludes the underemployed (engineers working at McDonald’s) and the unemployed who have run out of benefits and given up on their job search.  In reality, the unemployment rate is over 17% and rising, which is a lot closer to the 25% unemployment figures calculated during the Great Depression.  Yes, investment advisors assure you that unemployment is a “lagging” indicator, that its trendline follows the market by six to nine months, so it should be improving anytime now, but you also know something else.
• The market’s historic rally over the last several months has “baked in” expectations for increased revenues, meaning further improving earnings.  The assumption is that since increased revenues mean increased productivity, companies will need to start hiring again.  Only the problem is, revenues have not been increasing in a lot of cases.  Unfortunately, your investment analysts haven’t bothered to mention that with unemployment over 17%, people simply can’t afford to buy as many goods and services, so the revenues baked into market expectations aren’t panning out.
• As a result, you’re staring at a lending portfolio still hurting from the economic downturn, and you’re weighing it against Uncle Sam’s directive to lend money to people that can pay you back.  Well, exactly who on this list do you think is the best bet to do so?

There may be a few potentials, but the pickings are slim.  However, you’re trying desperately to bring in quality interest income for the bank.  And suddenly you realize something…the Fed’s willing to let you borrow funds from other banks at 0%, then turn around and loan that money to the U.S. Treasury at approximately 3%.  Yeah, it’s only 3%, but you can leverage as much as possible and produce greater returns.  It’s not exactly what Uncle Sam wanted, but it will turn a healthy profit…at least until the Fed Funds rate goes up.

There’s the real catch.  So many market analysts are worried that since we’re supposedly recovering and the worst is over, the Fed will start to hike up the lending rate.  But the Fed has repeatedly stated that it will not do so any time in the near future, and you know why?  Because it knows that the moment it ratchets up its key lending rate, these profits banks have derived from lending to the Treasury will evaporate, which puts you in the Loan department back to square one.  Here’s a very important fact to remember: Our economy has never been predicated on the idea that you can borrow from the Fed and sell to the Treasury and manage to earn a profit.  If it were, then banks would have no reason to lend to the public.  They could just lend to the “safe” borrower and earn their money that way.

And that’s the risk in banking.  Lending is risky business, which is why bankers are supposed to do their homework, stick to their guns, and only lend to people who can afford to pay them back.  They shouldn’t be lending exorbitant amounts of money by way of NINJA loans, and they shouldn’t be playing Russian roulette with depositor funds and hope the housing market never stumbles.  Now, with all that’s happened, banks are afraid to lend to its prime borrowers, and rightly so in many instances.  The markets have not been unfrozen.  The government’s plan is failing.

So many people are currently worried about the rampant inflation expected to infest our economy any time now.  Due to its staggering debt load, they argue, the U.S. will eventually default on its debt.  At this point, it could either sell its assets, like land (and other than subtle trades through foreign investors, there’s no way in hell we’ll do that on a large scale), or foreign creditors could decide to go to war against us.  China is the only country big enough to do so, but its economy is dependent upon us, its biggest consumer.  If we tank, so do they, and while the U.S. and China aren’t exactly BFF’s, I don’t think either of us want to go to war.  At least not yet. 

Another argument for inflation is that many think that the government flushed $700 billion in TARP funds into the economy, but instead most of those funds were given to the banks, many of which have now paid them back.  Keep in mind what I said in Part 1.  Inflation doesn’t hinge on the money supply; it hinges on money velocity.  Lots of people with decent credit nowadays are finding it difficult to get a loan, because banks are afraid to let go of their money.  And if no one can get money from the bank, then money doesn’t pass through the economy.  Consequently, revenues decrease, and the market gets spooked, and before you know it the banks will be back at Uncle Sam’s door, begging for those TARP funds they already gave back.

Remember what I said about an underlying theme of capitalism in Parts 1 and 2: One party is supposed to be compensated for its goods/services to another party, so the government can’t just give money to people who owe someone else for goods and services, otherwise it destroys the incentive of the general public to actually work for a living.  However, the government also will have a problem giving money back to the banks, since the taxpayer will be highly angered if the banks come crawling back to Uncle Sam.

Despite the run-up in the market, money velocity has been excruciatingly slow.  What we are staring at is a deflationary depression, the next leg of the market crash that really started in late 2007, then went crazy in late 2008, and is about to go crazy again in early 2010.  A deflationary depression is what the Great Depression was, and it’s characterized by a severe lack of money velocity through the economy.  In a deflationary depression, every asset class other than cash loses its value.  That means all forms of securities (stocks, bonds, mutual funds, ETF’s, be they large-cap, mid-cap, small-cap, developed markets, emerging markets, etc.) as well as real estate, oil, gold, and any other commodity or precious metal you can think of will drop.  Big time.  If people don’t have money, they can’t pay you for these items.  If you don’t believe me, check out the prices of every market, commodity, and real estate investment you want between September 2007 and November 2008.  My guess is that no matter what you pick, that asset will likely have lost at least 25% of its value.  I can guarantee you that all of my widely-diversified mutual funds at the time did.  Actually, I’m out of mutual funds entirely now, and probably always will be, but that’s a whole other discussion and beside the point here. 

*******

Hopefully I’ve now laid out in excruciating detail why I believe the market’s gonna drop again.  You may think I’m crazy.  I know your investment advisor will, but like I said, I’m not asking for an advisory fee.

Since starting this particular series of posts, I’ve received comments from a few good friends of mine, all of them very smart individuals, who have been rattled to some degree by what I’ve written.  There’s a reason I titled it “The Bloody Sequel.”  Please understand that I’m not trying to play Chicken Little and claim it’s the end of the world or anything like that.  Instead, I’m just trying to follow the facts where they lead.  Know that after the crash in late 2008, I started to take investing very seriously, learning everything I could about it.  In light of this series of posts and what I believe will happen, I’d advise you to do the following.

• Get in cash…NOW – In a deflationary depression, the only thing that keeps its value—in fact, increases its value—is cash, because it holds more purchasing power when demand drops and everything turns cheap.  Look, if you tell your investment advisor you want to jump into cash right now, they’ll say you’re an idiot.  Just a few weeks ago one looked at me like I had three heads.  Sure, they’ll give you the spiel about sunshine and roses in our economic outlook, and they’ll assure you that this is just a minor correction.  To that, I would tell them this, “Get me out of the market for now.  However, if the Dow jumps to over 10,800, then get me back in.”  If they’re so certain the market’s perfectly fine, then you’ll only lose about 600 points on the ride to glory, and they can call me an idiot.
• Make sure your bank is safe – If you’ve been saving up some funds and got a nice chunk of money in there, you may want to go to your local branch and ask to know how well-capitalized they are.  I haven’t done this myself yet, so I don’t know the best plan of action, but at the very least they should be impressed you know what a capital ratio is and may hand you some info.  If they give you lip, then let them know you’re thinking about taking your business to a bank that’s well-capitalized.  However, there are also websites that will provide this info on all sorts of banks to you for a fee.
• Learn everything you can about investing – Like I said above, after the market crash in 2008, I suddenly got very serious about investing.  Don’t just put it in the hands of some investment analyst who follows the latest feel-good news.  If that analyst didn’t see the market crash coming in late 2008 or the market rise in early 2009, then don’t bother listening to them.  By contrast, the German dude Simon Maierhofer from www.etfguide.com did see both events playing out, which is why I started following his articles.  Like I said in the Prelude, I subscribe to their monthly and weekly publications, and they’re a gold mine of info.  They helped flesh out that uneasy feeling I had about the market rise last year.  I strongly encourage you to fork over the $150 in annual subscription money and learn from them, but before you do, read all the free info on their website.  I also encourage you to visit www.fool.com and read anything you can find by Morgan Housel, Tom or David Gardner (co-founders), Matt Koppenheffer, Alex Dumortier, and Anand Chokkavelu.  Any other writers are hit-or-miss, but these guys (especially Morgan) are very smart.
• Be very good at your job, and other jobs – A few months back I wrote a post about “Understanding the Why” and how truly knowing things like what you do at your job or in your faith make you a better person.  It applies very well in these times.  Don’t just “get by” at your job; be the best you can be at it.  And use any free time to learn other skills, like learning another language, or learning your way around tools, or all sorts of other things.  Even if we reach the 25% unemployment of the Great Depression, that still means 75% of people have a job.  Improving and increasing your skills will help you hang onto yours.
• Finally, be thankful for what you have, and pray – Personally, I know that I’ve been blessed in my life in so many ways, and too often I take for granted all the blessings God has given me.  It only takes a situation like Haiti to realize fears about another Great Depression are not the worst thing in the world.  But speaking to other Christians, I feel that whether I’m right or wrong, we should pray for guidance in these unsettling times regardless.  And not just for ourselves, but for the wisdom to know how we can bring God’s truth to others.  Times like these make people listen.

Sorry for the length of this post, but I wanted to get it all out of my system.  If you have any questions, just send me a comment by email.  Until my fake New Year’s resolutions next week…

God bless,

Adam

Bullspit & Bear Poop - The Bloody Sequel (Part 2)

Since closing at 10,725 on Tuesday, the Dow Jones has fallen over 550 points, down to 10,173, at the close of business on Friday.  That’s a drop of over 5% in three days, and we’re not done people.  Not even close.  It’s like the bears arrived just in time for Part 2.

As I mentioned in the Prelude earlier this week, in Part 2 I want to explain just what the hell actually happened to our economy, and specifically the banks, in late 2008.  In Part 2 of the original Bullspit series (again, you can find it by punching in Oct 15, 2008 on the posting calendar to the left and scrolling down), I explained the nature of the two major bears that went on a rampage through the economy.  These bad news bears go by the names MBS (for mortgage-backed securities) and CDS (for credit default swaps).  However, while I explained how they came about, I didn’t expound on how they hit the Balance Sheet we discussed in Part 1 of this series.

So let’s go back to our bank again.  Remember how in Part 1, I said we had ten years of healthy operations and our Balance Sheet looked pretty good?  Well, let’s pretend we change our name from Big Bank Corp to Bad Bank Corp, and the bears came after us.  Consequently, in late 2008 our Balance Sheet looked like this.

Assets                                      Liabilities

Cash                                5       Deposits             80

Loans (post MBS)              40       Fed funds           10

Other investments             10       CDS payments     60

Real estate owned             15       Equity               (80)

Total assets                 70      Total L&E        70

Ouch.  Ummm…do you want to explain this to the shareholders, or should I?  How about to the depositors?  Even less so?  (Sigh)  Okay, here goes.

Please understand this is a simplified version of what happened, but it gets the point across.  First, we’ll start with the fact that equity on our Balance Sheet is negative, to the tune of $80 million!  As I intimated about negative equity in Part 1 of this series, we just got “WaMu’ed.”  I’ll go ahead and blame the CEO since we fired him last week, but anyway, let’s start with the damage caused by Bear #1 – MBS.

As I explained in Part 1 of the original series, for several years banks had been lending the money belonging to their depositors to pretty much anyone with a pulse.  Didn’t matter if the borrower had No Income and No Job or Assets, the bank would just sign them up for a “NINJA” loan.  This line of reasoning came from the indefatigable assumption that the housing market would never, under any circumstances, EVER go down in value.  Consequently, the bank could sign up a doorstop for a NINJA loan, secure the loan with the home as collateral, ratchet up the interest charges, and then watch the money flow in.  The crappy (poopy?) loans were then packaged together and “securitized” (meaning turned into a bond, in this instance) and sold to other banks, as well as to private investors.

Well…it turns out that yes, believe it or not, the housing market actually can go down!  In the example above, let’s assume that of our original $80 million loan portfolio from Part 1, half of the balance was tied up in these poopy loans.  Either we directly financed the poop ourselves, or we bought poop from other banks.  Turns out that when the housing market dropped like a rock, we suddenly found out the borrowers had no money!  As a result, of our initial $40 million in poopy loans, we have $10 million in foreclosed houses to show for them (thus the increase from $5 million to $15 million in real estate owned).  The other $30 million ain’t ever getting paid back by the borrowers.  And that’s just Bear #1.

Now as for Bear #2 – CDS.  About that CEO we fired last week?  For several years under his direction, we’d been selling credit default swaps to anyone that wanted us to ensure payment on a loan.  Basically, if someone gave us $100k per year for ten years to guarantee a $10 million loan, we’d gladly take them up on that offer, and consequently receive $100k per year for simply being us, the guarantor.  Now…given the poopy loans on our own books, you would think that we’d have been a little suspicious about the loans on other people’s books.  But hey, it’s a $100k a year in free money, and the housing market’s never going down anyway, so why not?

(Sigh) We just got double-whammied.  Since the housing market tanked, we not only got slaughtered by the MBS, we also got slaughtered by the CDS.  Since that $10 million loan defaulted after only $3 million in payments, we now have to pay up on the remaining $7 million!  You’ll notice this potential liability never even appeared on the books before now.  We just figured it was so unlikely, and so undeterminable, that we would never have to worry about it.  Only now not only do we have to worry about it, but our shareholders (who gave us the equity) and our customers (who gave us the deposits) have to worry about it. 

We needed a hero.  We suddenly had loads of bear poop all over our Balance Sheet, and no way to shovel it off.  Basically, we needed someone with plenty of experience in shoveling poop.

Hello, Uncle Sam!

Part 3 of the original series discussed the government’s role in trying to save the economy.  Specifically, the good ol’ government devised a $700 billion plan to save our assets, as well as our equity.  I can only imagine how that phone call between Treasury Secretary Hank Paulsen and Fed Chairmen Ben Bernake went.

Hank – Hey Ben, we’ve hatched this scheme we think may be able to get the country out of this debt mess.

Ben – Really?  That’s great!  What’s it called?

Hank – We’re gonna name it the Troubled Assets Relief Program, or TARP for short.  Whaddya think?

Ben – Love it!  No matter what we do in D.C., we must have a catchy acronym.  Did you know that “Patriot” in the Patriot Act is an acronym? 

Hank – (pregnant pause) Look Ben, for this TARP thingy, I’m gonna need some money.

Ben – (more pause) How much?

Hank – I’m just spitballing at the moment here, but let’s start with $700 billion.

And so TARP was born.  Now that the government had $700 billion to play with, our bank had a fighting chance at survival.  Here’s what happened:

• First, to handle the MBS bear, the government paid us straight-up $40 million for those poopy loans we had on our balance sheet.  Granted, there’s no way on God’s green earth that anyone with any sense would have ever paid $40 million for those troubled assets, but by golly, we aren’t talking about someone with sense here.  So in exchange for $40 million, Uncle Sam got $10 million in foreclosed property and $30 million in poopy loans.  The government would later try to collect these loans or sell them for pennies on the dollar through the Public Private Investment Program, or PPIP (another acronym!), which is a fun story in itself, but let’s continue.
• Second, to handle the CDS bear, the government invested $60 million in our bank, straight to the equity line, and thus became, far and away, our largest shareholder (owner).  In doing so, the government effectively nationalized our bank, meaning it was owned by the government, meaning we just kicked the French expression laissez-faire out the door, and Adam Smith just rolled over in his grave.

People can argue all they want about whether this was the right thing to do, but the bottom line is that without Uncle Sam’s help, Bad Bank Corp would have gone under.  However, since Uncle Sam helped us out, our Balance Sheet now looks like this:

Assets                                      Liabilities

Cash                             105        Deposits              80

Loans (post MBS)              40        Fed funds            10

Other investments             10        CDS payments     60

Real estate owned              5        Equity                 10

Total assets              160       Total L&E       160

With just a measly $100 million influx of cash from the government, we’re liquid again.  Should it bother us that $100 million was the entire amount of assets we had at the start of this exercise before any government involvement?  Oh, well.  What’s done is done.  First order of business:

1)      We need to immediately pay off the $60 million in CDS payments with our surplus cash.  Doing so will drop both sides of the Balance Sheet by $60 million, and magically get us back to a 10% capital ratio.  Hooray, we’re healthy!

2)      Next, we need to work with the government to determine how much equity we need to raise to get Uncle Sam out of our Bank.  (Remember, of the $100 million Uncle Sam gave us, he only received $40 million in poopy assets.  We still owe Uncle Sam $60 million for what’s embedded in that equity line item.)  Here’s what we’ll do.  Around March 2009, the government will conduct “stress tests” to consider how much equity the bank would need to raise in order to weather the “worst-case scenario” for the economy (Ha! Not even close.)  Then, Uncle Sam will require us to conduct a public stock offering to raise this capital, and consequently replace the government’s equity with Joe Citizen’s equity over time.

3)      Finally, flush with the $40 million in cash that Uncle Sam paid us for the poopy assets, we need to lend again.  Get the money flowing.  Unfreeze the markets.  Lend like the wind.  In fact, the Fed will drop the Fed Funds rate to 0% to encourage us to lend as much as possible.  Only this time, Uncle Sam wants us to lend to people who can actually pay us back. 

Frankly, although I’ve joked a lot about it, in theory this whole scheme by the government was a brilliant plan, and if anything was going to work to pull us out of this impending depression, this might have been it.  Further, I do want to hammer home another point.  At the height of the initial crisis, many citizens were asking “where’s my bailout?” and thereby implying that the $700 billion in TARP funds should have gone directly to them versus into the banking system.  I want to make clear that this would have been a colossal mistake.  Remember, capitalism is based on the understanding that when one party provides goods/services, the other party compensates them for it.  However, had the government simply handed out money to the general public on a “needs” basis, that would have destroyed the foundation of capitalism (we’re not talking food stamps here; we’re talking about paying for homes that people should never have been in).  For anyone not deemed “needy enough” to receive funds, it would have begged the question, “What am I working for?”  If the government’s willing to compensate me for doing nothing, then why should I bother to work for that compensation?

And no matter what the misguided mind of Michael Moore says about it, capitalism is the best economic system ever devised by man.  Unlike communism and socialism, capitalism rewards those willing to take a chance, invent something new, improve upon something already established, find better ways to do things.  I received an email a few months back from a co-worker that aptly explained the difference between capitalism and socialism.  A capitalist professor wanted to convince his socialist students that capitalism was better, but they disagreed.  “It’s not right for some to benefit more than others,” they argued.   Very well, he said, would you prefer to be graded on a capitalist grading system or a socialist grading system.  They answered socialist grading system.  Consequently, when the results of the first test were complete, he announced that the class average was a “B” and thus that was everyone’s grade.  Those who didn’t study loved it, while those that would have made an “A” hated it.  The next time around, the class average was a “D” since none of the grade-getters bothered to study for the second test.  By the end of the semester, the class average was an “F.”

There are lots of reasons this country has long been regarded the greatest country in the world, and capitalism is one of them.  Don’t get me wrong.  There are some harsh realities involved with capitalism.  You can fail, and fail sensationally, but you can also succeed and be rewarded for it. 

All that being said, I believe we’re on the precipice of a very painful depression.  But the thing is, a lot of this pain, it can be argued, is the result of the government getting too involved in the economy over time.  In the final post I’ll explain why.  ‘Til then…

Bullspit & Bear Poop - The Bloody Sequel (Part 1)

I’m gonna go out on a limb and say that for all the blogs on Xanga and Facebook you could be reading, only this one has decided it would be a great idea to write an entertaining article about how banks and the economy works.  This may officially cement my status as a dork.

That being said, my guess is that most of whatever paycheck you have left at the end of every month goes into a bank, or at least you wish it did.  Yet the vast majority of the public has no idea how banks or the economy works, so frankly, I think that kinda makes this a little more important than who gets kicked off American Idol next week, so please hear the dork out.

First, you need a quick crash course in Accounting 101…quit dozing off in the back!  Basically, the first and most important statement in a set of financials for a company is called a Balance Sheet.  On the left side of the page is a company’s assets (everything you have); on the right side is the company’s liabilities (everything you owe) and equity (everything you own).  And by the way, it’s called a Balance Sheet for a reason.  Like some old, ancient Chinese proverb, “There must be balance.”  Assets must equal Liabilities plus Equity. 

A bank’s Balance Sheet is called a Statement of Condition, because that’s considered a more descriptive term when considering the purpose of a bank.  It’s meant to hold people’s money, so we’d like to know what condition it’s in.  However, for purposes of this discussion, I’m gonna call it a Balance Sheet, because there must be balance.  Let’s assume we started a bank called Big Bank Corp, and after ten years of healthy operations, our Balance Sheet looked like this (all dollars in millions…remember, we’re big boys).

Assets                                      Liabilities

Cash                                 5      Deposits             80

Loans                             80       Fed funds            10

Other investments           10                  

Real estate owned             5      Equity                 10

Total assets                100      Total L&E      100

Let’s run through the list of items above:

• Cash – You know what this is.  However, you might not know that most of the time, less than 5% of a bank’s assets is sitting in cash.  Consequently, if there’s a run on the bank, you have the scene from It’s a Wonderful Life.
• Loans – This is the bread ‘n butter of a bank.  Basically, the bank takes the money of depositors in the community, then turns around and lends it at a higher interest rate to others in the community.  The interest income it earns off these loans consequently pays the interest expense it owed depositors (i.e. your savings acct).  Most loans fall into the categories of commercial real estate, residential real estate, construction, and other (such as small business). 
• Other investments – Any money not going towards loans usually gets invested in “safe” securities, such as U.S. treasury securities, and Fannie Mae and Freddie Mac bonds…well, this stuff used to be safe.  But it could also be invested in other areas of the market.
• Real estate owned – This represents the houses, buildings, equipment, etc. that the bank has had to foreclose on.  Since the bank’s not in the business of selling houses, it would rather have this balance be zero.
• Deposits – This represents the money owed you, the depositor.  Basically, it’s the funds in your checking, savings, money market, and CD accounts.
• Fed funds – This item could be an asset or liability, depending on the bank.  Basically, if a bank has more depositors than opportunities for good loans, it will “sell” its excess funds overnight to other banks at an interest rate determined by the Federal Reserve (the Fed).  If the bank has more loan opportunities than deposits, it will “borrow” excess funds from other banks and pay the overnight interest rate.  When the media mentions “the lending rate” or “the Fed rate” or the “key interest rate,” they’re talking about this rate.  Currently, it’s sitting at zero, which means banks are borrowing from each other for free.  That’s an important piece of information to remember for later.
• Equity – Depending on the size and condition of the bank, among several factors, banks have to maintain a capital ratio, which means their equity has to equal a certain percentage of assets.  For purposes of this example, let’s say it’s 10% (as in the illustration above).  If a bank falls below that ratio, the Fed gets worried.  If equity turns negative, the bank is insolvent.  Bankrupt.  Screwed, blued, and tattooed.  Or, in modern terms, “WaMu’ed.”

Traditional banks are set up as mentioned above, and as described, they make their money by taking funds from depositors (you) and lending it out to people in the community, either for commercial or residential real estate loans, or construction loans, or small business loans.  So long as those loans are made to people that can pay them back, we’re cruisin’. 

Now about the economy in general…

• Before Yours Truly, there was another guy also named Adam Smith back in the 18^th century who wrote a landmark book called The Wealth of Nations, which lays out the framework for capitalism.  Consequently, he’s known as the father of modern economics.  In The Wealth of Nations, Smith expounds on the “invisible hand” that controls free markets in a manner that establishes equilibrium through self-interest, competition, and supply and demand.  He was very big into keeping government out of the economy, instead employing the philosophy of the French term laissez-faire, which means “leave it alone” or “let it be,” so he could have been a Beatle.
• When it comes to capitalism, there’s a very important aspect of this economic philosophy to keep in mind.  When one party provides a second party goods or services, the second party is supposed to compensate the first party.  Sounds simple enough, but you’ll see why this is important later.
• The Treasury Department of the United States manages the finances of the national government.  It oversees the collection of tax revenues through the I.R.S., pays the bills of the government, and issues debt in the form of Treasury securities on behalf of the government.  It’s also responsible for the minting of new money for the country, although the Fed is responsible for how much money stays in the economy.
• The Federal Reserve is the central bank of the U.S.  The Fed regulates nationally chartered banks (like ours in the example above) and oversees the FDIC.  It also significantly influences the nation’s monetary and credit policies by determining the size of the nation’s money supply, as well as the velocity through which money moves through the economy. 
• The terms money supply and money velocity are very important for purposes of this discussion.  Basically, the Fed controls the money supply by deciding how much money needs to be printed by the Treasury or later pulled back in from the banks.  The Fed controls the money velocity by determining the target Federal Funds rate mentioned above.  If markets get too saturated, and credit gets too loose, inflation starts to take place (prices rise).  At this point, the Fed will usually raise the Fed Funds rate, which reduces a bank’s incentive to borrow more money, and thus slows down lending and the money supply, thereby keeping prices from rising.  However, as markets start to “freeze,” meaning that credit dries up, deflation starts to take place (prices fall).  At this point the Fed will usually lower the Fed Funds rate, which provides banks the opportunity to borrow more money at cheaper rates in order to lend it to the community.  Again, that rate’s currently sitting at zero. 

Think that’s enough for tonight.  That should provide enough info for Part 2…and make your head hurt all at the same time!  J