FYI | Nov 23 2010
By Greg Peel
Last week legendary US investor Warren Buffett wrote an op-ed piece published in the New York Times which took the form of a letter, beginning “Dear Uncle Sam…”.
In it Buffett ostensibly declared his support for “Uncle Sam” in the form of the unmentioned two GFC-stricken administrations and the US Federal Reserve and their actions in coping with the crisis both then and now. It concludes:
“So…Uncle Sam, thanks to you and your aides. Often you are wasteful, and sometimes you are bullying. On occasion, you are downright maddening. But in this extraordinary emergency, you came through – and the world would look far different now if you had not.”
It was signed “your grateful nephew, Warren”. Clearly it was timed to rebuff growing criticism of Ben Bernanke and QE2. Bernanke himself had already written his own published piece in which he explained to a doubtful public just what the intentions of QE2 were and why the policy was necessary.
The letter has since meant the loss of Buffett's reputation and guru status in the eyes of many once fawning Wall Street observers. Aside from the financial advantages Buffett gleaned from the TARP and QE1, including protection of the big stake he took, pre-bail-out, in Goldman Sachs and the significant positions he held in Wells Fargo and Moody's, many critics are fuming at the implicit support of governments and Fed boards past and present. They see it very differently, and one Barry Ritholtz penned in response what he suggested was the same letter Buffett might have written had he first been given truth serum. It begins, “Dear Uncle Sucker…”.
The letter goes on to list all the events in the lead-up period which all were contributors to what became an inevitable GFC.
In 1999 there was the repeal of the Glass-Steagall Act, that which had ensured separation of commercial and investment banking and prevented the '87 Crash impacting on Main Street. From 1997 the credit agencies were allowed to change their business model from “investor pays” to “underwriter pays” which led to AAA ratings being for sale. In 2000 an act was passed to allow an over-the-counter derivatives market to develop outside CFTC jurisdiction, which ultimately gave us unlisted CDOs and CDSs.
Following 2001, then Fed chairman Alan Greenspan dropped the funds rate to 1% which ensured a housing bubble. In the decade to 2007, the Fed ignored its monitoring powers of mortgage credit-worthiness. And in 2004, the SEC waived the earlier twelve-to-one leverage limit on investment banks and allowed ratios of up to forty-to-one.
Ritholtz calls it ironic that the last amendment was actually called “the Bear Stearns exemption”. Perhaps equally ironic was that the staunchest lobbyist for the change was then Goldman Sachs CEO Hank Paulson, who has admitted that four years later saw him reduced to praying for guidance on the weekend of the Lehman collapse in his new role as Treasury Secretary.
Ritholtz suggests that Bernanke had the opportunity to right the regulatory wrongs and commensurately punish those executives who had brought their once great institutions to bankruptcy, but instead he saved the institutions and secured the offensive bonuses of said executives. And now here he is, effectively doing it all again.
An oft asked question asked among those less close to the action is: if QE1 hasn't made any difference to housing and unemployment and economic growth, why would QE2? The answer, according to many bloggers, is that QE has nothing to do with inflation mandates and employment targets and the like, but everything to do with what the Fed's role really is, and always has been, that of supporting the US banks.
Writing for Forbes, Richard Lehmann suggests that the Fed – which is a private company and not some independent government legislated body – “is owned by the banks and is run, first and foremost, in their interest”. It was the Administration which introduced the TARP to prevent immediate financial collapse, but it was the Fed who provided the longer term solution, which was to rebuild the banks' capital bases and provide earnings opportunities to offset the unrealised losses on mortgage securities.
By dropping the Fed funds rate to zero, Bernanke ensured that the banks could borrow for nothing and invest in longer-dated Treasuries at 3-4% which, when leveraged several times, could mean a risk-free 20-30% rate of return. The problem for Bernanke in his supposed role of keeper of the wider economy is that the banks chose only to profit from these “carry trades” and did not on-lend any money into the corporate sector where jobs could be created.
Zero interest rates were not enough, and by March last year the only possible solution the Fed had up its sleeve was to effectively drop rates into the negative by printing money, which became the couple of trillion dollars worth of QE1.
Yet still the banks would not lend to corporates, despite the recovery of their share prices in the rally of 2009 which allowed them to raise fresh capital. Given the rally basically began with QE1, that fresh capital could be construed as indirectly representing a hand-out from the Fed.
It was expected that the unemployment problem would still take a while to peak given its lagging nature but with the help of fiscal stimulus, the housing market soon appeared to be dragging itself out of the depths. However, the expiry of that stimulus earlier this year showed the policy up to be no more than smoke and mirrors. Recent data suggest the US property market is once again facing a downward spiral. If that is the case, the hope the US banks might have had that their “toxic” assets could still come good at maturity will evaporate and we still haven't seen the much feared commercial property collapse that most had assumed was a given post-GFC.
The Wall Street Journal's Andy Kessler made note in an article last week of the significance of the recent “take-under” of construction loan purveyor Wilmington Trust. “Take-under” is just a mocked-up expression used when a company is taken over in the usual sense but at a discount to its share price value rather than a premium as is usually the case. A standard takeover requires a 30% control premium as a rule, but Wilmington was sold at a 40% discount. The agreed price suggests that those inside the firm had a much graver view of the world than the stock market.
Bank analysts, including those in Australia, have been forced to look more closely at “book value” as a measure of listed bank valuation since the GFC than the typical measures of PE multiples and total shareholder return projections. Book value ascribes no sentiment factor or even earnings projections but is simply the market value of a bank's assets minus the market value of its liabilities. Bank of America's balance sheet has most recently claimed a book value of US$230m yet its current stock price (as at last week) implies a value for the business of only US$118m, notes Andy Kessler.
Who's right? The suggestion here is that the market believes BofA, and the same is true for the others, is denying the true market value of the assets on its books just as all US institutions still had toxic CDOs on their balance sheets at 70c in the dollar in 2008 when they were realistically devoid of any buyer.
Were the US property market to truly enter another downward spiral, Kessler suggests, then down would go the banks once more as well. With QE2, Bernanke might be claiming that “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending,” as he said in his own op-ed piece in the Washington Post, but Kessler believes that with QE2 Bernanke is simply buying the banks more time.
“In 2009,” notes Kessler, “even with TARP money injected directly into their balance sheets, banks faced a [US]$75bn capital shortfall. Mr Bernanke orchestrated a stock market rally so they could sell equity for much needed capital”.
Bernanke must nevertheless know that the Japanese have been trying to influence their own stock market for 20 years with little effect on the economy, says Kessler, and that QE tactics cannot be about forcing a dollar devaluation, as many claim, given history has shown such ploys have tended to destroy more jobs than they create.
It is this perceived US dollar devaluation, otherwise known as currency manipulation, that has the rest of the world in a lather. Japan is only one nation among many which has had to intervene to prevent the destructive revaluation of its own currency as the inverse of dollar weakness. There is only one collective import market on the planet and the exporter with the greatest currency advantage will be the winner. Every time one nation shifts on the see-saw through artificial policy, those on the other side of the see-saw have to shift the other way to prevent a tumble.
The US has been desperately trying to focus world attention on China as the villain. But the US has almost ingenuously found this policy to have backfired. Sure – China needs to revalue its own currency sooner rather than later to restore a global balance, but to arrogantly introduce yet another round of money printing on the one hand and then make heated accusations on the other that China is indeed the “manipulator” is sheer folly. The rest of the world is simply not that stupid and while not necessarily flag-wavers for Communist China, the rest of the world is pretty sick and tired of America and its arrogance in the face of a financial crisis which it clearly started. (Not that all else are blameless).
And so we now have a Currency War, despite the concept being nervously laughed off by Western leaders. Last week The Fundamental View picked up on a memo to clients from Mark Lapolla, global investment strategist at US-based Knight Capital. Knight Capital, notes TFV, executes more trades than any other US firm. The core of Lapolla's argument is simple, TFV suggests: “The world is done playing fair with each other. Government policy, economic security and resources, the tents of global trade, are all in a fragile state.
Lapolla wrote:
“The game is over…We expect a shockingly powerful rally in the dollar, broad-based weakness across the commodity sector, a dramatic widening of emerging market credit spreads, and what could prove to be a stampede of hot fund flows out of the emerging markets.
“We believe the data and government actions out of China, the back-up in US interest rates, the Fed’s emphatic commitment to QE2, intensifying pressures across the EU, broadly rising commodity prices, government efforts to control hot money flows, have finally pushed the global terms of trade to their tipping point.
“We appreciate both the gravity and the brevity of this note; but then again, the story is simple.”
It is little wonder that, aside from the new Troubles in Ireland and ongoing angst over Chinese interest rates, arguments over QE2 are currently making Wall Street and thus the world a lot more nervous than they are meant to be given QE2's direct intention.
All the while, nevertheless, in contemplating the “moral hazard” of TARPs and QE policies and emergency bail-outs, many still ponder what might have otherwise been had the free market been left to take its natural course. Maybe we're still yet to find out.
