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Past Commentaries

Current Commentary, Review and Outlook
June 9, 2012

To my Clients, Friends & Observers:

Recently I sat down with the GE 2011 annual report. Someone (perhaps Michael Lewis?) aptly described GE as “the world’s largest hedge fund” a while back. Hedge funds are relatively opaque and the GE annual report does not disappoint in this regard. The actual consolidated financial statements are 6 pages long. “Management’s Discussion and Analysis” is 34 pages long. The “Notes to Consolidated Financial Statements” are 59 pages long. “Notes” are explanations. Apparently GE had a “lotta ‘splainin’ to do.”

On Wednesday April 18, I attended a special conference with several analysts of Capital Economics (London, Toronto and Singapore) in Boston. The presentation was titled “The Euro-zone Break-Up.” They make a compelling case that, at the very least, a limited break-up is a fait accompli starting in 2012 with the departure of Greece. Portugal and perhaps Ireland will follow in 2013. Italy and Spain will remain for the time being but have high risks attached.

The exit process looks like this: redenomination, devaluation, default. So we should expect to see Greece revert to drachma from euros, triggering an immediate devaluation, and then a default on its debt obligations. We have seen this before in Argentina, which continues to suffer from the decisions of its politicians to spend money that has not been earned to buy political support. Capital Economics opines that a limited break-up would not be a minor event but not necessarily a disaster either.

The impact on U.S. GDP they forecast at -0.4% through 2013, not a dire consequence, although when trimmed from GDP growth of less than 3%, not sanguine either. The impact on the Euro-zone GDP is more significant, -4.8%.

More disturbing were some other considerations offered by Paul Ashcroft, Capital Economics’ Chief US Economist. He states that “US banks other gross exposures (mainly Credit Default Swaps) to peripheral euro-zone are equivalent to 55% of Tier 1 capital. Exposure to total euro-zone is 165%. European holdings account for 35% of assets at US money market mutual funds. Crisis already caused the collapse of MF Global.”

MF Global is the brokerage run by Goldman Sachs alum and former Governor and Senator from New Jersey, Jon Corzine, which bankruptcy filing revealed that $1.6 billion was missing from its customers’ accounts. At this time Mr. Corzine has not suffered any changes in his lifestyle.

US Banks’ actual exposure to Euro-zone holdings as a percentage of Tier 1 Capital Mr. Ashcroft puts at 60%, of which 13% is Portugal, Ireland, Italy, Greece and Spain.“Tier 1 Capital” is the core of bank assets. Last September the NY Times reported that the four largest US Banks held almost $250 trillion in credit default swaps. (The GDP of the planet is $65 trillion.) These are the same banks that the taxpayers “bailed out” in 2008. In 2007 there were a total of $62 trillion in outstanding contracts.

Credit default swaps (CDS) are not investments. The vast majority are not hedges and do not mitigate risk. They are bets. While they can be used to insure portfolio holdings against the risk of a default or credit event there does not have to be an insurable interest. Another bail-out baby, insurance giant AIG, sold billions of CDS to investors who had no insurable interest in third party debt obligations. For example, if money manager BHI entered into a contract with AIG, it might agree to pay AIG 55 basis points for a CDS on a particular issue of GM debt. That means BHI pays $55,000 annually for five years for AIG’s guarantee of $10 million of a particular GM bond. If GM does not default within the five years BHI will have lost $275,000. But if GM defaults BHI stands to gain as much as 3500% ($10 million) from AIG. This is indistinguishable from betting on a football game or a boxing match.

There are CDS bets outstanding that can never be paid in full, that may trigger yet another series of “Too Big To Fail” events. Absent a 100% certainty of their safety CDS have got to be banned but the U.S. does not yet have political leadership willing to challenge the financial oligarchy. It took a Great Depression and a president (FDR) who vowed to end banks’ speculative activities to pass the Glass-Steagall Act in 1933. It took men who could not be bribed or “lobbied” to pass the Banking Act and the Securities Acts of ’33 and ’34. What will it take to correct the banking system? Another Depression? Blood in the streets? Another Peron, Hitler, Chavez or Roosevelt? The investment banks will not discontinue CDS of their own volition. They must be outlawed.

On Language

There was a brilliant engineer named Benjamin Whorf who lived around Hartford, Connecticut most of the early 20th century. Though he worked as an industrial accident analyst for the Hartford Fire Insurance Company his hobby was linguistics. After inspecting a devastating industrial fire in which dozens of factory workers were incinerated he reported that the conflagration was aggravated by the “blowers” that fueled the fire with fresh oxygen from outside the building. His solution was to ban the use of “blowers,”  reverse their airflow, and re-name them “exhaust fans.”

The vast majority of investments are never “sold;” they are “placed.” At retail a stockbroker will “sell” an investment “product” to a client but that product was “placed” by the investment bank that created it with the retail brokerage whose job it is to “take” it. Investment banks and institutional investors do not “buy” or “sell.” They “place” or “take.” Products are not priced by negotiations of buyers and sellers; they are priced to a model of something else; priced to yield, priced to earnings, priced to book, priced to some synthetic equivalent. There is a glaring flaw with this pricing model. The creators and distributors cannot accurately price products so far away from any real market. The collapse in 2008 occurred because mortgages and all their derivatives were never priced properly. An accurate price is what a knowledgeable buyer is willing to pay for a fully disclosed product from a willing seller; that’s called “marking to market.”

Wall Street’s second proposal to solve the ’08 crisis was to end “mark-to-market” accounting which is no solution at all of course. (The first solution was simple – bail-out money.) It would be constructive to end the obfuscation and lack of accountability that comes with the “placement” of investment “products.” “Buying” and “selling” of “securities” would be a more realistic description of the activity that is supposed to be occurring and such usage might result in more realistic pricing.

Stockbrokers do not have a fiduciary responsibility to their clients as Registered Investment Advisors and Financial Planners do. There have been calls in Congress for years to require a fiduciary standard of all financial advisors including stockbrokers. The major wirehouses, like Merrill Lynch, have fought any such regulation. “Fiduciary” means the legal duty to act for the benefit of another, to do for the client what one would do for one’s self in the same circumstances.

Years ago, when I was a stockbroker, we had a branch meeting with the manager and a mutual fund wholesaler who were promoting a new fund that the firm wanted distributed. If you didn’t participate in selling the “fund of the month” for the firm you were made to suffer. (I suffered.) After the meeting one of the brokers asked about one of the disclosures in the fund brochure. “What the heck are inverse floaters?” he asked. I started to tell him, “It’s a borrower and lender swapping cash flows…” but he wouldn’t let me finish. “Stop! Don’t tell me! I don’t want to know!” he said, and left the room. He didn’t want any facts on his conscience that might have interfered with his ability to sell the fund. And he got on his phone and sold a lot of it for his 5% commission and his little prize in the office sales contest.

I’m reminded of Thomas More’s line in the play A Man For All Seasons, “Why Richard, it profit a man nothing to sell his soul for the whole world…but for Wales?” And from the same play, “The man who lies hides the truth, but the man who tells half-lies has forgotten where he put it.” This moral blindness is rife. It is a deliberate ignorance of anything that might interfere with some immediate gratification, another symptom of the sensationally addicted culture.

Money as a store of value… or something

Mr. Ashcroft’s discussion of currencies got me thinking about Eurodollars. They are rarely referenced anymore. Eurodollars are the term for American dollars exported globally – not just to Europe - in trade for our imports. Because the U.S. has been a net importer for over a generation there is a huge pool of American currency abroad. This pool of the reserve currency mainly facilitates international settlements and trades primarily in London.

So when I returned to my office I went to the Federal Reserve statements on the internet to see what Eurodollars totaled these days. And lo and behold – it is no longer reported. The Fed stopped reporting this when they stopped reporting money supply M3 in 2006 - an event that confounded me at the time.

From other sources, Eurodollars are estimated at approximately $2.5 trillion. In the U.S., money supply M2 has increased more than 10% year over year. For an economy growing at a rate of only 2% this excess currency is an inflation and a devaluation. To pay for our imports a significant amount of these devaluing dollars are exported - but not reported. This is “off-balance sheet” accounting. Perhaps the Congressman from Texas, Ron Paul, has a point when he calls for an audit of the Fed. He is frequently derided as a “wacko” in the media because that is easier to for people to understand than what is being done to them by the banking cartel that is running their nation.

The Fed continues inflating the money supply and devaluing the currency. This keeps the stock market and the top-tier real estate markets floating. The private New York/Washington club of money changers continues to privatize the gains for themselves and socialize the losses for the rest. This is a legal confiscation of wealth from the middle class to an increasingly concentrated Wall Street and Washington elite. While the rest of the country wallows in stagnant housing prices and foreclosures the real estate markets in Boston, New York, Connecticut and Maryland have actually experienced price increases as much as 10% in the last year.

There is nothing to gain by an S&P 500 at 5,000 if the purchasing power of the dollar declines 80%. That contingency will not bother those who control 80% of the wealth. Until the club is busted up, it is clear there will be another financial crisis, more TBTF’s, greater concentration of wealth. These potential crises are of a magnitude that would annihilate the social fabric. The debts of the investment bankers’ have been absolved without penalty and transferred to the rest of us, to be paid off over generations with a significantly reduced standard of living.

Looking ahead

Other forecasts by Capital Economics are U.S. GDP of 2% in ’12 increasing to 2.5% in ’13; inflation at 2%; S&P 500 Index at 1350 in ’12 and ’13; gold at $2,200 in ’12, $2,000 in ’13; Brent crude oil at $95 by year end and $85 in ’13; Fed funds remaining at .25% for the next 2 years; and a 10 year US TSY yield of 2%. They also expect a Dollar/Euro exchange rate of 1.10 for the next two years, down from 1.31 now. This speaks to the depth of the recession expected across the pond. Get ready to travel.

In December I reported that, according to S&P Capital IQ Research, at a P/E ratio of 12, and earnings of $110 in 2012, the S&P 500 Index would trade at 1320, an increase of approximately 8% at that time. That return, combined with a portfolio dividend yield of 3% would give us a return of better than 10%, a satisfactory bogey. The S&P then blew through 1320 on the way to 1400 in the first quarter. Corporate earnings continue to be strong and 70% of first quarter earnings reported are in excess of analysts’ expectations. The S&P 500 P/E is currently 15.7 and headwinds are unchanged from December. They include the European problems, high unemployment and a lame economic recovery, the election, shaky credit markets globally, and huge tax increases set for next January 1. I would not be surprised – nor terribly dissatisfied – to see the year end with the S&P back at 1320.

Low interest rates that may stay near zero through 2013 make the bond market a dangerous place. It is impossible to assume any new exposure greater than a year in duration. It’s time for caution. I want to preserve the gains we have so far this year and stay risk averse.

As I finish writing this, Sarkozy has lost in France to a left-leaning Mr. Hollande, Greece is threatening to default, and Germany is threatening to withhold payment of further rescue funds. These are interesting times, but they always are to me.

Kind regards,
Dennis M. O’Connor

PS: Some entertaining resources if you’re interested are:

 - The Big Short, by Michael Lewis, about several who “saw it coming” and shorted accordingly;

 - Confidence Game, by Christine Richard, about Bill Ackman, a brilliant hedge fund manager who saw trouble ahead in 2002 and fought in vain for regulators to examine and censure the muni  bond insurers for their high-risk, unsustainable business models;

- and a movie, Margin Call, released in 2011, loosely based on the demise of Lehman Brothers or Bear Stearns.