Apparently I'm not the only one feeling a little squeamish. You have to be optimistic, yes, but realistic too, and it's hard not to think about things like, oh, a war with no end, the price of gas and food, the dollars that are rotting
in my pocket, the cost of my kids' educations, the price of my
health insurance, and the chronic, systemic corruption of our political
economy. Why am I not relieved watching our presidential candidates
address little or none of the above? Sure, I'm all for
"hope" and "change" but could I maybe see a few of
the details?
There is a small bust of George Washington in my
office. What would he think, this president who had to be begged to serve,
who did so without pay or vanity, and who retired so gracefully? How would
he react to this election burlesque today, overweighted in greedy,
pandering, vain ideologues winking and nodding, talking in code, saying
everything and saying nothing? The challenges for the next president are
so enormous that I'm frankly suspicious of any candidate who wants
it badly. They say that Fred Thompson "doesn't want it badly
enough." Who would?
The politically savvy will always deflect
responsibility for any action with an uncertain outcome. Best to have
someone to blame in place at all times. One would think from watching the
news that the Federal Reserve chairman is solely responsible for the
economy and the stock market of the United States. The executive branch is
a lame duck shackled to its crusade 150 degrees around the globe, waiting
for relief that only history will bring. I recommend Sun Tsu's
"Art of War" for everyone's reading list. The
legislative branch seems to do as little as possible and I suppose we
should be grateful. It probably pays better. Why risk alienating lobbyists
and donors by doing something? In any case we have the judicial branch to
make the laws.
Our most recently retired Fed chairman fell in love
with this arrangement - and with himself apparently, although I'm
not certain of the sequence. Now, with a press agent and a book deal, he
won't shut up, despite the inarguable fact that it was his easy
money policies which let the party get out of hand to the extent of the
hangover we suffer today. As recently as '05 it was his testimony
that there was "no housing bubble."
Our dollar has lost
50% of its value against the Euro, 40% against the pound and over 20%
against a basket of Asian currencies since 2002. The price of oil has
tripled in dollars, doubled in Euros and remained the same in gold. We
have inflation: rising prices, falling currency and diminished purchasing
power. Whatever happened to the objective of price stability?
Moody's Investor Services has announced that the U.S. Treasury Bond
could lose its AAA credit rating within ten years. Our standard of living,
let alone our retirement plan, is at great risk.
The producer price
index was up 6.3% in 2007, consumer prices up 4.1%. Cost of food increased
nearly 25%; oil and gas energy an additional 18%. Inventories rose .4% in
December. Leading indicators are down three months in a row. The
Philadelphia Manufacturing Index dropped precipitously to -20.9 in January
from -1.6 in December. Yes, the signals of recession or slowdown are
multiplying. The Fed will cut rates further - at the further expense
of dollar value - to keep the party going. I would rather suffer the
slowdown - we all would - rather than sacrifice our purchasing
power! We are quietly being legally robbed and none of the presidential
candidates addresses it, other than Rep. Ron Paul, M.D., who has been
glibly marginalized as a dope.
I watched Chairman Bernanke address
Congress this morning and many of the questions put to him were about the
type of "short-term stimulus" that Congress might pass to help
the economy. Here we go again: the Fed's going cut rates, Congress
is going to mail everybody a check, the president is going to come up with
some temporary business spending incentives. Same ol' same 'ol
'til next time, and the next times are coming harder and faster.
Here are the best things Congress could do short-term: stop pasting
band-aids on an economic slowdown and start fixing the long-term,
structural problems, starting with the moral hazards of its own behaviors,
like taking money from foreign interests. Pass H.R. 2600, which has been
stuck in committee since June. That is the Border Tax Equity Act of 2007,
co-sponsored by 14 Reps from both parties. It would tax imports to the
same degree that their Value Added Taxes are exempted by their countries
of origin. It would start to level the playing field for our
manufacturers. Start exporting our health and safety standards to
countries that are exporting the products of almost slave-labor at clearly
predatory prices. Fine and imprison the personnel of companies hiring
undocumented aliens. (That would end the illegal alien problem in 6
months.) Boycott and sanction OPEC countries. (That's another bill
that can't seem to get started, NOPEC, sponsored by Arlen Spector.)
Open ANWR, the Gulf of Mexico and the Santa Barbara channel to oil
drilling. Make the tax cuts permanent and stop the pork barrel spending.
Here's the best thing the Fed could do short-term: cut the Funds
rate to 2.5% to get it in line with the rest of the yield curve, which
would then be positive, and then leave it alone. Stop printing excess
money. Stop talking to the Street. Start talking up the dollar. Though
open-market actions are generally ineffectual, political campaigns and
jawboning have had results at stabilizing the currency. Start talking,
loudly, about the cost of war and the effects on the economy.
Here's the best thing the administration could do: end this war in
Iraq as quickly and systematically as possible. Apart from the deaths of
over 4,000 heroic young Americans and the tens of thousands of Iraqis,
this has been phenomenally expensive. It is an economic disaster. We
experienced sharp inflation shocks after WWI, WWII and Vietnam. Does
anyone care to mention the fathomless stupidity of the policy called " Guns and Butter"; during the Johnson administration? We paid
the price for over ten years and the Social Security system has never
recovered. The Fed is printing money to finance a war. Let us recall
Eisenhower's warning about the military industrial complex. Get out
of the Middle East, NATO and Korea entirely; we have no allies there that
can't take care of themselves. Start using diplomacy and economic
weight instead of the military. There is no need to put missiles in
Eastern Europe other than to recreate a Russian enemy. There is a
rationale for trade sanctions and tariffs; start suggesting them to
beneficial effect. Talk softly and carry a big stick. Ask for
Congressional support for global trade policies.
The CMO: A Personal
Memoir
Though it seems that "subprime" is the culprit
for everything housing related, in fact there are structural problems with
the securitization of the mortgage industry, inherent problems left
unaddressed since the creation of mortgage-backed securities in the
1980's. The problems with pricing collateralized mortgage
obligations have surfaced repeatedly over the last twenty years. They
simply can't be priced like bonds.
I bought my first CMO for
clients on May 25, 1988. It was CMO MLT 31C, with an indicated annual
yield of 11% to final maturity on 5/8/2009. I bought my second CMO for
clients on June 22, 1988. It was CMO MLT 32B, with a yield of 10.01% to
final maturity on 8/1/2008. I read the prospectus for each thoroughly.
These were pools of mortgages, grouped into proportions of principal and
interest repayment called "tranches." Tranch A would pay all
principal first and a little bit of interest last; tranch G would pay
nothing but interest to start and principal only at the end; tranches B
and C paid some combination of principal and interest in different
proportions between A and G. CMO's appeared attractive to certain
institutions which wanted some predictability of duration and return.
Bear in mind that all mortgages must carry some prepayment assumptions
and with a pool of mortgages these assumptions can only estimate an
average life of the securitized debt. The average life of a CMO is
critical to its duration. Duration is the formula used to accurately price
a fixed income security as market interest rates (yields) change. This is
not a straight-line relationship, in fact the change of price/yield is
convex. The convexity of bond prices to interest rate changes (or the
volatility of bond prices) is as much a function of the expectation of
interest rate changes as it is to actual market interest rates
Here's the bottom line: the best calculations we can make for the
duration and convexity of a specific bond - with a fixed maturity
and interest rate - are approximations. For a pool of a thousand
different mortgages the estimates and assumptions are magnified. So is the
margin of error or unpredictability. The only certainty is that the
results will be somewhere in a range.
Those early CMO's were
the only ones I have ever positioned. I liked the product. They were,
quite literally, "plain vanilla," which is the term given to
those first generation CMO's. At those rates my clients were
doubling their money in less than seven years. (They lasted about 5 or 6
years before being completely paid out.) But subsequent CMO offerings were
not plain vanilla. The prospecti had become impenetrable documents 80
pages or longer, with litanies of estimates and assumptions spread across
30 or 40 exchangeable tranches, some with floaters and/or inverse
floaters. They were full of smoke and mirrors to me. Because of inaccurate
prepayment assumptions CMO's eventually could only be grouped
according to "original average life."
Not too long
afterwards, in 1989, I sold a client a "joint and survivor"
life insurance policy. This policy replaced an existing policy on which
the client was still paying annual premiums and actually seeing declining
cash values. This new policy required one payment, a single premium of
$140,000, and would pay close to a million dollars, to be used for estate
taxes, upon the second death of the married couple. Internal rate of
return was greater than 7%. If they died within 20 years it was a very
good investment. If they lived longer than that it still wasn't a
bad investment. One of the things I always insisted on from insurance
underwriters was an illustration of the lowest interest rate possible for
the policy, the "worst case scenario." The insurance company
in this case had an A+ claims-paying rating, the highest given by A.M.
Best, the rating agency.
When I reviewed the first annual policy
statement with my client I was shocked. The value of the policy was much
less than originally illustrated despite the fact that interest rates
hadn't changed much. I called the company and got a revised
"in-force" illustration along with some reassurances. OK. In
year two, the problem had gotten worse: in addition to deteriorating
valuations the policy was now showing premium payments taken out of
dividends. I called the company again. This time I needed an explanation
for why a "vanishing premium" option was being exercised when
neither I nor the client had authorized it. I also wanted to know
precisely what the underlying portfolio of securities was that funded the
policy. The policy was performing worse than the "worst case
interest rate scenario" they had illustrated and interest rates had
not changed. They wouldn't reveal the investments.
So I sent a
three page letter with attachments to the Commissioner of Insurance here
in Massachusetts. Her completely unsympathetic response was that I had
most likely misrepresented the policy I sold and that I should be prepared
to make a full accounting to the underwriter and prepare for some
potential regulatory censure. She was undoubtedly very popular with the
insurance industry and probably considered me "off the
reservation." I don't respond well to this type of bullying. So back I went to the underwriter in Toronto, telling them explicitly what
they had done wrong and what I wanted them to do to make my client whole.
Their response was another threat letter. Sandbagged for the last time, I
asked my clients if they would allow me to help them litigate. They
consented.
Two weeks later I sat in the offices of Millberg, Weiss,
Hines, Bershad, & Lerach in New York, stating the facts on behalf of
my clients, who became leaders of a class action suit against the
insurance company. It resulted in a settlement, almost nine years later,
of over $500 million to the plaintiff's class. My clients were made
whole and finally, the mystery of the underlying investments was solved.
They were CMO's, packaged and sold by the investment bankers of my
former firm. There were many class action suits in the 90's against
insurance companies with policies featuring "vanishing
premiums" that never vanished. Most were invested in CMO-type
products.
So why then, if these things can't be priced
properly, are they still being sold? Why, to make matters worse, do these
structured products contain sub-prime (junk and worse) debt obligations? Well, in the interest of either diversification or deception many bankers
buried measures of sub-prime junk in large pools of mortgage backed
product to be distributed to other institutions around the world. This
neither mitigated any risk nor hid the nature of these sub-prime bombs.
It's kind of like having "a touch of ebola" or "a
little HIV." These things have been continually written and sold for
the easy money they've generated. They have been sold and
subsequently relied on as loan collateral by institutions large and small
around the world. What a disgraceful export. If no laws have been broken,
then we need some new laws.
Despite the mayhem it has created
– globally – Wall Street had a record year in 2007 for
bonuses. This includes Merrill Lynch, which took $12 billion in losses in
the last two quarters and yet paid out compensation that exceeded
revenues. It also includes Jeffries Group, which we own, and which
recorded $140 million in net earnings for the year, but which took a $24
million loss in the 4th quarter because of bonuses and compensation costs
paid to keep executives from going to competitors. This is absurd. Where
are the stockholders bonuses?
Maxed Out
Throughout history
morality sometimes gets ignored when it comes to making money. Such times
can be perilous.
I am reminded of the remark made to me by my manager at
my first brokerage firm which refused to pay me an investment banking fee
I had earned. He said, "Nobody lied, the truth changed." I
left a month later. That firm, and perhaps too much of the industry,
became overpopulated with "wise guys" in management. They are
paying the price now. It seems today it is immoral not to make money and
those that don't are punished.
Maxed Out is the name of a
current documentary DVD that I recently rented from Blockbuster. I was so
impressed by it that I bought two copies for my lending library. I urge
everyone to watch this movie. The credit card industry, as this movie
shows, preys on those least able to pay: the infirm, the young and
naive, the irresponsible, the poor and the ignorant. The industry
lobbied hard for the discard of usury laws, and won. Not too long ago they
scored with Congress again, changing the bankruptcy laws so that creditors
can own their debtors for life.
This is not hyperbole, given the
fact that an average person maxed out on their credit cards and making
minimum monthly payments will likely die before the principal is repaid. Some card companies often deliberately hold payment checks or not cash
them at all in order to provoke late fees, penalties and higher interest
rates. Total costs can exceed 40% annually. The profits are too obscene to
quibble about the price in human misery. Welcome to Pottersville!
Such a corporate culture obviously found its way to the mortgage business.
The term "sub-prime" was no less respectable than "junk
bond" until very recently, and there is a good market for junk.
Funny thing is, in the corporate world, a "prime" borrower is
something less than best credit risk. Junk bonds are traded in the light
of day; sub-prime loans have been hidden in pools of other debts.
This is not a one-way ticket
A global economic meltdown is in no
one's best interest. If we can avoid a world war, economic growth of
the developing nations will accrue to our benefit and we will all be
wealthier. There will be many multilateral trade agreements and
compromises along the way. The best defense against circumstances beyond
our control is to own the participating companies. There is no other place
to go. Better an owner than a borrower. There is little return for lenders
in the fixed income markets. The markdown in the equity markets so far
this year is the largest since 2002. Bearish sentiment reached 70% last
week. The highest I can recall was 65% in 1995 after which the market
returned 23% in the following 12 months. To sell into the present panic
would be a big mistake; better to hedge. However, this sell-off could
accelerate if credit default swaps fail. These swaps are derivatives
designed to mitigate defaults - to an extent.
Perhaps a moratorium
on the dismantling of the securities regulations created during the Great
Depression is in order. I question whether voiding Glass-Steagall was a
good idea. I regret that the uptick rule for short sales was eliminated
last year. Clearly, the production and distribution of derivatives needs
oversight. Hedge funds need more transparency. The costs of mistakes or
malfeasance extend far beyond the participation of the "accredited
investors" in the funds.
You have to be optimistic. Things do
change when they have to change. Right now there may be a consensus
forming that trade and finance have got to change. It is in neither the
best interest of the U.S. nor the rest of the world to lose the dollar as
the reserve currency. The dollar has to be defended with sound monetary
and fiscal policies and fair trading agreements. Whole chunks of American
capital infrastructure are being traded for oil. This is like selling off
parcels of the family farm for pizza and beer. Communicate with your
representatives.
The correction in real estate is creating great
opportunities for those capable of buying. Right now there are million
dollar properties auctioning for $400,000 in San Diego County. Many of the
untouchable real estate markets are accessible again. Keep your powder dry
and your eyes peeled. Even better opportunities are ahead into 2009.
Best regards,
Dennis M. O'Connor
