Looking Into: Banking (What Got Us Into This Mess?)
By Mike Frazier

The U.S. is struggling through the greatest credit crisis in its history. What makes this crisis different from the Great Depression? The proliferation of debt. Greed is the co-conspirator. Americans borrowed too much. Financial institutions took on too much risk. Assets were artificially inflated by the use of leverage. Prudent underwriting practices took a back-seat to quick profits evidenced by Bear Stearns over-leveraged position of 35-to-1 in its final hour. AIG, was actually a hedge fund in an insurance wrapper. Both government regulators and private rating agencies failed their mandate miserably – safety and fairness were not assured. The public was kept in the dark, hence the current cry for “transparency.” Most people did play by the rules, which makes the situation that much more painful, frustrating and unfair.

Here’s a simple example of what got us here. Joe and Jane Home Buyer wanted to buy a house. They were able to get 100% financing from a bank. They had no down payment and showed no verifiable source of income. They were tempted by an interest-only teaser rate, which started at less than 3%. That rate would jump exponentially in 5 years, potentially doubling the monthly payment. But life was good, so nobody cared about the risk. Tick-tock!

This model worked for the better part of a decade. Property values went up, masking the underlying risks. Many of these loans were re-packaged and sold across the globe as Mortgage Backed Securities. Demand for such investments went through the roof. And why not? Excess capital was chasing elevated returns that weren’t found in the stock or bond markets. Then prices started to fall. Tick-tock!

The U.S. housing market ultimately collapsed because the foundation was too weak to support it. With the decline in housing prices, these mortgages became toxic. Many home-owners owed more than the actual property was worth so many homeowners just walked away from the house and the loan. Tick-tock!

Here’s where the madness is compounded. Insurance products were created to cover losses in the event of such a default. The buyer of the insurance pays a regular premium for peace of mind in case losses occur. Sound similar to home-owners insurance? The comparison ends there. These products are called Credit Default Swaps (CDS), and demand exploded for these securities in the decade. In fact, the CDS market was worth $45 Trillion by 2007. That is twice what the U.S. Stock Market represents. Taking it a step further, the CDS market isn’t even regulated. Contracts can be traded from investor to investor without oversight. Adequate reserves did not have to be in place to cover an actual default. Many investors were speculators or hedge funds that had no direct relationship with the underlying assets. The large banks were the most active in this market, as it seemed like easy money in a healthy economy. This was a ticking time bomb. Tick-tock … boom!

The Troubled Asset Relief Program (TARP) was born in response to the credit crisis. After much delay and debate, TARP was passed freeing up the banks to lend again. The problem was that then Treasury Secretary Paulsen changed the terms almost immediately, deciding that instead of absorbing the bad loans, Treasury would just inject the banks with capital. There was very little oversight as to where the money was to be spent. By this time, the banking system didn’t need alphabet soup to make it better. It needed a brain transplant.

But the soup kept coming. The Term Asset-Backed Securities
Loan Facility (TALF) was passed in November, specifically targeting consumers and small businesses. Its purpose was to provide up to $1 trillion in secured loans to accredited borrowers in attempt to re-liquefy the credit markets. The credit freeze threatened credit cards, consumer financing and even company payrolls. The world runs on credit as that clever Visa commercial suggests, and when credit froze, the financial pipes burst.

In February 2009, Tim Geithner, the new Treasury Secretary,
unveiled the next stage of facilitating the flow of credit and enhanced liquidity. The Public-Private Investment Program (PPIP) will purchase the bad loans from financial institutions. This is what we thought the original TARP was supposed to accomplish. A key differentiator is that it will involve private investors, which creates a market to determine a fair price for these loans so investors can participate in the recovery. The plan can buy up to $1 trillion in assets in hopes it will improve asset values and increase bank lending activity.

The incoherent terms and anger over the handling of AIG damaged public confidence and stymied progress. You simply can’t change the rules mid-game; not if you plan on winning the game. We need to promote private investment, and people will not put precious money to work unless they understand the terms and feel they can profit from it. It looks like the administration has learned this early, and PPIP seems to address it.

U.S. home prices declined by 19% in January from a year ago. However, housing is showing some signs of life with starts stats and new home sales perking up. Home mortgage
rates have dipped under 5%, encouraging folks to refinance and maybe even buy a new home. Maybe. Even with rock-bottom mortgage rates, people fearing job loss may shy away from a new home purchase; but perhaps not for long, with Government programs that will protect them if they lose their jobs. And if they are first-time buyers. And if it’s Tuesday and cloudy. (Just kidding about that last one.)

The road to recovery hit a major speed bump on March 30th when GM poured cold water on new found optimisim. Detroit was given 60 days to restructure or face a work-out at the hands of the Federal government. Brand new General Motors CEO Henderson knows his company needs a clean balance sheet to demonstrate it is viable so more plants could close. He also announced that GM will offer payment protection for 24 months of ownership. These are good signs. The Stock Market: Stocks are signaling that we’re out of trouble and heading for a recovery. March alone witnessed stocks jumping 20% in a brisk 13 days of trading. Even bank stocks are being scoffed-up by bargain hunters. Tech stocks led the parade due to their natural growth propensity and strong cash flow which obviates a need to borrow. Since the stock market is a leading economic indicator, positive moves in stocks are what pre-curse an economic recovery.

Bonds recovered first, as usual, half due to the dearth of inflation and half due to the Fed cutting interest rates to the nub. Yield-seeking investors traditionally rely on bonds which provide predictable cash. Soon, these yield-centrics will begin looking into the virtue of stocks: stocks paying solid dividends and stocks that have a history
of raising dividends each year. Dividend increases wards off inflation fears by offsetting the inflation with greater dividend payouts. This actually increases spendable
cash for investors. In other words the fixed cash flow from bonds can be complemented by the variable cash flow from stock dividends.

Telephone company stocks have long been safe havens for investors seeking yield. For example, telephone companies like AT&T pay great dividends and are more attractive in 2009 due to the global explosion of smart phones, cell phones, wireless technology and broadband. Energy stocks provide a similar safe haven.

Jobs: Jobs are still problematic. March unemployment numbers could reach 8.5%, up from 8.1% in February. Layoffs continue and some shops are closing their doors. More alphabet soup is needed here to create jobs faster than they disappear. But we need to be careful when using jobs to determine economic recovery. There is a strong dichotomy between unemployment and unemployment claims. The actual unemployment rate itself is a lagging economic indicator. Unemployment claims, however, tend to turn before the unemployment rate. Therefore, we are watching for signs of a decline in claims which will be a positive sign for the economy going forward.

Employment trends predict consumer behavior because the American economy relies on consumer spending tothe tune of 70% of our nation’s GDP. Therefore, without the consumer, our economy is stalled on the road to recovery. To jump-start spending, the government needs to invest in job creation which will trickle down to increased confidence to spend by consumers.

Our choice investment sectors going forward are technology, healthcare, energy, and China: