Babeled

Ethics appears to be a disappearing ideal in the business world, especially when executives are taking vacations with tax dollars, as well as getting their “golden parachutes” handed to them for a job poorly done.  In the midst of a crashing market, we have seen multiple bailouts given to companies that were on the verge of going belly up due to their excessive greed.  So for my amusement and I hope yours, I have compiled a list of quotes that I feel every Wall Street executive should read.  Enjoy.

1. Earnings can be pliable as putty when a charlatan heads the company reporting them. (Warren Buffet, American Investment Entrepreneur)

2. How do we know when irrational exuberance has unduly escalated asset values?  (Alan Greenspan, Chairman of US Federal Reserve Board)

3. If ethics are poor at the top, that behavior is copied down through the organization.  (Robert Noyce, inventor of the silicon chip)

4. The inherent vice of capitalism is the uneven division of blessings, while the inherent virtue of socialism is the equal division of misery. (Sir Winston Churchill, British Prime Minister)

5. I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things.  (Benjamin Franklin, American diplomat, inventor, and writer)

Notice how, despite what Barack Obama and the media will tell you, it was the Republicans calling for tighter oversight of Fannie and Freddie back in 2004.  But the Democrats were quick to defend those who made them rich, even going so far as to lob pathetic personal insults at regulators attempting to raise the alarm.

Now let’s hear Speaker of The House, Nancy Pelosi’s viscious politcal rhetoric and finger-pointing only moments before the Bailout vote on what was supposed to be a non-partisan bill to help the American people.

Are House Republicans expected to endorse her comments by voting for the measure? So why did the Media give Speaker Pelosi a free pass after they called the following a “Political Stunt.”

But nothing was ever said about Obama’s casual attitude on the subject or his refusal to set aside politics for two days to do his job.  Could this be because Obama benefits from economic turmoil?

So, America, does the montage you just saw at all represent the picture that the media has painted for you about the two parties, the economic crisis, and the candidates?

On the first video, what party attempted to raise the alarm FOUR YEARS AGO on Fannie and Freddie while Senator Obama lined his pockets with their dirty money?  What party was on the side of the “Wall Street Fat Cats?”

On the last three videos, which of those three appeared to reach across the aisle to work with both parties?

Who is the leader and who are the dividers?

The media is lying to you!  Don’t fall for it.

~Man Overboard

A draft of the Emergency Economic Stabilization Act of 2008 (EESA), which the infamous $700 government bail-out of financial institutions is now officially dubbed, has been issued over the weekend.  Per the draft document the EESA’s main goal is to “restore liquidity and stability to the financial system of the United States” in a manner that:

(A) protects home values, college funds, retirement accounts, and life savings; (B) preserves homeownership and promotes jobs and economic growth; (C) maximizes overall returns to the taxpayers of the United States; and (D) provides public accountability for the exercise of such authority.

The EESA lays out two primary options for financial institutions under what is known as the Troubled Asset Relief Program (TARP), a part of the EESA.  TARP provides financial institutions with the ability to sell “troubled assets”, to be defined within 2 days of the EESA’s anticipated passage, by the U.S. Secretary of Treasury, at a value that cannot exceed the original face value of the asset.  The other option is insurance for those things classified as “troubled assets”.  In this case, the U.S. Treasury will sell insurance to financial institutions to guarantee the values and interest pay-outs on the asset by requiring the financial institution to pay an insurance premium to the government (similar to FDIC insurance).

In order to ensure that the EESA has the desired effect, the Financial Stability Oversight Board (FSOB) was created in the Act to review all financial aspects.  The FSOB consists of the Chairman of the Board of Governors of the Federal Reserve System, Secretary of Treasury, Director of Federal Home Finance Agency, the Chairman of the Securities and Exchange Commission (SEC), and the Secretary of Housing and Urban Development.  These individuals have the ability to appoint third party analysts to review transactions made under the authority granted by the EESA for malfeasance, fraud, and reasonability.  This is the government’s answer to the “blank check” sentiment that is already beginning to circulate amongst citizens.

The EESA 110-page draft goes on to list in excruciating detail the various committees that may be called and dissolved at will to review myriad aspects of the execution of the EESA and governance.  Those of us who are number-crunchers, eager to challenge and dive into the accounting and finance side of the EESA looking for feasibility and quantitative economic impact data, are left extremely unsatisfied by the EESA draft.  At no point in the draft are the (A) types of assets for purchase or insurance eligibility defined or identified specifically; (B) methods for valuation of the hereto undefined assets specified; (C) vehicles for funding the TARP; or (D) projection of potential value of “troubled assets” that would qualify for government purchase or insurance.

The most clear assertion of things to be classified as “troubled assets” comes from the amorphous language of in the definitions section of the EESA.  This definition reads as follows:

(9) The term “troubled assets” means - (A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary [of Treasury] determines promotes financial market stability; and (B) any other financial instrument that the Secretary [of Treasury], after consultation with the Chairman of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.

In this case, we see EESA’s focus is mortgage-backed securities and mortgages.  However, part B of the definition is what is most troubling.  While the approval of adding other financial assets for eligibility under the EESA must be recommended by both the Secretary of Treasury and the Federal Reserve Chairman, then approved by Congressional committees, the EESA document itself gives me pause when following the impacts of this Act through to their logical conclusion.  The language above grants the ability for the aforementioned individuals to recommend and approve ANY financial instrument for qualification under the EESA, hinging only on the requirement that the purchase or insurance of said security must promote financial market stability.

This is so troubling because at any point in an economic downturn, many financial instruments could be seen as “troubled assets” as that is the nature of financial decline.  Using the tech stock bubble and 9/11 as an example, a rapid, broad stock market decline causes serious economic impacts to corporations across many sectors resulting in job loss and GDP contraction (economic shrinkage).  If the EESA had been in place during a stock market decline of such magnitude, or larger, would we be seeing the Secretary and Chairman of the Fed requesting to bail-out companies with huge stock losses in their marketable securities or pension funds?  While answering that question is mere conjecture, the fact remains that the language being used in this Act opens the door for future actions such as the one just described to be taken by the government.  I would really not like to see our government develop a habit of throwing money at corporations with irresponsible financial practices.

The funding for all expenses, including administrative costs of executing this Act, is left ambiguously up to the language in chapter 31 of title 31, United States Code (Title 31 Money and Finance, Subtitle III Financial Management, Chapter 31 Public Debt).  This basically says that the funding for this Act is going to come from the issuance of a variety of government bonds and notes, not to exceed the public debit limit.  A little math lesson here: If the government were to sell $1,000 bonds or notes (most carry a face value of less than $1,000, but for sake of proving this point with maximum arithmetic ease we will use $1,000), they would need to sell 250 million bonds/notes to cover the initial $250 billion cash outlay forecasted for the EESA.

Although government bonds are considered less risky than corporate-backed ones, the fact remains that there must be a market of interested buyers for the bonds in order to raise money in this fashion.  With the ever-increasing shakiness of the U.S. economy, the government’s revenue stream (taxes) is in jeopardy due to a higher jobless rate (6.1% most recent figure) and corporate profits on the decline.  Therefore, the government has less revenue to back their securities, making them riskier and reducing the market of buyers for these bonds/notes.  I personally think it is unrealistic to assume that enough capital will be generated through a government bonds issuance to cover the cost of this Act.

The EESA still must pass Congress and be signed by the President, and will undoubtedly see revisions before it is signed into law, but this is a revealing first look at what our law-makers have been working so diligently on over the past week.  While I may not entirely agree with the legislation, I commend our government officials for stepping up to the plate and putting in the hours at night and over the weekend to work on what they feel is best for their constituents.  Even in the face of potentially huge bi-partisan contentions, they were able to go to work and produce a deliverable in a relatively short amount of time in response to an extremely complex situation.  I eagerly await more substance and will report back with analysis and insight that I may be able to provide on the matter.

This is all Bill Clinton’s fault.   Although Senator Phil Gramm (R-TX) introduced the legislation in 1999, ultimately the burden of blame for the U.S.’s current economic crisis rests with the President who let the Gramm-Leach-Bliley Act pass.  This is the bill that overturned the part of the Banking Act of 1933, also known as the Glass-Steagall Act, that said commercial banks, those that accept deposits from customers and lend that money to borrowers, could not engage in the practice of underwriting securities.

The banking industry had been pushing extremely hard for the repeal of this part of the Banking Act of 1933.  Their argument was that more corporations were turning to investment banks because of lower costs due to less regulation.  Commercial banks were losing customers and therefore revenue to both investment banks and foreign banks, many of whom did not have the same regulations that split the activities of deposit acceptance from securities underwriting.

The Banking Act of 1933 was put into place during the Great Depression for very good reason.  The practice of underwriting securities is inherently riskier than traditional loans because credit standards are less of a concern due to the nature of the transaction.  An investment bank essentially borrows money from a commercial bank to give to a corporation in return for either stock or bond agreements that the investment bank then sells to private investors via the stock exchanges and bond markets.

The investment bank, whose repayment depends upon their ability to sell the securities to investors, care very little about the future financial stability of the entity they gave money to in exchange for the securities because the investors who purchase the securities from the investment bank are taking all of the financial risk assumed with giving money to that entity. The risk to the firm underwriting the security is in the nature of the agreement and the current market dynamics.  One of the types of securities causing our current problems is mortgage-backed securities (MBS).

Traditionally, mortgage backed securities were considered very low-risk investment instruments because most people paid their mortgages with a very predictable default rate.  People were riding the internet stock wave of the late nineteen nineties and did not predict that the stock prices were grossly over-valued and therefore must stabilize.  Coupled with the unforeseen tragedy of 9/11 and the subsequent financial market crash, the Federal Reserve systematically lowered interest rates to historic lows to combat the financial crisis at the time.

The resulting low interest rates on mortgages led to an enormous amount of people purchasing homes.  Basic economics tells us that if demand increases at a rate greater than supply, then prices increase.  Home prices began to skyrocket due to the lowering of interest rates. Increasing home prices starting reaching a point that many people could not meet the requirements for traditional mortgages based on the inflated property values.  To respond to this, banks began offering new loan instruments, such as the interest-only mortgage, that bypassed typical credit standards and down payment requirements.

The Federal Reserve always walks an interest rate tight rope, trying to maintain balance between setting rates too low, which leads to inflation (so they say), or being too high, which stifles economic growth through making borrowing money cost-prohibitive.  While these historically low interest rates were causing economic growth through real estate profits, all good things must come to an end and the Federal Reserve began to raise interest rates by quadrupling them over an eighteen-month period from 2005 into 2006.  This caused variable rate mortgages to suddenly become much more expensive on a monthly basis to the borrower.  People then began to default on these mortgages in record numbers.

Back to basic economics again: if a large population of borrowers are opting to take the credit hit of defaulting on a mortgage, this leads to a large population of people who can no longer qualify for a mortgage thereby decreasing the demand for homes.  Decreasing demand with an ever-increasing supply indefinitely leads to lower prices.  Now, commercial banks are financially burdened with a property that is lower in value than the money they lent to someone to buy it, thus accepting the loss.

Investment banks are being hurt in this situation because of the mortgage-backed securities (MBS).  When borrowers stopped paying their mortgages, investment banks had to devalue their MBS and take a loss.  So, since commercial banks were now allowed to own investment banking firms, ultimately the cash flow of the commercial banks were hurt.  This is how commercial banks are now taking huge losses on two fronts; all a result of the Gramm-Leach-Bliley Act of 1999.

Another part in this history is the formation of the Federal Deposit Insurance Company (FDIC), also a product of the Banking Act of 1933 meant to bring an end to the Great Depression.  Since the FDIC will have to pay banks’ depositors enormous sums of money for claims should the bank go bankrupt, the government usually attempts other means to avert the need to pay out on deposit insurance for a bank failure.  These other means have manifested both directly and indirectly impacted many of the financial crises during 2008: Bear Stearns’ near bankruptcy led to the government relaxation of traditional FTC waiting periods in order to allow JP Morgan Chase to acquire Stearns before it had to liquidate the firm’s assets, the Federal Government takeover of Fannie Mae and Freddie Mac, the Bank of America acquisition of Merrill Lynch through relaxed FTC regulations, the temporary ban on short selling certain financial sector stocks, the Lehman Brother’s deal, and inexorably to the $700 billion Federal Government bail-out that is still not finalized.  These events will be the subject matter for part 2 of the U.S. Economy in Crisis Explained series.

Short selling is simply betting the per share price of a corporation’s stock will decline.  More precisely, an investor agrees to borrow a certain quantity of stock that another investor (the lender) owns with the intent to return the stock at a later date.  The borrower will then purchase shares at a point in the future to return to the lender. If all goes well for the borrower (the one attempting to short sell, or “short”), the stock price will have fallen so that they can pay the lender back with shares that cost less than the borrowed shares.  The net effect is the short seller profits in the amount the per share price declined.

Short selling is considered a highly risky practice because a stock’s share price can, in theory, rise indefinitely.  This is not the case with the inverse; zero is as far as the stock can drop.  If the per share price were to rise on a stock that you were selling short, you would lose money in the amount that the share price increased over the borrowed share price.

While it is risky, short selling is also regarded as a practice that provides liquidity to the financial markets.  “Provide liquidity,” and its various incarnations, is a ubiquitous phrase in the news, yet rarely explained by the article in which it appears, even to the point of being indecipherable with context clues.  Providing liquidity in the stock market means producing money flow.  It’s that simple.  Providing stock market liquidity is to drive market forces in influencing investors to purchase and sell stock.

Many people are convinced that short sellers are artificially hurting the financial sector through their practices.  It has been said that short sellers spread rumors and falsities to cause a negative reaction to a company they have a short position in so that they can profit from the stock’s decline.  This is probably true, and I am sure someone will come back with an exact example of a scandal coming to light, but for the time being let’s assume that it is probably safe to say that some people are greedy enough to lie to make money.  However, this only affects the certain stock in question, not an entire stock market decline.

The SEC temporarily banned the short selling of 799 stocks in the financial sector on September 19, 2008.  The rationale behind the ban is that short sellers have been and will only continue to make the financial sector share prices tailspin.  The logic of this is inherently flawed because short sellers agree to return higher-priced shares back to the lender by replacing them with lower per share price stock.  The short sellers must purchase stock to give back to the lender.  When shares of a corporation’s stock are purchased, the supply/demand ratio of the stock changes leading to a natural increase in stock price.

The connection to make here is that in a time when stock prices of financial sector corporations are plummeting, short sellers are continuously borrowing and then purchasing stock to repay the lender at various price points.  The short sellers are virtually the only investors purchasing shares in these tarnished stocks because they are more than happy to purchase so that they can “pay” back their stock lender and pocket the difference.   One could make the argument that at a time like this with stocks in a very specific sector all in a downward spiral, that short sellers are providing the liquidity to the market necessary to help these corporations’ share prices level off.

Banning short selling of these stocks has mostly caused backlash from the markets as it is seen as too overt of government interference in the market.  It is worth noting that the United Kingdom’s financial regulator, the U.S.’s SEC counterpart, the Financial Services authority (FSA), has also introduced a similar ban on short selling.  It was also acknowledge by Chancellor Alistair Darling of the U.K. that short selling does indeed provide needed liquidity in periods of decline, but that it was harmful in their current situation.  This rhetoric sounds oddly familiar.