Finance Industry Futures I: Credit, Leverage, Malfeasance and Broken Business Models

Table of Contents
Re-thinking, Re-Thinking, Re-Thinking? It's Over, It's Over...Yeah Right! Boiled Frogs Getting Flayed Fundamental Breakage in the BM Private Equity Futures - from Golden(Gilt) to Iron Age 4 Year Crunch, Broken BizzMods Bad Times, Bad Companies: More Finance Industry Vicious Credit, Economy, Market Cycle Spotted Frannie From Pan to Fire: Rescue Me...Us...the System ? 2 3 4 5 6 7 8 10 11

Introduction and Summary
We have all had to learn more than we ever wanted to know about the internal workings of the Finance Industry and its impacts on the rest of the economy. After, literally, decades of viewing the industry as a magic black box where superintelligent wizards created wealth out of thin air we’ve all learned, painfully, that the wizards had more in common with carnival side-show hustlers out to make a fast buck by fleecing the next fool in line. We’ve also learned, even more painfully and unfortunately, that Finance wasn’t just another industry and part of the economy. Instead it was the lifeblood who’s credit creation mechanisms kept the real economy flowing. Now we all know that systemic risk means that the survival of the economy could be at stake. We’ve been tracking the Finance Industry for over two years now and following a learning curve of our own and translating those learnings into various postings and discussions. Starting with early in 2008, in this case, with the suggestion that the Industry was going to have to be re-thought. And debunking other early 2008 fantasies that the credit crunch and the problems with the Industry would go away soon. In fact they were just beginning and as the crunch went to crisis we found out that the business models were badly flawed. This set of postings traced the evolution of the breakdown and near-collapse of the Industry from early 2008 until the end of the year. Sadly all of this analysis is far from out of date. The problems with malfeasant behavior, willful ignorance, violations of fiduciary trust, lack of understanding and badly flawed, even broken, business models are still with us and will be for years. As we look back at the crisis perhaps the scariest thing is that the leadership of the industry was in denial until the cusp of the collapse. And would have taken us all over the edge of the cliff without government intervention. It will take years to contain, stabilize and repair the damage within the industry and, more broadly, for the economy as a whole. Perhaps the worst of all though is that it appears that the Industry is not only still in denial but attempting to return to business as usual. Where this is important to you is in several ways. First off, as a potential direct stakeholder: investor, employee or supplier. Secondly as a customer and thirdly as a member of society. Unless these problems are corrected and new strategies, business models and services that are value-creating, instead of leverage manipulating, result the Industry will perform poorly, credit will continue to be restricted and society will remain threatened. Put that another way…by paying attention to the warnings and analysis at the time you could have avoided loosing a lot of money, suffering a lot of pain and could even made a lot of money with the right investment tactics. We think the same thing will hold true in the future because all the problems discussed are still in place, only in slightly different form.

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WRFest 20Jan08(FinInd): Re-thinking, Re-Thinking, Re-Thinking ? Last week, actually the last several, were terrible for the markets. And judging by the carnage in Asia and Europe so far today we can anticipate more trouble as the markets re-open. While it' not clear how much farther we' got to go it looks s ve like a major shift in outlook and sentiment is underway. One which, partly in a spirit of schadenfreude, we' been pointing ve to for quite a while now. There was so much last week in fact on the spreading credit contagion that we pulled those excerpts out into a seperate post (Ebolatization Contagion: Credit Mess II) to highlight them. A comment on that post asked an interesting and key question: It' as if you are discriminating between financial sector growth, which I assume you measure in financial s terms, and economic value, which I also assume you measure in in financial terms. That is, there is nonvalue adding financial growth. Am I close to correct here?If so, how do we distinguish between the valueadding financial growth and that which does not add value? One could argue that any shift of resources into newer sectors helpe the overall economy become more efficient - in the case of the Finance Industry by helping to raise and create capital and more efficiently allocate it. The question we were asking that led to the comment was whether or not the shift of resources into the Finance Industry had gone too far and our implied answer was "hell yes". But it was an answer based on a fair amount of prior investigation on the rapidly rising share of the Financial sector in profits (The Heart of the Matter: Profits vs Earnings ?), on the buyback and buyout manias (Market Drivers 3 (Buybacks):Investment, Hiring, Nah...Bonus, Bonus, Bonus ! plus two prior posts) and on what' turning s out to be alleged profits built on leverage and unaceptable risks (Rocks, Ponds, Perverse Incentives: More on Credit Contagion) In other words, as write-downs continue, we' arguing that most of the Finance Industry profits that were booked in the re last several years will disappear. And that disappearnce is reflected in the poor outlooks for many of the major companies AND their need to re-capitalize. Taking these arguments and investigations all together it seems reasonable to argue that indeed to much money went into bad investment ideas, that capital was very inefficiently allocated and, as a result, the overall health of the economy will be badly damaged. And, further, that the industry itself is going to have to re-think its' business models which increasingly appear to be badly....badly broken. The readings, links and excerpts on the continuation sustain this argument and extend it. But to anticipate what we think is happening is at least two things. First, the industry needs to re-think and a new set of business models has yet to make an appearance. And second, as a consequence, despite all the folks who' starting to argue that all the catastrophes have been priced into the stocks of re the Financials we' a long way from seeing a bottom grounded in fundamental realities. If and when we recover re economically we' likely to see a major bounce in Financials based on that argument. In fact we' likely to see some re re bounced that will be trading opportunities before then. But not investing opportunities. Until the industry re-thinks itself it won'be well-grounded IMHO. The trick as an investor will be to watch the evolution of the reconstruction of the industry t and then invest. We covered some of these points in an earlier readings collection on the Industry ("Interesting Times" for the Finance Industry: Readings & Resources) which is worth reviewing as well). One of the stories there that encapsulates the situation and provides a nice historical overview is this: Wall Street doesn't want you After an era of innovation in financial services that benefited the middle class, The Street has abandoned individual investors in favor of big institutions and wealthy private traders. It' s time for big changes. Wall Street doesn'care about the individual investor anymore. We' not profitable t re enough. Look at the billions the financial industry has made in recent years from trading, buying and packaging mortgages and credit cards, financing buyouts and selling ways to reduce risk. That kind of business drove operating income at Goldman Sachs) to $14.6 billion in 2006 from just $3.3 billion in 2002, a 340% increase, and at Merrill Lynch to $10.4 billion in 2006 from $2.3 billion in 2002, a 350% increase. Until they blew up, that is. It' not just that Wall Street' newest inventions -- collateralized debt s s obligations and asset-backed commercial paper and the like -- are irrelevant to the stuff we care about, like having enough for retirement. Wall Street' actions seem positively dangerous to our goals. It wasn' s t always this way. For 20 years, beginning in 1975, Wall Street produced a wave of innovation for middleclass investors that brought more and more people into the financial markets. The revolution began in 1975 with the invention of cash-management accounts at Merrill Lynch. From our position in time, it' s hard to remember that there once was a day when all we had were savings and checking accounts, and that the two were so rigidly separated that you couldn'write a check from an account that paid interest t If any of this makes sense to you it' a good opportunity to apply the thinking and tools for analyzing industry/company s performance we sketched in another post as well:Winners & Loosers: Rubble Sorting Page 2of 13

The bottomline - we' not anywhere near a bottom, the industry has broken itself, there are good operators who will get re out of this mess and innovators who will come up with the next wave of ideas and business models. In other words there will be significant opportunities in the Finance Industry over the next several years but they ain'here yet. But it' never to t s late to start investigating and building a little shopping list for when things start to turnaround ! Good luck and good hunting ! Keep your powder dry for now.

April 24, 2008

Readings (Finance): It's Over, It's Over...Yeah Right html Here' our rather massive collection of readings excepts related to the s Finance Industry. Judging from the fact that the ETF, XLF, is up almost 4% to day clearly the worst is over. Of course that not only is there no good news on the economic front but that this has been a month of writedowns and downsizings gone wild we' admit to feeling a tad ll disconnected to the new realities. With this large a collection it' be ll hard to summarize and just skimming the headlines, let alone the excerpts, will just about put you in the picture. But we' ll take a pass. 1. The general theory, other than the talking heads talking themselves into thinking the "worst is over", seems to be that this was the kitchen-sink finale and from now on it' be tough, very tough, but clear sailing. Until we see fundamental ll reform and re-structuring we' going to be locked into this boom-bust financial cycle with increasing frequency and re severity of breakdowns. 2. The structural flaws of the industry' business models have yet to be addressed because it' the work of a decade or s s more - fair, considering it took nearly three to evolve this mess. Speaking of boiled frogs. UBS recently came out with the most candid internal appraisal which could be paraphrased as, "boy, did we ever screw the pooch on this" and "there was a total lack of either adult supervision or responsible business management". Seems fair to us. 3. The writeoffs aren'over and the various institutions are going to be exposed to more as Housing continues its' t dive off the cliff, bad mortgages and securities reset and other asset classes, e.g. consumer debt, business loans, etc. come under increasing pressure. Future writeoffs will continue the debacle most likely. Which will in turn continue to put pressure on capital and will likely lead to a need for more infusions - the capital base of many of the banks is inadequate as it is without more writedowns. 3. In reaction to the destruction of capital the banks are tightening up on credit enormously. The business cycle was going to put serious pressure on loans anyway and lead to defaults, losses and bankruptcies. Combine the two and we have yet another Perfect Storm. And the writedowns, infusions, capital pressures, losses, etc. will feedback on one another. In other words in addition to the writedown problems we are just heading into a classical increase in loan losses. 4. These troubles in slightly different form are percolating to other sectors. While not exposed to the securitization debacle the Regional Banks are just beginning to feel the pain and are headed down their own slippery slop, I mean slope. 5. Accounting for this mess has been disingenous to deceptive with Level III "funny-money" assets protected and inappropriately valued and with various manuvers being used to keep other writeoffs and impairments away from the balance sheet and the bottomline. Even if nothing changes there' therefore still be serious risks hiding in the wings. d 6. Each major sector is having problems from LBO loans to the PE firms. For example no LBO' no fees. And the LBO s debt is getting written off at ginormous discounts. The PE guys are going to have to re-discover their roots of actually focusing on and improving the operations of their portfolio companies. Hedge funds are being called on the carpet as well. 7. And this all doesn'mention the burgeoning job losses that have actually been fairly low so far. t

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8. When you look at individual companies from UBS to Merrill to Wachovia to National City to Credit Suisse are facing major hurdles unique to them as well as the general breakdowns. 9. There are few, almost no, good stories on any front in this mess of messes. A possible exception is JP Morgan where Dimon has provided discipline and adult supervision. As a result JPM may be in a good position to do a little shopping. We' hard put to find anybody else. re Nominations are open. Before or after your excerpt skim the one single thing we think you ought to dive in on is George Soros' interview on Charlie Rose: A conversation with George Soros, Chairman, Soros Fund Management. And take a look at the chart at the right which shows corporate profits over the long term both in absolute terms and as shares of the total. There' a lot of information hiding there. For example why did corporate s profits surge so hugely in this decade ? Well ask all the people who didn'get the jobs a real recovery would have t generated. But for our purposes it' the shares that tell the story. Look at shares of the Financials.After growing gradually s with the slow evolution of all this cleverness from 10% to 20% in the ' it stayed in the 20% range thruout the ' 80s 90s. And then suddenly boomed to 30% around 2000. Rapidly ! Now what sudden major structural innovation, say on the order of Pharmaceuticals, Electronics or the Internet lies behind that ? What new major source of value was created ? In case you' wondering that' both a rhetorical question and something for you to ponder. Because if there were no such re s innovation, i.e. if Financial firms were able to grab a dispproportionate share of profits thru a combination of a weak economy and financial engineering, then it' not sustainable. And we' back to our first point. s re May 07, 2008

Business (Finance Industry): Boiled Frogs Getting Flayed The meme running around the Street and the Treasury is, of course, that the worst is over. As we' noted previously ve that' a bit more than disingenuous (WRFest 4Apr08(Markets): Do We Stay, Do We Go..Jimmy,Readings (Finance): It's Over, s It's Over...Yeah Right). The worst of the credit crisis in terms of a deep structural breakdown is over which just leaves us with a re-pricing of risk, de-leveraging and a burgeoning economic downturn that will lead to more writedowns, balance sheet pressures and losses from more bad loans and be based on feedback from the real economy. As opposed to internal dysfunctions in the broken credit markets. The real worst is yet to come and nobody' paying any attention. Us s usual ? Well not quite or entirely. Finally we' seeing some serious consideration of that feedback loop as well as a variety of re articles finally addressing the real fundamentals of the Finance Industry. Are their business models broken ? We think so. And as a result there' going to have to be some very deep and fundamental re-thinking followed by some even deeper s re-building, re-structuring and painful changes. Otherwise we' just go thru this again...and again...and again. ll All of which is reflected in the various company stories of continuing writedowns JUST dealing with the aftermath of all that bad paper. Some very serious players from JPM to Wolfensohn see more serious trouble ahead. Banks are going to be seeking and needing even more capital with all that implies about dilution, earnings pressures, tighter lending standards and so and so on. We' collected a bunch of stories that support that line of argument but conclude the ve excerpts with two poster children. On Fannie Mae who' recent announcements of surprisingly large losses, more trouble s ahead and more capital raising were greeted by a stock price jump, of all things ! Which grossly misses the real, deepseated damages done and the work to be faced. Our other poster child is Citigroup which, under Vikram Pandit, has made the right emergency moves but now everybody wants a clear, quick fix to make it all right. After four months in the job he' s supposed to lay out the workable strategy for the next decade ?! Give me a break. It' this kind of thinking that created all the problems in the first place. While the jury is out and will be for s some time to come he seems to us to be taking some of the right, small steps. As he says you' got to get some of the ve immediate, small and operational improvements in place before you start re-engineering the super-structure. And Citi is a badly broken as they come, at least IOHO. For those of sufficiently long memories this reminds us of the early days of Gerstner' time at IBM when everybody wanted a vision and a strategy. As he said, "that' the last thing we need right s s now". Ditto for Citi. We' see where Pandit goes but in our book he' started right. The question anybody else getting ll s it ?

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May 23, 2008

Finance Ind II(Readings): Fundamental Breakage in the BM Let' keep cranking on trying to take apart the current situation and strategic outlook for the Finance Industry. But first we s should note that BM stands for "Business Model". Not what you thought it stood for but, nontheless, the pun was intended. And gets to the heart of our argument - which is that the business models of key sectors of the Finance Industry are flawed to badly broken, and we believe that many of the readings support that. The extent of the breakage depends on the sector but those which depended on leveraged trading and investment are most exposed for multiple reasons which are discussed below. Those closer to traditional banking and finance practices have lots of room to improve but equally a good dose of sound business practice, a little innovation and an increased focus on marketing and customer service would go a long way. If you are a stakeholder in any of these you need to walk thru the blueprint and use it as a checklist for assessing their statii and outlook. The chart at right will be no surprise of course. It shows the Industry as a whole (XLF), the Broker-Dealers (IAI), the Insurance sub-industry (IAK) and Regional Banks (IAT). If you buy the arguments of the last three posts (Market, Economy, Finance I) we' had a bull rally with terrible misjudgments on valuations and ve earnings outlooks with a weakening economy which has yet to tip over into a real downturn. Consumer demand has been weakening in any case, and that was before factoring in the implicit tax of energy and food costs surges, which would feedback destructively to hiring and investment spending (per the normal causal linkages). And as a result we were about to see many more boulders topple into the credit pond with a series of feedback loops between deteriorating economics and worsening delinquencies. Net net the question would therefore be how much farther on that chart - over and above where we think the markets are going ? Well we could let you just skim the readings excerpts and reach your own interpretations. Which we urge you to do. BUT...we' also like to testfly the framework we deployed against our strategic evaluation of Citi as a way of thinking d about the industry as a whole. Both because we think the general enterprise framework works and because the work that Pandit and his team have done strikes us as capturing 80-90% of the total industry situation (excluding the Insurance industry of course). (Poster-child II: Citi's Potential Turn-around as Performance Examplar) You' find the readings below ll collected in various takes on the Strategic Outlook, specific companies (including one that shows AIG' writeoffs and s capital raising changing radically in a week as well as UBS' huge discounted rights offering...shocking though nobody s appeared shocked...numbness setting in all over ?). The final section gets to the heart of the matter by providing various readings on thinking about the futures of the industry...that is does their business model and strategies still work, if they ever did ? Based on those readings, all the prior posts which basically dealth with the same question and the strategic assessments in Citi' presentation we end up s with the graphic at right. After two decades of innovation in the ' and ' 70s 80s which provided tremendous value-add and new services for consumers and business the industry shifted its' emphasis to leverage, complex products and trading on its' own account. That worked, apparently, since the mid-90s til last year. And then broke badly despite bringing us an unprecedented series of booms and busts for the same underlying structural reasons. Now we' in a regime where de-leveraging will be the dominant macrore environmental theme and as a result capital requirements will be raised, explicitly by regulation or implicitly by investment returns. So instead of being able to reap the profits from being leveraged 30x, or 40x or 70x the banks, brokers/dealers are entering an era where they' have to return to ll fundamentals. Hence our judgements in the various shade of warning indicators as to whether the business models of the last decade are sustainable going forward. We could argue thru each sector individually and then discuss each of the major players but won'- though we do think t this is the kind of evaluation any employee, investor or stakeholder needs to do for each and every one of them. What we will assert though is that these fundamental re-thinkings aren'widely recognized, acknowledged or accepted though t several key commentators have made similar observations. And this kind of re-thinking is clearly implicit in Citi' new s strategic framework. So apply the Buffett test - which of these are businesses you' want to own a piece of as d businessess ? Our answer - not many until these re-structurings are begun. On the other hand as Rubenstein, Buffett, Page 5of 13

Jubak, are pointing out there will be lots of gems to be sorted from the rubble. Once the rubble all falls down...which point we are IOHO a long way from. May 25, 2008

Finance Ind III (Readings): Private Equity Futures - from Golden(Gilt) to Iron Age A major and critical part of the financial frenzies of the last several years have been the LBO buyout and somewhat related buyback booms. As most of us know by now there' been a relative freeze on LBO activity since last summer, at s least among the very large/large PE funds. Talking to my friends in the mid-size business that began to show up abruptly around the holidays and, judging from various statistics on mid-size deals, has spread there as well, if not as seriously. Yet at the same time the various PE firms have continued, successfully, to raise enormous amounts of investment dollars. Despite the fact that, if anything, the freeze continues and, if you believe our analysis, is likely to face much worse. Part of it of course is that buyout funds have, over the years provided unusually good returns and part of it is that there have been few alternatives in this era of low why not ? And another part, how much we don'know, is that LBO activity, or more correctly Private t Equity investing is actually facing several interesting opportunities. Thought not as business as usual. But let' backtrack a bit and start s with this chart, slightly dated, of the cycle in buyout fund investments. You' have to update it a bit in your minds eye with the ' and ' data ll 06 07 which was even larger than the illustrated ' The catch is that buyout 05. investment kept on during YTD for this year as well. As you can see historically there were pronounced cycles in the business accompanied by a general upward trend in the amount of funds raised. A trend that was non-linear. It' be interesting to see what updated versions of this chart look like when they become available ll because if the news headlines are right fund raising hasn'busted so far t even if investing has. There' another interesting aspect of this, which is what do you do with the s money. With so much of it floating around there was not only an enormous increase in total funds but a lot of new firms and funds got started. Like the Hedge Fund industry though there are also enormous differences in performance. My suspicion is that these historical differences in fund performance and in performance over the years are about to get greatly exaggerated as we find out who' been swimming naked indeed. In the first s sub-chart notice that the top firms enormously outperform the rest of the pack. And then bear in mind that all the newbies performance is not yet, and won'be for some time, reflected in those numbers. The second subt chart suggests that there' also a big difference in performance over time s that' worth looking at as well. s Take a careful look at this chart and notice that the years of great performance are years of significant downturn - that is investments made during ' and ' did exceptionally well. Why ? Well largely 91 01 because they weren'made at extraordinarily high multiples with t unusual leverage built into them. All of which is not true this last few years. This time around there were three things that were generally true. 1) Prices (EBITDA multiples) were exceptionally high - most likely as a friend of mine has pointed out historically unique and never to be repeated. 2) Funding was easy and cheap so the levels of leverage in deals was also unusually large - which is about to come back and haunt folks a great deal. And 3) the terms of that borrowing were extraordinarily lenient - what' called "covenant re lite" in terms of re-payment, default and other loan terms. Which means a lot of deals got done at too high a price, with too much Page 6of 13

leverage and assuming that prices would keep going up. Stop me when this all sounds familiar. Yet in these potential disasters lurks at least a couple of key alternatives. Actually several. First off all that debt is going to generate a lot more distressed debt than in previous cycles and the PE firms are going to be able to pick it up for half price, or perhaps better. Though they' then face some serious workout problems. Which leads to the second major ll opportunity for those who kept some dry powder and their heads - as Wilbur Ross has shown in his beginning to buy up mortgage servicing firms. There' be a lot of companies across many industries who used capital to buyback their own ll stock, are now leveraged at the beginning of a major downturn AND didn'make the operational improvements they t should have with those funds. Judging from the historical cycles illustrated above that suggests that as we move into and thru the downturn, whatever it' length and depth, PE companies who focus on returning to their roots and have the skills s and acumen to do so will be doing well in the years ahead. By return to their roots we mean moving away from financial engineering, though not ignoring or neglecting the benefits of capital re-structuring. And moving toward what' been claimed as the major benefit, capability and strategy of PE firms. s Putting in money, re-vamping operations, instilling good management and management practices and in general returing enterprises to high performance status. The firms that can do that in the next few years stand to do very well indeed and ought to be entering a new era. Not a golden one that turned out to be gilt. Rather an "Age of Iron". Look back at the second chart and the huge jump in performance between the top and restof the pack, especially during tough times. As you go over the readings below you' find a lot of these various aspects reflected from the section on the Strategic ll Outlook to indicators of current deals slowing and/or going bad. To my favorite section on the Mid-Markets. Now there' s not a lot ever covered in the MSM on the mid-markets. So what you' read there are the excerpts from various newsletters ll and seminar announcements which have come to my attention. Which aside from their intrinsic merits also are great indicators of the outlook - and they all are focused, one way or another, on the situation as we' sketched it. Life is about ve to get interesting indeed for the Private Equity industry. June 16, 2008

Markets and Financials:4 Year Crunch, Broken BizzMods In this collection of readings excerpts we combine Markets and Financials because the underlying issues are so intertwined. As usual the same talking head debate continues - is the worst over ? And what would trigger an uptick in the market ? But the game has changed on several fronts and two of the critical things we' talking about for months are now ve common currency memes and being reflected in almost every discussion we read or hear. The two ?

Credit Crisis to Broken BizzMod
1) The Credit Crisis has morphed into an on-going credit crunch where key players are now talking about seeing things take the next 2-4 years to work out. We refer you to the accompanying graphic charting the propagation of the contagion that we' used before. (Finance Ind(Readings): ve Barbarians, Fixes and Outlooks) Interestingly one of the chief new naysayers is Bob Doll, CIO of Blackrock, who' earlier s assessments that the worst was over has changed to the most pessimistic 2-4 estimate. It turns out that what he meant to say was that the breakdown was over and now we' into the re longer-running de-leveraging and risk re-pricing. you tell me. :) 2) Which leads to the new key issue/meme - the broken business model of the financial industry.(Finance Ind II(Readings): Fundamental Breakage in the BM) In the excerpts we' collected a ve bunch of key CNBC vidclips that talk about Investment Banks, Private Equity, the re-structuring of the LBO business, a bursting Hedge Fund bubble and some of the consequences.(Finance Ind III Page 7of 13

(Readings): Private Equity Futures - from Golden(Gilt) to Iron Age) The interview with James Stewart on long-term business model breakage is especially worth listening to IOHO. But the one you should/must listen to is Meredith Whitney' - who' s s assessment, based as it is on deep industry analysis, wide familiarities with the key companies and players and very deep analysis still, strangely enough, sounds a lot like ours.

Market Assessment How this is playing out in the markets is fascinating. The "will we go, will we stay, Jimmy Durante" theme remains with us...all based around an apparent lack of clarity with regard to the economic outlook. A surge in Unemployment took out the market week before last and good news on Retail Sales brought it back this last Fri. Good news which, when you parse it out, is anything but.(HF

Indicators (Sales, Rates, Money, Inflation, Oil, Dollar): Unscheduled Interruption) We' highlighted four key technical indicators in the chart and you' notice that despite Fri' surge that we ve ll s

didn'recover all that much ground. t Just for fun here' the 1-year weekly and 5-year monthly charts s presented as simply as possible with a little trading trend stuff thrown in. Continuing our usual interpretation we don'see any signs in either of t these that the markets are pricing in anything serious in our economic future. If you do please let us know. A point, btw, made in several of the excerpts. Notice on both that we got back essentially to the 200-day MA after correcting a mild 10% correction and that we' still barely busting re the long-term lower bound on the trend. Sector Comparisons

When you de-compose the overall market into sectors (having covered the int' l situation and emerging economies jointly in the prior post) an interesting picture emerges in the short/intermediate-terms and the longer-run. Here we' divided ve the SP sector ETFs into the worse and better performers. As you can see the only real pain is in Financials (XLF) - what a surprise - with Con. Discretionary (XLY) doing poorly and Healthcare (XLV) not feeling the love while Con. Staple (XLP) is holding up reasonably well considering what the economic numbers are telling us. On the other hand the vaunted strong performers aren' over a year, t, doing that well either whether it' Technology (XLK), Industrials (XLI) or Materials s (XLB). Only Energy (XLE) is still going gang-busters. If any theme emerges it' s that Energy still has a good story and nobody else does but nobody' s admitting it as yet. Then when you shift your perspectives to the longer-term it gets even more interesting. Over the long-term the story' consistent but still not s "pronounced" - that is we haven'seen the clear emergence of a strong t direction, let alone one that matches up with our views on the economic outlook. Over five years Finance has essentially given up all it' gains s and if you belive the BM discussion (puns intended) there' a lot worse to s come. Of the Weak group nobody' done particularly well. Of the Strong s group only Energy has truly been an outstanding performer while the rest have done decently well. In the last five years we had, perhaps, three-five dominant investing themes. Real Estate that went bust but made money. Emerging Markets which are shifting rapidly. Energy and Commodities - still rolling along. The New World Economy while true that would appear to be shifting somewhat as well. And then what ? July 25, 2008

Bad Times, Bad Companies: More Finance Industry
Page 8of 13 Time to re-visit some confessionals. In case you didn' notice the recent market t rally was driven by the Financials ! Of all things. And they were driven by better than expected earnings, i.e. smaller than disastrous write-offs and terrible but not catastrophic impacts to their bottomlines. Unfortunately when you actually start parsing the news instead of reading the newswires PR announcements a slightly different set of pictures emerges. But let' start with this "simple", by our s standards, little chart of the Finance ETF, XLF. On the "since Oct" chart the recent runup was huge IOHO - more even than the April surprise when it was all over. When you look at the 10-day chart you get the more granular anatomy and that it' starting to fade. Hopefully as some semblance of reality fades in. It s hardly took a day, or less than, for the talking heads to get trotted out to talk about "worst is over" again and the time to be investigating putting money to work in the financials was now. One of the readings you' see excerpted is ll about Bill Miller - the most exemplary fund manager of legend of the last two decades - who got completely trimmed up by large and bad bets on just that thesis. What happened ? Well for one thing let' remind ourselves of the arguments from the last post about what constitutes a good company (Bad Times, Good s Companies: Who's Swimming Naked). And then suggest that we' looking at bad times for bad companies. re Economic Consequences But, before pursuing that, you need to think about the consequences which are complex, convoluted but ultimately not surprising. When banks start writing off big numbers they take big hits on their capital and have less to loan. When they think the economic situation isn'good they tighten up lending standards. The t end results is that credit gets scarcer and the economy experiences more down-pressure. Which gets reflected in interest rates and the money supply. Which is worsened in a credit crisis by elevated rates as risks are re-priced. All of which you see in this chart. On the top the 3Mo spread between Treasuries and Financial commercial paper remain at elevated levels while the spread between higher quality and more risky corporate bonds does as well. The really fascinating, puzzling and scary thing is that the spread between very short-term Fed Funds and 10Yr Treasuries has widened out enormously. That usually only happens when the economy is booming, there' a serious fear of inflation or s rates are getting driven up by exchange rate pressures. Almost none of that seems to be the problem right now though. The middle chart shows the YoY% growth in the inflation-adjusted monetary base - and it' approx. 3.5% and returning to a downtrend. In other words s despite a slowing economy, very low Fed rates and everything else that should be mitigating things credit is drying up at a serious rate. And it' NOT inflation as you can see on the bottom which compares core CPI to the spread between TIPs s and 10YRs. The biggest, most astute and biggest bettors in the world don'see inflation as a problem. After parsing all the t puts and takes we end up with a metastasizing credit crunch slowly oozing its' way/weight thru the economy. And you wondered why mortgage rates were jumping ! Business Implications & Inferences Returning to contemplate the XLF jump leaves one more than a bit puzzled. Here' a set of hypothesis that you might s want to kick around. 1. The Fed thru magic, innovation and cojones has created enough instruments to provide technical tools to address the credit crisis but we' still faced with the consequences of bad business decisions and a slowing economy. At least we' re re not facing collapse as we were in March. 2. The Financials have "merely" worked their way thru the immediate consequences of the crisis, not the crunch. As the economy slows the "credit death spiral" we' talked about before will start working it' way on their balance sheets, ve s losses and loss provisions. With attendant impacts on profit and credit availability. IN other words this still has a long way to go. AmExp' results should be reviewed for the reality check. s 3. None of this is/was being factored into the market' thinking on the financials....otherwise we shouldn'have seen a s t bounce. 4. Another thing we' talked about is broken business models, the strategic consequences of de-leveraging and the need ve to fundamental re-think all the major banking/finance segments for future prospects when leverage gets driven to a more rational 10X or less from the 20-30X that many were depending on for profits. Page 9of 13

5. While several commentators have noted this from Charlie Gasparino to Bill Gross it would appear to not be being reflected in much of anyone' real thinking or investing. We refer you to Jim Jubak' recent column (today ?) on the s s terrible outlook for several major financials. In his and our estimation this is going to take years to re-engineer. And nobody is facing that music that we can tell. On any front. We' refer you back to a prior post (Red Sky Mornings, Investor Take Warning: More Finance Industry) for more graphics ll and discussion of leverage vs business models vs breakage. But if you don'look at much else please take a moment and t consider these two CNBC vidclips: • • Getting Back to the Basics The future of Wall Street lies in its simpler sleeker past, says George Ball, Sanders Morris Harris Group. Merrill' Comeback Man CNBC' Charlie Gasparino takes a look at the executive who helped Merrill Lynch raise s s billions in new capital seven months ago.

UPDATE: One of the great recent discovers I"ve made is how truly balanced and sensible the Canadian Business News Network is. More on that later but for now here' a very recent clip outlining why a sensible sounding sr. investor thinks it' s s time to get back into Financials: • BNN sets you up for your trading day with Clement Gignac, senior VP, chief economist and strategist, National Bank Financial.

As it happens I continue to disagree with him for all the reasons discussed but his reasoning would be reasonable if we were in normal times. Nonetheless he' clear, articulate and intelligent interviewed. A real pleasure to listen to !! s August 10, 2008

News Alert: Vicious Credit, Economy, Market Cycle Spotted We interrupt our regularly scheduled posting to warn you that our early storm warning system has detected more early signs of bad credit weather. Over the weekend our alert news monitors found a new wave of back-on-balance sheet adjustments, Fannie Mae issued worse than expected news, both GSE' (FNM, s FRE) announced that they would be restricting new mortgage loans and guarantees. And (H/T CalculatedRisk) Fannie' conference call tells us that the s books closed in June but there were significant deteriorations in July MORE THAN THEY ANTICIPATED when putting together their books. As you can see from the early warning reserve dashboard Fannie has both upped its' reserves and doesn'begin to cover its' t risks. Making a huge Treasury equity investment increasingly likely, indeed mandatory to keep them from sliding into major default (dare one say the BK-word ?) and at least threatening to follow Merrill in throwing existing stockholders to the wolves of insolvency. What's It All Mean: the Vicious Circle Grinds On Now to provide us with some on spot emergency future storm analysis, straight from the University of LetsCreateaChart, is Prof. Cycle Feedback. Prof. Can you tell us what' going on ? Well Mr. Blog is appears we have several seperate subs cycles that are providing positive feedback, that is they are reinforcing each other. In good times you know that as a Virtuous Cycle and we rode it up this last few years rather merrily if blindly. Unfortuanately it' well on it' way to reversing s s itself and turning into a Vicious Cycle. Which we at the Prognostication Center hope doesn'metastasize into a Perfect t Cycle Storm.

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As you can see it' a little complicated and we didn'try and show everything. But we' shown the status as best we can s t ve by color coding and line thickness. You can see where the accelerating collapse of the Housing Markets has created a breakdown in the Credit Markets while also weakening the Economy. The breakdown in the Credit Markets led to major weakness in the broader Markets which in turn fed back with declining investment values to put further pressure on the Credit Markets. Unfortunately the Economy, both here and abroad, hasn' yet shown or felt the full effects, nor weakened t as much as we anticipated from its' own internal, organic weaknesses. When that happens that will establish a 2-way feedback between the Economies (Domestic, Int' each of them and their respective Markets and also with the Credit l), Market. So we anticipate having to revise some of these to heavier and redder some time soon. Let' hope not, though. s

September 06, 2008

Frannie From Pan to Fire (Update2): Rescue Me...Us...the System ? A little earlier this evening an interesting and very major story just came out on the WSJ online that Fannie and Freddie are about to have the Treasury impose a "rescue" plan of some sort or another. We' see what happens over the ll weekend but it looks like the long-delayed other boot (Paul Bunyan' spare) is about to be dropped. This is good news s and bad news. You might want to review a little history (Bad Times, Really Bad Behavior, Bad Trouble: Fannie/Freddie and Perdition

socialist bailouts are another thing IOHO. Weekend Updates and Summaries: BigPicture, CalculatedRisk and Matt Trivvsanno & crew have come thru with summaries analysis and consequences that you should have in you reading lists. BigPicture: Fannie & Freddie Weekend Wrap Up/Linkfest,Treasury Takeover of GSEs: 10 Key Points CalculatedRisk: Fannie & Freddie Thoughts Matt Trivisonno: The Fan-Fred Short-Squeeze Rally Update2: More interesting news below in the readings section detailing the behind the scenes on the Frannie rescue AND the impact on the Housing markets. Plus an assessment of widespread the problems with banking capital shortfalls are. Confirm our themes and "worsen" them in essence.

Road). This is ironic since the markets, after reacting in what we consider a properly rational way to an abysmal employment report, rallied back today to close in positive territory for the non-tech businesses. Guess what - it was the Financials, the Homebuilders and Consumer Discretionary that were up. All the things that a metastasizing credit credit crisis and an accelerating slowdown are going to hurt the worst. The continued triumph of delusion over analysis IOHO. Ironically in the after-hours markets the Frannie Twins were down about -20%+ ! Though to be fair, if very confused, XLF was up almost 5% and XHB up almost 3%. Clearly the weekenders think Frannie is toast but it bodes well for the financials and the homebuilders. BtW Barry Ritholz has obviously been up and reading as his excellent summary of the news is here: Roundup: Fannie & Freddie Bailout. His opinions about

Let us try and disabuse everyone of those notions that a) a Frannie bailout is pork-barrel politics, b) that the Financials are /will be in good shape and c) it' safe to get back in. And do so by complementing all the news roundups with our usual focus on the structural context and consequences. In other s words , what' the lay of the land and what' the weather therein. s s

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State of the Credit Markets
Starting by looking at the state of the credit markets using some of our standard indicators. What you see here are three different credit/money market measures the can tell us quite a bit about what' s going on. First up is the spread between FedFunds and 10Yr Treasuries - which mixes instruments a bit - but is still telling us that the Yield Curve is "market favorable". That is short-term money is cheap, which generally encourages investing because borrowing is inexpensive. And longer-term money ain'that expensive at around 4% t and dropping. But the really interesting thing about that spread is the abrupt switch around Nov. from no spread, indicating a flat/inverted yield curve and tight short-term money, to now. In this puzzle-palace world the short-term drop was Fed policy at work but why the long-term rates are staying up is....dollar ? More interesting though is the spread between 3Mo Treasures and corporate commercial paper, which is still very elevated over last year and appears to be rising. An indicator that there' still a lot of fear and uncertainty in the market. s Finally is the inflation-adjusted monetary base which tells us the effective supply of money is growing or shrinking. Normally it shrinks during downturns and this time is no exception ...except it' been shrinking longer and farther than the s economy' been downturning so far ! The reason - it' called credit tightening. In other words the credit markets are s s working but under enormous pressures. If you' like to see a really cool and implicitly informative history of how the yield d re curve works and relates to the markets try this: Dynamic Yield Curve. And in case you' wondering why you care Wikipedia has a decent, thorough and balanced description.

Frannie's Failures and Consequences
After the break you' find a largish collection of readings that bear on ll all this from the news that the Chinese banks have backed away from Frannie, for what now seem like sound, rational reasons. Which makes the rates they have to pay to borrow higher, funding harder to get and so on. Which leads us to one of the gray-headed potential triggers - though it' been months/years in the making. Bill Gross' s s latest newsletter talked about a financial tsunami freezing up and then collapsing the markets and specifically the need to rescue Frannie on Thur. But he wasn'alone - Paul Volcker, perhaps the t most respected central banker in seven decades, came out flatly the same day and said the system is broken, more write-offs are coming and we need to re-engineer it. He further added he' never seen a s crisis this complex or painful. Our fear is that once we move beyond the perennial Pollyannas and into more realistic territory there' still a limited grasp of what a s breakdown in Frannie, let alone the whole system, would mean for the economy. Shucks...:) We' not even sure we get it and we' re ve been flapping our gums for months. Certainly if the XLF keeps getting run up like this though our fears of a major breakdown are very far afield from the common understanding. In other words there' still a lot of piping to pay for and Bill and Paul are telling us s the bill' coming due. s There' a bunch of other readings we think are worth your time s including some more on the lingering after-effects and some very good discussion, similar to questions we' raised but ve now done in a wider venue by somebody who' very knowledgeable, about the future down-sizing of the industry. Plus s some interesting stories of folks who have been or are navigating these storms thru what we' call business acumen, guts d and discipline. The one story though we really urge you to click thru, read, download think about is Robert Solow' review of Kevin s Phillips book on "Bad Money". His shrill polemic against the Finance Industry. While there' a lot wrong he apparently s didn'bother to figure out what worked but dug up some 100 year old anti-capitalist conspiracy theory stuff from William t Jennings Bryan and his "cross of gold" speeches and re-furbished them. Now we' not denying there' a lot broken and a re s lot of malfeasant behavior since we' been arguing that as well. What Solow - btw, one of the best 100 economists of the ve Page 12of 13

last sixty plus years and a Nobel winner - does is is take you on a detailed tour and analytical dissection of the industry and the roles it plays and why it' so necessary. While also discussing what' wrong and thoughts about fixing it. s s

Final Words: Frannie, Systemic Risk and Malfeasance
There' a lot of words being bandied about that this is yet another example of socialist intervention in the markets. Instead s they screwed up, let them fail. Well this is disingenous at best and also ignorant both of how one thing leads to another and what underpins markets. Here are some things to think about that' help you correct that. ll 1. First put out the fire and save the women and the children, don'lock the door because they aren'correctly dressed to t t appear in public. 2. Use this crisis to make structural repairs that regulators, the Fed (Greenspan) and others have been trying to make for years, if not decades, as Frannie increasingly spiraled out of control thru lobbying and corruption of Congress to protect its' interests and in the name of greed. 3. We all benefited from that greed and wallowed in it. The only thing that held up the US economy after the ' downturn 01 was Housing and what drove housing was debt securitization. There is no single one of us who' investments, incomes, s jobs and general well-being didn'benefit some way or another. Old sayings come to mind...either when you eat at the t King' table be loyal to your salt...or bring your own taster. Or both. s 4. As the chart makes clear a Frannie failure would turn a nightmare Housing market into a catastrophic collapse and be a systemic threat to the entire financial system. BSC was a Sunday park stroll as compared to the Mongols' visit to Baghdad in comparison. But that' not the worst of it - because the full faith and credit of the US government was involved and s exploited the credit-worthiness of the US Treasury was and is at stake and the Chinese have fired more than one public warning shot. For a fuller discussion of the consequences Jim Jubak does a beautiful job: The huge threat to the US 5. Markets don'exist in a vacuum but rely on a whole host of hidden infrastructure from a legal system to enforce t contracts to security forces to make sure that one is free to trade and exchange as well as to defend the property you' re trading and filing law suites over. The financial markets wouldn'exist without the regulatory framework that' been t s evolved to ensure their smooth, orderly and honest functioning over the last eight decades. That machinery is creaky and aging and needs a major overhaul. But to pretend it doesn'exist nor that it isn'in the public interest is ill-informed, to say t t the last (again we refer you to Solow' review). s With all the ideological ranting and raving you' make better decisions if you understand the organic dependency of ll markets on government instead of pretending it doesn'exist. With that in mind here' the readings to back up some or all t s of those assertions.

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