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A White Paper
Surya Capital Management, LLC
July 18, 2008
How to Kill the Bear and Revive the Dead Bull?
July 18, 2008 Amid all the gloom and doom and a steady drum beat surrounding housing debacle and credit crisis, do you want to feel better? Well, here is the prescription, not so much of a bitter medicine, as much of a decisiveness and determination by the proper constituents. These solutions may sound ideological, nevertheless, many of them, if not all, are practical enough to implement, should we decide to implement them. Investors are very unforgiving these days and continue to punish imprudent risk management. This time around, just a wishful thinking or a patchwork of regulations is not going to cut it to cure the current ills. Investors will feel completely satisfied only when new and sound policies are enacted. We lost a great opportunity post tech bubble to straighten us out, we sure do not wish to loose this one, else America is sure on the path of a grave decline. The difference is that the U.S. just had a lost decade like Japan had it in 90s and no body knew it was coming. Now, everyone knows we are going to have another lost decade and hence a nasty market decline especially in light of the financials, lifeblood of the U.S. economy. However, U.S. can have another lost decade, this time what will be different is that the most people will know it. Japan had another lost decade in 2000s. U.S. only started two decades later. It is unfortunate that the Federal Reserve has shown a lack of leadership for last 10 years and has been led by the pressure from Wall Street instead of the other way around. It also paid a lip service to the Congress and its spend-thrift ways. If the Street wants morphine, the Fed always stood ready to deliver it, event after event, meeting their expectations instead of setting their expectations. Obviously, one cannot expect much from the shortterm minded Wall Street, but hey, how about expecting the correct vision and leadership from our leaders? It is the Fed that has to keep long-term interests of American people in mind, not for just few wealthy Wall Street stakeholders. The Fed’s independence has been greatly compromised since the 1998 collapse of Long Term Capital Management (LTCM) and this is one main reason why the Fed should be stripped off its power to control both, growth and inflation, at the same time. Price stability or inflation is much more important than the growth for our mature economy. A truly independent Fed sure can achieve both target, however, a weak Fed cannot achieve that feat. For a change, just the price stability will do. Let us rise and save this once-great nation. If U.S. was not in a decline, then the legendary investor like Warren Buffett would not be the U.S. Dollar bear since 2001. One good thing that can come out of this bad situation is that we can emerge stronger than ever with solid financial institutions under the watch of sound regulatory framework destined to rule the world once again instead of loosing arm one day and a leg the next under current circumstances. We can avoid being succumbed to selling off piece after piece of our assets as we have been doing for last twelve months. Let us not cripple our financial institutions any further.
We need a real leadership from the likes of Federal Reserve and Treasury Secretary. Mr. Henry Paulson at the helm of U.S. Treasury is showing some good signs of a true leadership. Unfortunately, he may not have a fortitude to go all the way due to his ties and hence an affection with the Wall Street. Besides, the ultimate authority lies with the Congress, precisely a root cause or at least an enabler of our paralyzed institutions. How do we put an end to a nasty bear market and revive the long-dead bull. The bull was dead since 2000, what we had during 2002-2007 was a long bear market rally in a secular bear market prone to last 2 decades for de-leveraging United States and unwind excesses built-up in prior two decades. Secular bear market is here to stay, believe it or not, punctuated by major relief rallies, in absence of major structural changes. Who is it to tell you that if leveraging can build-up over two decades, then de-leveraging may not take two decades to undo it, in absence of sound fiscal and monetary policies? We just had a lost decade by S&P 500 delivering a zero return from 1998 to 2008. Let us save ourselves from having another decade. The seeds of the current crisis were sown by the lack of political will to do the right things. This is a crisis of confidence, not a crisis of capital. Underlying problem is not a lack of capital, instead a loss of confidence in the U.S. financial institutions arose from their imprudent risk management over the several years. U.S. consumers and businesses have not thrown in the towel yet, except for their recent sufferings caused by surging inflation. U.S. Government’s inability or a lack of political will to manage these very institutions and systemic risk created by them only exacerbated the situation. Explosive growth of Fannie Mae and Freddie Mac during the last two decades is a testament to that fact. The way the U.S. economy is managed by the Federal Reserve and Congress with the help of multitude of regulators is the cause of this crisis, not that they are responding to the crisis created by someone else. Saner heads need to prevail in order to avoid systemic failures. Mortgage mess was created by the creative and greedy minds of Wall Street in conjunction with naïvete or greed of American people. However, it was accomplished only with the blind eye of Federal Reserve, Congress and several regulators. The U.S. just has had a rude awakening with a giant wake-up call. Let us make the best out of it. There is plenty of money in the world waiting to be invested in the market. Let the chickens come home to the roost. Lot of wealth transfer has happened due to Fed induced inflation and spikes in oil and commodities. U.S. has exported inflation through out the world in order to get out of its hole. Let the money flow begin to U.S. in its earnest. The dumb money already came from foreign countries in the form of early investors in the financial institutions during initial jolts in the financial world in late 2007 and early 2008. However, there is only so much of dumb money around. The smart money is in a much greater quantity and they will not invest in the U.S. and its institutions, unless they see a real progress here.
Then savvy investors will come roaring back to these institutions as they see this sinking ship turn around. World is awash with cash at this time. Investors flush with cash can turn to the U.S. if they see opportunities in the form of reenergized country. The very reason we had a lost decade is due to misguided U.S. policies, not scarcity of capital. It was directed away from the U.S. Asset allocation models of all financial types have been gradually lowering U.S. exposure over the years. What we are witnessing right now is a re-pricing of risk which was long absent in the U.S. markets from all real to financial assets. At the current pace under current pessimistic moods, it will not take much longer to go into the abyss. We are at the inflection point, where the re-pricing of assets started to occur during the last twelve months. Now, the inflection point can lead us toward either much greater despair or toward legitimate hope for a new America. The systemic risk was recognized by many market savants long time ago, whereas now it is being recognized by the masses. Unfortunately, these clairvoyants were beyond the understanding of a common man and mainstream media and certainly ignored by politico for their short-term gains. As of late, the law makers’ propensity to do something about this debacle is well placed, yet not enough, at least, not yet. It is an encouraging sign that the lawmakers are finally awakening to the fact that we need to put new and sound regulations in place. So far, they have been more band-aid type solutions than real sweeping reforms. We can only wish that they are comprehensive enough and soon enough before it causes lot more damage to the U.S. economy. Fortunately, the financial ills have not spilled to the general economy on a big scale yet, however, those days may not be far, if “right things” are not done swiftly. In order to put an end to the massive declines in the housing along with financial stocks, regain the lost confidence and in turn avert a possible severe recession or even a depression in the future, here are the specifics of the prescription. We certainly do not need a status quo. It sure will bring one of the two; severe recession or hyper inflation. It is the decisiveness and long term solutions brought forth by the U.S. Government, instead of a patchwork of regulations that will do the trick. U.S. can be reinvigorated again by doing the following things. 1. Change the Federal Reserve mandate to inflation or price-stability only and not let it try to perform the heroic balancing act between growth and inflation. Let us face it; we are a mature economy and not some emerging country that can act like a spirited entrepreneur to create something out of nothing or act aggressively to supercharge its growth. Fed’s counterpart European Central Bank (ECB) seems to be doing just fine on that front. Let us fight the inflation tooth and nail and stop the lethal and perennial slide in the U.S. dollar, ever since 2001. Unfortunately, inflation was non-existent according to the Bureau of Labor Statistics (BLS) account for years and only now it started rearing its ugly head. Although ask a poor Joe how this silent killer was
hurting his pocket for last few years. Have they made any real wage gains over the years? Fed wanted the ammunition badly and BLS provided it a plenty. 2. Nationalize Fannie Mae and Freddie Mac immediately and abolish them within the specific time frame of five to seven years by selling-off their assets without any explicit or implicit guaranties. Enough nonsense of implicit guaranties and its charter to increase the homeownership! Also, are numerous Federal Home Loan Banks and Ginnie Mae absolutely necessary? Yes, taking on Fan and Fred’s additional 5 trillion dollars in additional liabilities on Fed’s balance sheet is significant and may cause some strain, yet it is temporary and manageable. With the massive reforms, it can be offloaded within 3 to 5 years without disrupting the markets instead of 5 to 7 years with a slow progress. Private enterprises will sure scoop up these securities in no time without any kind of guaranties with the removal of all uncertainties in the marketplace. 3. Enact new regulations to set the proper (and significantly lower) leverage ratios for all financial institutions including investment banks. Let us put a limit on the greed and give them five years to mend their ways. 4. Expand Federal Deposit Insurance Corporation (FDIC) role to include investment banks or give SEC the power to handle investment bank failures. This ensures that there can never be another crisis, there can only be failures. With the repeal of Glass-Steagall Act in 1999, not much distinction is left between commercial and investment banks. This helps remove the fuzziness between the commercial and investment banks and also removes systemic risk due to solid regulatory framework. Further, FDIC insurance limit of $100,000 is a practical joke played on poor John and Jane Doe. If a depositor needs a complete safety, why is he/she deprived of it by some arbitrary limit on the amount? It is deceitful at best and immoral at its worst. How can a U.S. Government have a modus operandi like that? Besides, having a limit is a moot point anyway, since, an informed depositor spreads the deposits across several accounts and banks, it is the uninformed depositor who gets the short end of the stick. How about putting a system in place where there are no bank runs or lines at the bank trying to withdraw their money as soon as they sense trouble. Can’t we have a system when the depositors are always protected regardless of what happens to the bank. There are plenty of places for people to play with their money. Bank deposits should not be one of them. It is ironic that a reckless borrower may get a respite from the lender and government for his over-the-top mortgage, but conservative depositor may get none or have to wait for months to get his money back under current environment.
5. Consolidate or get rid of certain alphabet soup agencies such as GNMA, FHFB, OFHEO, OCC, OTS, etc. The future and form of FHA, SEC is more debatable. As we are seeing right now, SEC has taken a back seat behind Federal Reserve and the U.S. Treasury. Also, why does SEC allow an existence of NRSRO oligopoly consisting of Moody’s, S&P and Fitch? Isn’t that somewhat of a contributor to the mortgage mess? 6. Make the accounting body Financial Accounting Standards Board (FASB) more potent and stop the nonsense of off-balance sheet items. Why Structured Investment Vehicles (SIVs) were off balance sheet at first and now being brought back in to balance sheet? What about joint-ventures (JVs)? Remember the option expensing hoopla during the tech heydays? Deal ferociously with accounting issues such as mark-to-model and mark-tomarket assets, cost accounting versus market value accounting, goodwill treatment under acquisition, etc. Enough about overstated book values by ton of goodwill/intangibles on the books! In other words, we need measures to reflect true tangible book value under all circumstances. 7. Make BLS more potent to capture true inflation numbers and not skewed to fit the Fed intentions, especially to direct Fed toward the correct path. 8. Federal Trade Commission (FTC) has turned a blind eye to several mergers that should not have taken place under its watch. Who suffers ultimately? The consumer or business does at the cost of lower prices and innovation. We need to make FTC really potent and help improve competitiveness of U.S. especially in today’s global nature of business. One near-term prediction one can make is the approval of InBev and AnheuserBusch aside from numerous mega bank mergers, bell companies, cable company mergers and even software mergers such as Oracle shopping spree. As we write this, Oracle and SAP just announced price increases. They sure have a clear ground to operate in. Who will suffer, once again, innovation and cost! To further turbo-charge the U.S. economy, the following is prescribed. 9. Make massive investments in the aging (or crumbling?) infrastructure such as roads, bridges and buildings to save U.S. from the obsolescence and loosing our competitive edge. When was the last tall building built? When did the truly massive (countrywide) highway infrastructure projects take place, except for band-aid projects surrounding major metro areas? According to American Society of Civil Engineers (ASCE), the United States received a “D” score on its infrastructure and posited that it will need more than one trillion dollars worth of investments to get it to the par.
Our forefathers had a great vision to pass on to us what we are enjoying today. The current generation, on the other hand, has failed spectacularly to invest in the future. One only need look outside the country to see how far and fast we are falling behind and threatening our mere existence. U.S. is in the process of loosing its leadership, competitive edge and charm that goes along with it. Further, stop the urban sprawl and enact policies to induce more growth in far reaching places as opposed to over-burdening our existing aging infrastructure in the cities. Ever increasing commute times are a testament to that fact. If we do not play catch-up and then some, the next generation and rest of the world will look to the U.S. as a fallen hero twenty-five years from now. 10. Cut the corporate tax rate to bring U.S. more in line with other developed countries and increase our competitiveness. Obviously, this is less palatable to democrats. Failing to reform Social Security and Medicare shows a lack of vision and leadership on part of current generation of lawmakers. The healthcare reform and lobbyist influence are topics by themselves, which are other gigantic problems, that America is facing today and need to tackle soon. Dare we mention IRS and its mumbo jumbo due to archaic and massive tax codes? The above solutions will not only satisfy longtime critics of the Fed and the U.S. Government regulations, it will satisfy the Street as well. Above solutions can gain the bipartisan support without a whole lot of friction, provided that true leaders emerge from current Congress given the current crisis. It is an irony that the President Bush propelled tax cuts could not become permanent and they are reverting back to the original levels in 2011. We wish that they had become permanent or were never enacted in the first place causing more uncertainty in the marketplace and the U.S. tax payers’ minds, not to mention showing the rift between democrats and republications that continue to prove that the two parties cannot even agree on most important aspects affecting American people. We believe that it did more harm than good reinforcing the belief of the U.S. tax payer that the Government is not capable of leading the country in the right direction. For those fortunate enough to contribute more toward Individual retirement account (IRA), the contribution limit was increased in the Bush era, which was left unchanged for close to two decades. Now, who knows when the Congress will be ready to raise it again. It sure means that the issue will need to be brought back to the table again in next 10, 20 or 30 years, whenever the leader emerges. If it is indexed to inflation, one need not touch it again. Alternatively, if lawmakers routinely review it, then we need not worry about it. Another great proposal by Bush administration of privatizing the social security did not go anywhere in last 5 years. For further strengthening of U.S. government, it needs to privatize the social security and hence remove the uncertainty it is creating for the next generation. Even if the current crisis is resolved, we better stay buckled up for the next
crisis created by Social Security and Medicare liabilities sometime during next couple decades. Let us not just talk the U.S. dollar in to making it strong. Let us walk the talk that we have been talking for years. U.S. dollar is gradually loosing its role of world’s favored reserve currency as the world reserves are being diversified away from the U.S. dollar. Otherwise, legendary investor such as Warren Buffett would not be bearish on dollar for a long time. Let us make the U.S. dollar strong in reality and not strip it off the role of world’s favored reserve currency for our own sake. Further evidence to the lost confidence in the U.S. dollar and U.S. Government’s role of managing it is the currency pegs being abandoned by countries after countries to deal with U.S. exported inflation problems. Let us put everything behind. Uncertainty and anxiety peaks just prior to a bankruptcy or receivership for any corporation. Soon after that, it becomes old news. Perhaps, we can save the U.S. auto industry from killing under its own weight and a dire inflation. Our born-again auto industry has shed its many legacy liabilities at last and hence better equipped to compete globally and it sure deserves one last chance to do it. Wrong headed policies have caused a real decline in the standard of living during the last seven years, due to significantly reduced purchasing power of the U.S. dollar, quite contrary to popular beliefs held by many. Don’t ask the Government or even prosperity pandits. Just ask a poor John and Jane Doe, how much more prosperous are they, really. Having loaded up with bigger houses, SUVs and iPods by loading up on debt is not a real prosperity. It is a phony prosperity, unlike claimed by many naïve financial types. As it is unraveling now, the same people are abandoning their houses and SUVs even faster. With ever declining savings rate during the last decade along with two asset bubbles (stock and housing) fostered only consumerism and did not create a real prosperity. They enjoyed a good standard of living for a while, however, the bigger question is that are they really able to sustain that standard? So, far the answer is no. Now, poor souls have to dig in their retirement kitty to keep going. What a pity! As for the arguments about prosperity, enough claims about U.S. prospering through out the 90s. It was all on the borrowed time and dime. As far as the learned eyes can see, it was all fake prosperity built upon depleted savings and inflated (should we say temporary) asset values. If it was a true prosperity, people would not be trading their SUVs in droves and SUV sales will not plummet like a hot potato even with $4.00 a gallon gas, which is still significantly lower than the rest of the World. Prosperity comes from real money in the bank, real increase in the net worth from sound asset values, not from over-inflated asset values. Truly prosperous do not alter their lifestyles significantly at the first whip of the trouble. Considering this, is U.S. anymore prosperous than it was 10 years ago? If so, why do bank stocks are approaching their 10 to 15 year lows? If the money man himself (i.e. bank) is not anymore prosperous, how can a common man be?
Yes, America is prospering, if you consider only upper echelons of the country. They, no doubt, have prospered, which is evident from the number of tax returns filed for individuals with over $200,000 in income over the last several years. Is that the main America? The point of contention is that the existing policies are dividing America in to two parts, where one (rich) class is prospering and middle / lower income class is suffering. Insidious inflation is sapping the purchasing power of middle/lower income class for quite some time that we feel America is going backward and not forward. The chasm between rich and poor is growing like wild fires due to misplaced priorities in today’s America. We are soon going to become the world of haves and have-nots, if no emergency measures take place soon. Are we going to be incited to change the course only when the wild protests or even revolt and riots, commonly seen in the developing countries, erupt through out the nation? We already have started seeing strikes and riots caused by U.S. exported inflation in certain countries. At the current rate, it will not be too long before we see it at home. Balancing growth with inflation in a mature country under weak regulatory environment and myopic lawmakers’ watch is a wishful thinking at best and catastrophic at its worst as we are witnessing now. With measures prescribed in here, the middle and lower-income class will get a much needed relief from this inflation stranglehold and feel optimistic again about their own and country’s future. Consumer confidence at a multi-decade low is something to worry about more than the multi-decade low of housing numbers since they came off artificially high numbers anyway. Next decade may not bring double digit returns for the stock market, however, it sure lays a solid foundation to avoid another lost decade and possibly deliver a good single digit returns. Otherwise we are doomed for another lost decade along with a high misery index, which is a summation of inflation and unemployment figures. As for the teaser, how is the senator Charles Schumer (D-NY) for his way of handling IndyMac situation much different than several white collar criminals who crossed the fine lines and got in the jail? Enough about fuzzy accounting standards, hypocritical politicians and regulators slamming hard on companies just as the they fall hard along with the stock market! Look at what was borne out of 2000-2002 bear market, a Sarbanes-Oxley Act (Sar-Box). Common sense tells us that the highest level officials at the company, a chief executive officer (CEO) and chief financial officer (CFO) should know their financials and what they are signing. So, what is Sar-Box for? Isn’t it implicit that the CEO and CFO should be liable for what they say and what is on their books in any case? Why create extra burden by Sar-Box. Well, several large foreign companies sneaked out by severing their ties by de-listing their stocks and to camp out with lesser known pink-sheet names. Do we want to keep enacting new nonsensical regulations (or a patchwork of it) and become less and less competitive in this highly competitive and intertwined world? Do we want another such raft of regulations to deal with the latest crisis?
Long ago, financials became a domain of pseudo value investors due to its relatively low valuations. Unfortunately, unless and until these pseudo value investors are thoroughly expunged, the new breed of true hard-core value investors will not emerge and bull market in financials will not begin. The size of Fannie and Freddie reached the epic proportions, which now must be dismantled in its current form, else it is destined to create a bigger havoc down the road. Much of the toxic assets from variety of institutions need to be off-loaded from their asset base. Level headed market watchers, who did not drink easy-money cool-aid, saw this financial Armageddon approaching the world for years. As it was pretty easy to spot in the making, they kept telling the world that the time bomb was ticking and it was a matter of time before it blasts. It was a question of when and not if. U.S. dispensed the drug of easy money for years and the World gladly accepted it. No more! The American people and the world at large are awakened now! Seeds of the lost decade were sown a decade ago, when Federal Reserve helped rescue LTCM stake holders and lowering interest rates soon after without any need. Further, Federal Reserve kept fostering Wall Street mentality that the big daddy is always going to be there to rescue, in case, if they ever get in the trouble and no matter what they do. So, the Wall Street and financial institutions waived adios to prudent risk management and embarked upon greed laden long journey. Federal Reserve inflated M3, a measure of money in circulation, way out in late 1999 in order to stave-off possible Millennium computer meltdown in the form of ever bigger technology and Internet stock bubble. In order to deal with the aftermath of the tech meltdown in 2000-2001, it kept the rates too low for too long between 2001 and 2004 and in the process gave a birth to new asset bubble, a housing bubble! In order to deal with the aftereffects of burst housing bubble, the Fed responded by cutting rates in 2007 and 2008, where as in fact they should have raised the rates to counter ever growing threat from inflation for which we are paying the hefty price now. Growth took a priority over inflation. Cutting the rates did not do much good anyway and did not work as intended, otherwise we will not be here today talking about this crisis. We are still anxiously watching the great act of Fed here. Is the Fed going to raise the rates or lower the rates in the next meeting? Where does it stop? Well, if the Fed does not stop, the Dow will stop at 5,000. Is that what we really want? Let us stop the market slide in its tracks. Some of us know what the Fed should do, we just do not know what the Fed will do. For the Fed, growth and avoiding recession (at any cost) was a priority and not monstrous inflation genie that was coming out of the bottle little by little. Stagflation is the buzz word these days. We may well end up in the depression before we know it, unless some draconian measures are put in place. Japan did not have stagflation during its recent lost decades, but they had depression. We may be facing a same fate in absence of true leadership. Inflation or depression, neither one is desirable for sure.
Before U.S. loses its glory days for ever, before it gets too late, let us do some damage control here. Let us remove the threats to our glory, restore the damaged areas within short few years and solidify ourselves so that we can never get in such dire straits again. It is all about conditioning our minds to long-term gain with some short-term pain. Enough of postponing the pain for short-term gains (we had it several times), enough of avoiding recession after recession by blowing a bubble after bubble! Let us once and for all take this bitter medicine, like former Fed Chairman Paul Walker did in late 70s and early 80s in order to restore our monetary health. At the same time, we need our lawmakers to take some wise actions to restore our fiscal health. Let us induce the severe pain and generate a crescendo now in lieu of dying a thousand deaths over the next 10 years. The bottom line is that the U.S. investor needs to feel optimistic about the U.S. markets again and the U.S. consumer needs to feel well served, else, the U.S. economy will continue to sink gradually and it will take the investor along for the rough ride. Unless, the Fed and Congress get its act together, the markets are not going to calm down. In fact, the stock market is destined to go down to the PE ratio of 8 (similar to previous bear market bottoms) over excruciating few years under the weight of ugly inflation numbers from around PE of 16 that it sported for last few years. The mainstream media needs to awaken to this fact and need to get in the bandwagon of Fed and Congress bashing and make our case. Unfortunately, the Fed is in the box and now in no position to do much to foster growth, except for keeping a tight leash on the inflation. Well, that is all we want for now. We need no more stimuli that it kept providing for years for no right reasons. Now is the high time that the Federal Reserve stop dispensing drugs and instead serve some bitter medicine to cure our ills. Say no to drugs and boom and bust cycles caused by these easy money shots! Several banks and brokers traded at close to half their tangible book value during last Savings & Loan crisis in early 90s. At the present times with a much larger crisis on hand, we are not anywhere close to that number for the most part. We can save our trip to that point, if we do the right things now. By Jay Patel email@example.com Surya Capital Management, LLC
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