Small Cap Stocks

After recognizing that TARP, as originally proposed, had no possibility of working due to the impossibility of properly purchasing worthless toxic assets, Paulson and Bernanke did an about face and are now going to inject capital directly into major financial institutions to help solve the financial crisis.

While “The Market” reacted positively, and correctly I might add, to the proposal of our government acquiring stakes in banks (see this prior post where we discuss this option), a deeper look into the new TARP bank-ownership scheme, should convince you that there is nothing really extraordinary about this latest “printing press” solution to the financial crisis.

Ultimately, nothing is really being done to rectify the financial system or the housing market or the real economy. Therefore, the financial system remains a house of cards, with the possibility of another panic at any time. Sadly, despite an opportunity to fix things, absolutely nothing has been done to set up the financial system on a firmer footing.

In the new TARP, while the banks get money quickly (after forcing the world economies to its knees), there is absolutely no real additional oversight over banks. There are no firings of negligent management, no guarantee of any lending, no attempt to recover stolen money from criminal activities at financial institutions, no mortgage reform, and most importantly no reigning in of fraudulent, speculative and dangerous derivatives, such as credit default swaps.

In the end, Paulson and Bernanke, have proposed no lasting solution to this crisis. Instead, they remain determined to try anything to keep the status quo, reinflate asset prices, and restart a credit ponzi scheme. But, ponzi schemes are difficult to get started again, once people are aware of the underlying scheme. A smarter solution perhaps would be to attempt to restructure financial institutions with an eye to developing an economic system that is not a ponzi scheme. Spending cash on real economic activity instead of supporting financial speculation in paper assets, would appear to be a good idea. But of course this solution is an impossibility, since it would entail a major contraction of employment in the financial industry, upsetting the status quo that Paulson and Bernanke are intent on supporting.

Bottom line: Remain Skeptical and Do No Invest Heavily in Equities as Valuation Measures Will Continue to Remain Under Pressure for Some Time.

I find some ray of hope in the recent announcement that the Treasury is finally considering taking ownership stakes in banks. Nationalizing, or in some way recapitalizing, the large commercial banks in the US, if done correctly, would, I believe, end this financial crisis and restore confidence to the system very quickly (though of course it cannot avert a recession). My hope is that an immediate takeover of banks will transpire over the next few days.

It’s a simple solution, but for various reasons, Paulson and Bernanke have refused to act quickly on this solution, despite the fact some European countries are now taking this path and despite the fact that such a solution has worked magic in other financial crises. Instead, the Fed and Treasury are intent on using textbook economics (Bernanke) and cronyism (Paulson) to destroy the financial system. Unfortunately, their plan is backfiring and I think a government takeover of commercial banks in this country, and the start of completely clean slate, is now our only way out of this financial (and soon to be social) disaster.

Here’s what the government should, and I hope will do, in the next few days to avert a further meltdown of the financial system, which could lead to major shortages of basic products (see this link). There’s still hope that some degree of moral sentiment will sweep over our current leadership and they will do the right thing. But, don’t bet on it.

Here’s what should happen, in order of priority:

In a move that defies logic the Federal Reserve has now decided to lend money to non-financial corporations, transforming itself into a financial institution, like any other, but with unchecked powers and absolutely no monetary constraints (i.e. regular banks actually do have a balance sheet and reserve requirements). With this new lending facility, the Fed is slowing moving away from its intended function of a “lender of last resort” to a “lender of only resort”.

Is this move a good one? Since the Fed has already proven that it cannot even lend money properly to financial companies where it conceivably has some inside information, are we now to believe that the Fed can lend intelligently to non-financial corporations given that it has zero experience or knowledge of this market?

How many people who work at the Fed have any corporate lending experience in the short-term commercial paper market? Can the Fed actually know enough about eligible non-financial corporations to possibly buy their debt? Won’t this inability to do due diligence in the non-financial market greatly increase the potential of fraudulent loans and massive financial theft in the US?

I’m honestly not sure how this latest move of desperation by the Fed is designed to provide any confidence to investors or banks to start lending again. In fact, I think it may paradoxically lead to a further contraction of credit from banks.

Coincidentally, if the Fed simply used $700 billion to buy an existing bank (or merge/nationalize several banks), with existing deposits (which it fully guaranteed), and an existing infrastructure to make non-financial loans, the crisis would slowly end. But, alas that solution is simply too easy and does not feed Bernanke’s addiction to print money and Paulson’s propensity to provide financial rewards to his cronies.

Overall, there seems little reason for optimism at this time, despite sharply lower stock prices and we remain in danger of permanently damaging the financial system as we know it, leading to a sustained period of low equity prices.

As you may well know as the credit crisis gained momentum the Fed relaxed it’s lending requirements and has been allowing nearly any financial institution to borrow money against nearly any type of financial collateral. In a somewhat comic state of affairs, now the Treasury is going to use $800 billion to buy back from the banks what basically amounts to the same collateral that it has been lending against to the banks!

The analogy would be if a bank, let’s call it Bank OPM, lends you $1 million to buy a house that is supposedly worth $1 million. You then take the money, and subsequently default on the loan (it’s possible you never even buy the house, which is a “phantom” house). Instead of just taking over the house as in a normal foreclosure, Bank OPM decides to actually buy the house from you at whatever you think is the right price for the house. Of course, you’d be jumping for joy, since this would be the craziest thing you could ever imagine. What could be the motivation of OPM bank to do this?

Let’s say Bank OPM agrees to buy the house from you for $500K, you walk away and are now $500K+ richer (or more depending on if the house was originally really worth $1 million). Not a bad deal for defaulting on your loans. OBM Bank, of course would be out $1.5 million and be sitting on asset worth at most $500K. In order for OPM bank to make money, though, the house would need to more than triple in value, an impossibility.

Of course, such a situation, as described above, would be completely outrageous and considered criminal by anyone examining OPM bank’s books. Anyone looking at these transactions would obviously assume (correctly) that you and some executives at OPM bank are in cohoots and are just stealing money from the bank.

However, the Fed and the Treasury are somehow now allowed to operate as the fictional OPM bank described above. Instead of just seizing the assets against which they already lent against to failed banks, the Treasury is now agreeing to pay insolvent banks for the same assets it has already lent them money on. It’s simply incredible that nobody has actually asked Paulson how this alchemy is going to work.

So the banks essentially walk away with $800 billion in new capital, for which they don’t put up a dime, and get to default on the initial $800 billion or so, which they have already borrowed from the Fed (and did what with?). Great deal for the banks, but bad deal for the Fed, the Treasury, and the US taxpayer.

What could be the motivation be for such a scheme? We’ll let you decide.

I believe the logic of the above is irrefutable which would clearly explain why confidence in the US financial markets is completely broken. Incredibly, considering the price of treasuries, people are still lining up to give more money to the US Government to support the above criminal scheme. But, the faster they give the money to the Fed the quicker it will disappears into the financial black hole of banks. At some point, investors will recognize that giving money to the Fed to launder is not going to safeguard their money or help the economy. The most it will do is allow Paulson and his Goldman buddies (every single person on Paulson’s rescue team is from Goldman), to steal more money from the US. When foreign investors clearly see Paulson’s motivations, what emergency measures will then be concocted to save our financial system? Maybe they’ll actually ask Paulson and the rest of the bankers to pay back the money that was stolen? Fat chance.

Note: Guess who’s overseeing the TARP? Neal Kashkari, a former Goldman Sachs banker. Now you can see why Buffett bought into Goldman. If you can’t beat em’, join em’.

An understanding of credit derivatives, and specifically Credit Default Swaps (CDS), is important for comprehending the current financial crisis. An interesting paper describing the Credit Default Swap market can be found here. What is now obvious is that trillions of dollars have been siphoned off from the economy in recent years by phony CDS contracts.

The interesting part of the credit default swap market is that in many instances the amount of CDS written can, and continues to, vastly exceed the underlying credit, a completely irrational situation which can seemingly inflate the actual credit obligations in society to infinity. Of course, there is also no truly conceivable way (though bankers have of course invented ingenious ways of combating this problem) of actually honoring CDS contracts when the volume of CDS exceeds the outstanding volume of credit.

The reason for allowing this type of situation, though, was simply due to the fact that sellers/traders of CDS (like AIG) recognized some time ago that they can write CDS’s endlessly, pocket the “premiums”, and never truly set aside “reserves” to actually pay for these obligations in the event of a credit default. It’s classic insurance fraud, i.e. taking in premiums, never truly setting aside reserves, and paying huge salaries from those premiums. The situation is somewhat analogous to a life insurance company writing the same insurance policty over and over again on particular individuals, and never actually putting any money into reserves, on the assumption that people will never die. A great game until someone calls your bluff.

Some other fascinating tidbits from the paper referenced above:

“Up until 2004, the majority of credit default swaps were written on single names, but after the introduction of widely accepted credit indices in 2004 the major impetus to growth and market liquidity has been credit default swaps on indices.”

So instead of actually using CDS to limit risk on particular credits, financial institutions were essentially gambling on the credit market as a whole!

“According to the British Bankers Association, the notional amount outstanding of credit derivatives has grown from $180 billion in 1997 to over $20 trillion in 2006. Other surveys report higher numbers. ISDA, for example, began collecting CDS notional amounts in 2001, and reports growth from $632 billion in 2001 to over $34 trillion by the end of 2006; annual growth has exceeded 100 percent since mid-2004. And the Bank for International Settlements, which began collecting comprehensive statistics in 2004, reports growth of notional amount from $6.4 trillion at the end of 2004 to over $20 trillion as of June 2006 (BIS 2006).”

“The most significant change has been in the importance of hedge funds, which tend to function as both buyers and sellers: In 2000, hedge funds were 3 percent of buyers and 5 percent of sellers, but by 2006 had grown to 28 percent of buyers and 32 percent of sellers.”

With trillions upon trillions of CDS’s written by financial institutions and/or hedge funds, with no intent on paying up (and no ability to pay up), a bailout of $850 billion or a $1 trillion obviously won’t do anything. As I mentioned in the past, you can’t bail out a leverated Ponzi Scheme, as you need infinite amounts of money. Now the Fed and Treasury, have, in theory, an infinite money supply, but will printing trillions upon trillions of dollars really benefit the economy?

I was pleased to find the following article on RGE Monitor which highlights, as I’ve been posting from some time now, the massive financial fraud currently being perpetrated in the US. It would seem that the $700 billion bailout is the final crescendo of this fraud.

But back to the topic of stocks:
I’ve refrained from writing about individual stocks during this crisis, since it’s difficult to figure out how to invest in this environment simply because such blatant and obvious fraud on the macro level, cannot but significantly undermines one’s confidence in the financial system as a whole.

Seemingly, stock multiples need to contract significantly from here, in order to compensate investors for the added risk of investing in this new financial environment, where assets are seized without regard for shareholders, $100 of billions of dollars is transfered without legal authority etc.

Will we return to 1973-1974 multiples of 5X-7X earnings for the average stock? It’s quite conceivable. If that’s the case, I’d stay away from stocks for quite some time. Time will tell.

Here is the link to article mentioned above: http://www.rgemonitor.com/financemarkets-monitor/253850/financial_eugenics__the_paulson_plan_for_survivor_bias

Some excerpts:

“Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks…What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come…This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury…
The basic plan is to set up a federal money laundering operation.”