Small Cap Stocks

In a move designed to divert attention from the real fraud in the AIG bailout, i.e. the counterparty payouts, the House approved a bill to slap punishing taxes on employee bonuses from firms bailed out by taxpayers. Will this close the story on this silly saga?
I’m sure Wall Street is not too worried about taxes on bonuses. There are already more tax-efficient ways to shift the bailout money around.

One method is to just raise base salaries. A more clever scheme, though, has been devised by Goldman: Disguise bonuses as loans.

After pilfering $15 billion from the taxpayer via the AIG shell, Goldman announced the other day a large loan program for its employees who were facing “financial hardship”. You can read about the Goldman loan program here.

Read an interesting article the other night about how the President of Brazil, Lula, is looking to make changes in the savings system in Brazil so that larger investors can actually receive a higher interest rate on direct bank savings accounts. This is being investigated so as to provide an attractive risk-free alternative to government bonds, as interest rates fall in the country. Current interest income in savings account in Brazil is a little more than 6%. The full article (in Portuguese) is available here.

Interesting how a supposed third-world country, has a better sense of economic reality that the US. As opposed to Brazil’s desire to help savers, the Fed and Treasury in the US, are attempting to destroy savings, and encourage rampant speculation, by giving virtually no interest on bank savings accounts and by printing unlimited amounts of money. Make sense?

Incidentally, Lula had an interesting comment when the crisis first started nearly two years ago. He wondered why Brazil was struggling to get investment grade status, and the US was still considered investment grade. Brazil he said has a huge current account surplus, and the US is up to its eyeballs in debt (and now drowning in debt). Which country sounds like the better credit, he wondered? The problem, of course, is that the rating agencies are owned by the US.

With regards to the Fed’s money-printing announcement yesterday, there is an interesting quote on Bloomberg that describes the issue perfectly:

“With one hand the government is issuing debt, and with the other it’s repurchasing it using paper that it is printing,” said Lawrence Creatura, a Rochester, New York-based money manager at Federated Investors Inc., which oversees $407 billion. “This is a shell game that’s not going to be overlooked by global investors.”

In every boom and bust, there are competing memes, which catch investors attention and drive prices to extremes.

During the current financial crisis, the prevailing meme, at least over the last few months, has been that the large US financial institutions are insolvent. This meme is founded on a balance sheet perspective. Since it has been the accepted the meme, prices of financials have plummeted.

Recently, many famous investors and CEO’s, including Warren Buffett (who is biased to the extent that he has major investments in financial institutions), have been trying to create a new meme, based on bank’s income. The meme is that: Banks can earn their way out of this mess because of their basic “spread” lending business and their “princely” lending spreads, as Buffett calls it. Incidentally, I put forward this same exact theory (wrongly I might now add) nearly six months ago when the crisis first started, in this post: Ignore the Bailout Drama.

If this new “Earn Their Way Out” meme takes hold, and the focus turns away from banks balance sheet, a viewpoint which would be strengthened by some sort of repeal of Mark-to-Market, we will almost definitely see a continued rally in stocks for quite some time, with only minor sell-offs.

Whether or not this meme is correct or not (note: it is incorrect), is not really the issue. If enough respected people repeat it, and focus attention away from bank balance sheets, stocks will continue to rise, especially if the new meme gives people confidence in the banking system again.

But, don’t hold out much hope for a sustained rally as the new meme, despite backing by people like Buffett, is completely false. As I’ve mentioned in the past, the true profits at banks have nothing to do with lending off of princely spreads. Big banks, which are the ones we’re worried about, make their money off of securitizations, trading of derivatives (i.e. imaginary securities), and ponzi-like financial funding structures. The princely spread business is old-fashioned banking and could never support the big banks in any meaningful way. Try to find a banker getting a $100 million bonus because of princely lending spreads.

To the extent that securitizations, trading, and ponzi-finance are the profit centers of our big financial institutions, the balance sheet will always be more important than the income statement and repealing of mark-to-market is ridiculous. Essentially, large financial institutions, whether rightly or wrongly, are simply gigantic hedge funds and as such they must be treated as such, both from an accounting and valuation perspective. One wonders what would happen if it became completely legal for hedge funds to determine their income based on what the fund says the assets are worth, rather than what the market says they are worth? Would one be able to then avoid a margin call by simply proving that a certain stock should theoretically be trading at a much higher price, even though it is now at a much lower price?

There is an excellent Roubini Article today about his response to a reporter seeking comment on Bernard Madoff’s life after pleading guilty.

Roubini’s response highlighted many of the major points I have brought out on this website over the last few years and he quoted at length one of my favorite economists, Minsky, who was the first economist to really articulate the nature of ponzi finance and its role in the modern economy.

It’s a great read. Here is the link to the full article:
http://www.rgemonitor.com/blog/roubini/255955/bernie_madoff_is_the_mirror_of_a_made-off_ponzi_economy

A brief qoute to whet your appetite:

“Americans lived in a Made-off and Ponzi bubble economy for a decade or even longer. Madoff is the mirror of the American economy and of its overleveraged agents: a house of cards of leverage over leverage by households, financial firms and corporations that has now gone bust.”

This weekend the Wall Street Journal published an excellent article on the AIG bailout, which provided for the first time a small glimpse into the bailout money trail.

WSJ:

“The beneficiaries of the government’s bailout of American International Group Inc. include at least two dozen U.S. and foreign financial institutions that have been paid roughly $50 billion since the Federal Reserve first extended aid to the insurance giant.

Among those institutions are Goldman Sachs Group Inc. and Germany’s Deutsche Bank AG, each of which received roughly $6 billion in payments between mid-September and December 2008, according to a confidential document and people familiar with the matter…” The entire article can be found here and is worth the a read.

After reading the article it is now seems clear why zombie banks are essential to the financial system and why overt nationalization will never happen.

With the collapse of their asset securitization ponzi schemes, major banks have a giant financial hole to fill, especially as it pertains to their obscene compensation programs for employees. Laundering money into zombie banks, in the guise of needed bailouts and naked CDS payouts, is clearly the best method for generating cash to support the status quo at the remaining banks.

If zombie banks are to go bankrupt, it’s unlikely that these types of payoffs would be allowed under the watchful eye of a government-appointed bankruptcy court. And therefore under the bankruptcy scenario, surviving banks would be forced to consider massive layoffs and salary reductions, which would in turn send certain economies, e.g. New York, into certain depressions. So in an effort to prevent a meltdown in certain favored economies, zombie banks are a necessary evil in the view of the Fed and Treasury, both of whom are controlled by the major financial institutions.

So what’s the end game here?

On the one hand, it seems inconceivable that this bailout fraud, which is clearly the largest financial fraud committed in the history of capitalism, can go unnoticed (Note: It took Madoff 20 years to steal some $30 billion, while it took our major banks only a few months to pilfer five times that amount). It seems certain to engender social outrage, further disillusionment with the US financial system, and demands for justice. All of this should keep the markets under pressure for quite some time.

However, at the same time, $150 billion can of course buy you a lot of security, legal defense, and depressed assets. Amazingly, surviving financial behemoths, have another $1 trillion+ coming down the pike via the TALF. With increasing pressure to prove that they can earn money legitimately, and provide some benefit to society other than the occasional bubble, I’m sure that major financial institutions will do everything in their power to reflate asset prices, for at least a short while. With the Fed money-printing machine on their side, the “asset-inflationary” effects of all this cash will be impossible to ignore, at some point (when is the obvious question).