Small Cap Stocks

Today Paul Volcker outlined a financial plan, which harks back to Glass-Steagall Act days:

“Maybe we ought to have a kind of two-tier financial system,” Volcker, who heads President Barack Obama’s Economic Recovery Advisory Board, said today at a conference at New York University’s Stern School of Business.

Commercial banks would provide customers with depository services and access to credit and would be highly regulated, while securities firms would have the freedom to take on more risk and practice trading, “relatively free of regulation,” Volcker said.

I couldn’t agree more. Basic banking services (i.e. deposits and simple mortgage loans) are as essential to our society as electricity and water. As such, basic banking should morph into a regulated utility so that society can function normally and economic activity can grow off a firm basis. The more speculative and ponzi-like aspects of banking, like trading, asset-backed securities, and the like, can be carried on by non-regulated financial institutions with their own capital and at their own risk. In this way society as a whole is protected against the loss of basic social functions, while substantial gains are still available to those who which to bet in the financial markets and other non-essential economic spheres.

And for those die hard capitalists who decry all forms of government regulation, I ask: how they would generate profits if they woke up every morning to find themselves without electricity and running water? You can’t have any form of capitalism without regulation of basic necessities that ensure a stable social framework. And simple banking services, including the right to obtain a mortgage to own your own home or get a solid education, are surely basic social needs like water and electricity, and therefore should only be administered by a regulated government entity.

Has it dawned on anyone else that we are now living in a financial anarchy? Every day, short sellers using a variety of derivative securities (e.g. SKF), CDS , and other financial instruments, are allowed to run wild and pummel US stock and credit markets, causing a cascade of negative feedback loops, which in turn cause increasing real economic harm worldwide.

Yes, we need to restructure our financial institutions, yes there was fraud at big banks, yes the government should not be expected to bail out investors (including credit holders), and yes the economy is in shambles, but how does allowing financial instruments that merely make matters worse by further destroying confidence help the situation? Isn’t it the duty of a democratic government to protect its citizens from undue harm, in order to create a more stable society?

If certain financial instruments are exacerbating the economic downturn and preventing the needed restructuring of our financial system in a rational manner, shouldn’t the government outlaw these instruments immediately? Why couldn’t the government simply nullify many harmful credit derivatives and CDS contracts? Are we truly afraid of the backlash from various counterparties, when those counterparties themselves are bent on destroying our economic system?

What are your thoughts?

Barney Frank said he will seek legislation to “make it illegal for anybody to securitize 100 percent of anything.”

“It’s 100 percent securitization that allows bad originations because people make loans and don’t have to worry about being paid back,” Frank said. “Nobody should be taking more risk than he or she can afford to pay off.”

It’s encouraging to see that finally at least one politician understands the crux of the financial crisis. However, Mr. Frank will surely run up against massive resistance in trying to curb securitization. Securitization lies at the heart of Wall Street’s obscene pay packages, the current crisis, and the ongoing financial fraud at big banks. It’s also the main thrust of Geithner’s TALF scheme. It’s doubtful Mr. Frank will have any chance of pushing thru any needed securitization legislation when he’s up against Wall Street foes and their partner Geithner, all of whom have way more to lose than the average American, who has basically already lost it all.

There was an interesting article in Bloomberg today that highlighted the unique aspect of the current crisis: There are many people who are benefiting from the complete financial collapse and it is not in their interest to see any meaningful recovery or beneficial restructuring. The culprit once again are Credit Default Swaps.

Here’s a simple explanation of the issue from the article:

“Before, you really had to worry mostly about where you were in the” company’s capital structure. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

“Say you’ve lent $100 million to a company and you had bought $100 million in credit-default swaps,” said Henry Hu, a law professor at the University of Texas in Austin. “In that circumstance, the creditor really doesn’t care whether or not the company goes under.”

“You’re given these control rights under loan agreements or bond indentures on the general assumption that if you’re a creditor, you have an interest in the borrower surviving,” said Hu, who’s written about so-called empty creditors. “Because of things like credit-default swaps, that assumption no longer holds.”

In reading the above and the rest of the article, you may be wondering why Credit Default Swaps are still legal despite their clear role in causing the financial and economic crisis (where does anyone think the AIG bailout money is going?) and the danger they pose to a sound financial system. The answer, as always, is money and influence. If even Warren Buffett is gambling in Credit Default Swaps, how can anyone have the guts to outlaw and nullify these destructive, and completely useless, financial instruments? Ultimately, though at some point, the prospect of a major social dislocation due to the ongoing real economic meltdown, may force the hand of the CDS gambling gang who now hold the world hostage in an attempt to make billions. For surely all the money in the world will be worthless in the event of a complete financial and economic collapse, which sadly seems more possible with each passing day.

Interesting quote today in a Bloomberg article on GE:

“Creditors are being bailed out everywhere but equity owners are not,” said William Poole, president of the St. Louis Federal Reserve Bank until March 2008. “What that does is create cascading weakness because you can’t raise any equity capital.”

This is of course the key problem for equities: No respect and a government that is intent on destroying equity whenever they can get their hands on it. This despite the fact that if we actually capitalized businesses with more equity, as opposed to credit, we would not have a major economic crisis ever few years. Greater equity financing is, for various reasons, much safer and would improve financial stability, as many economists, like the late Minsky have suggested.

Need proof of that? Consider the .com bubble, which was entirely an equity-based bubble. Yes the .com bubble caused a major market downturn, but the real economic contraction was actually minimal and the overall effects were very short-lived. Quite the opposite with the current credit crisis. The entire world economy has now been put at risk due to an overuse of credit financing.

So why the bailout of creditors and the continued drive towards maintaining the status quo of a predominantly credit-based financing for the economy? It’s simple: Greed.

There’s simply too much money to be made in the credit markets, given the ponzi-like nature of credit financing (i.e. “refinancing”, which is by definition a ponzi) with its myriad of credit derivatives. So when faced with the choice of an economic crisis every few years that undermines social well being or a more stable society with less economic volatility which promotes social harmony instead of wealth accumulation by a few, financial institutions and individuals (like Pimco, Bill Gross), that profit handsomely from these major financial dislocations, will always push for greater credit financing and financial instability.

In case you haven’t read the news, the TALF is now basically open for business.

The TALF is the Fed and Treasuries “stimulus” program for the financial economy. It’s far more important, in the financial world, than Obama’s stimulus plan for the production economy. The amount of money to be poured into the TALF is enormous (plan is for $2 trillion, I believe) and sure to grow larger with time.

As is evident from even a cursory reading of the TALF, the program, which provides non-recourse loans (i.e. free money) to private funds, will engineer gigantic, essentially risk-free, profits for a handful of politically-connected financial firms, and other financially-related businesses.

Moreover, as the TALF is expanded in due time to nearly every securitization market (it’s limited now to only certain types of assets), additional large profits will be generated by private funds.

At some point this newly created capital will find its way into the stock market, keeping a floor under the market and I believe ultimately leading to a sustained recovery (at least for a short while).

So, I think, with the arrival of the TALF, the time for bearish sentiment is near its end and many beaten down stocks could jump significantly in the months ahead.

As Markets continue to hit new decade lows, many sacred economic theories are now proving to be complete myths. The inability to shelf these mythical economic theories is perpetuating the crisis.

The first myth that needs to be shattered: Lower Interest Rates by the Fed as a response to every financial crisis.

For nearly fifteen years now, or longer, every financial crisis has been met with the same Fed response: low interest rates.

The result: More bubbles, increasing financial instability, and the now ludicrous situation whereby savers no longer have the ability to receive any kind of normal risk-free interest on their capital.

What should be done: Raise interest rates to a more rational level so that savers can generate modest income, risk-free, off of their savings and not have to resort to speculative ventures and ponzi schemes, ala Madoff, to generate passive income.

Of course there is the irrational fear that raising interest rates would further depress the housing market, as if housing was truly the cause of this financial crisis.

However, even considering the largely imaginary negatives associated with higher rates, one needs to look at the flipside of higher interest rates. Higher risk-free rates will vastly increase the passive income of savers, and this money will find itself recycled back into the economy in a myriad of ways, thereby boosting the economy. Increased passive income via higher rates will also prove to be a boon to the psychology of most individuals as they see their investments in savings grow every month, instead of shrink.

So higher interest rates will undoubtedly have a positive effect on the economy and there is ample evidence that countries do just fine, and grow spectacularly, even with abnormally high interest rates, e.g. Brazil.

So why the continued emphasis on low interest rates? Three basic reasons: A mistaken view of the history of the Great Depression, a basic inability of most in power to fight tradition/status quo, and, most importantly politics. Without the interest rate lever (which should be determined by the Market) the Fed has little to do as an institution.