Are They Liars or Just Stupid?

Last fall, Sec Paulson ran into the capital building with three pages of scribble claiming that Armageddon was upon us if Congress didn’t permit a $700B bailout by the weekend. I know that most of Congress doesn’t read their own legislation (they’re either lazy or can’t read, I’m not sure which), but three pages doesn’t seem like a lengthy consumption. So who’s more at fault, Paulson for playing Chicken Little or Congress for believing it?

OK, switch gears… A lender has the prerogative to set whatever terms they want. How many terms could possibly be crammed into three pages? Given that it probably took an entire paragraph to spell out seven hundred billion zero million zero thousand and no cents, I’m guessing there weren’t requirements to receive TARP funds (certainly not a credit check by the looks of things). So now we have Barney Frank, among others, crying that AIG has carried on with business as usual. WHAT DID THEY EXPECT?!

Let us not forget that AIG made over $21B in profits for 2006. Whatever employment deals and bonuses AIG has with their employees obviously works under usual circumstances. OK, fine, we aren’t in usual circumstances, but if the lender isn’t going to specify restrictions what is a company to do but consider paying 0.1% of revenue in bonuses? Reality check… $170M is 1/1000th of AIG’s revenue. Don’t get me wrong, $170M is a large some of cash, and it certainly was poor judgment not to curtail bonuses under such circumstances. But what business does Congress have complaining about AIG operating procedures if they didn’t specify their expectations with the loan? I’m pretty sure AMEX isn’t going to call me if I buy a gold plated hammer for $5,000 whether I can afford it or not as long as I have room on my credit card.

I’m really getting tired of the whining from Congress when they are the ones how lent the money in the first place. If they don’t do their due diligence then shame on them. Of course, that really ends up being shame on us for voting these jokers into office. Keep in mind that Barney Frank is the same guy that needled lenders into loosening credit standards because “everyone deserves” home ownership regardless of their ability to pay the mortgage. Then Paulson and Bush needled FASB into mark to market rules that totally fabricated trillions in write-downs on performing assets. Finally, Pres Obama figures that if the federal checkbook has any checks left there must be cash to cover it. Our US Treasury has borrowed over $3 Trillion so far this year, more than the last 10 years combined.

And our government is now complaining that our biggest lender is wondering if we have our financial house in order. Who can blame China’s Wen for his remarks? For years we’ve been complaining about China’s spending habits and our glass house is looking awfully fragile to be throwing stones. Meanwhile Bernanke is on 60 minutes and Obama is on the Tonight Show. STOP THE WORLD, I WANT OFF!

The recession is a drag but cycles do happen. While we all hold some blame for the original cycle, our government has turned a burning ember into a four alarm fire. And all the fire trucks have pulled up with tanks full of ethanol.

I can’t even start on state financial complaints because I can’t believe what my home state of California is doing. When it sinks in, I’ll comment. I just keep thinking I’m going to wake up from this nightmare.

In the meantime, I’ll keep buying fundamentally sound stock issues that demonstrate good value. I still like Dow Chemical even though the stock is up almost 20% in the last week. Avoid bank deposits if you can. The rates are dismal. For safe cash returns try buying VFIIX to get some federally backed Ginnie Mae’s (GNMA). Brace yourself though, while the markets jumped a bit last week there’s still some dark clouds on the horizon. I’m not a depression doomsayer but we are technically still in a bear market.

Have a nice day…

The Sage Says We Fell Off A Cliff

Well, I certainly made a costly mistake and didn’t see the spring meltdown coming. I was certain that “healthy” financial firms wouldn’t see their stock prices fall to a small percentage of their net worth. Of course, I also didn’t see $3.3 Trillion in borrowing from the US government in my lifetime. Needless to say, the markets are not impressed with the direction of new President is taking us. And while he discounts the markets as simply pole taking, the real world US citizen is watching their savings shrivel.

Mr. Buffett says the US economy fell off a cliff but better times are to come. I’m actually a little more optimistic, go figure. I’m very disturbed by the governmental borrowing and wasteful spending. Unfortunately, I see an inflation hit in the coming years because of this, so prepare your finances for inflation risks. On the silver lining, however, I see a valuation opportunity that seems to be only mildly mentioned on various financial sites.

Let’s take one of my favorite large banks, Wells Fargo, for example. This company is currently trading at half of the balances sheet net worth. In other words, if I had $45 Billion lying around, I could buy Wells Fargo, sell all the assets, settle all the debts, and have $90 Billion left over. Such a move would be a handsome 100% profit for my trouble. There are two gotchas in this scenario. First, balance sheets rarely show the whole picture. Historically, however, the picture is not always bleak. Corporations are not allowed to determine income based on cash flow. If a company purchases a desk for an office it can’t write off the purchase amount against incomes. It is only allowed to write off approximately 20% of the purchase price each year. Interestingly, the desk will probably stay in service far beyond five years, so year six will show a balance sheet entry of zero for the desk when the desk still has some value remaining. In this example, the balance sheet is undervalued. However, sometimes companies don’t write off assets at all and carry them on the balance sheet for an amount that is actually higher than the asset could ever fetch from a fire sale situation. For example, Circuit City never achieved anything close to parity when it liquidated its inventory. Thus, we have an example of an overvalued balance sheet. When you take the good with the bad, you have to assume that balance sheets are at least somewhat “balanced”. (especially since the CEO and Board are now on the hook for lawsuits if they cook the books)

But there is still a missing element here. President Bush (W), enacted a lame provision with the best of intentions. (famous last words) FASB, the governing body for accounting rules, was instructed to create a mark to market provision. I’ve talked about this provision before, but the short version is this. If Countrywide has an average of 40% losses on their loans because they made bad loans they are required to write down their balance sheet to the amount they could actually sell the loans for, say 50%. If Wells Fargo had not made any bad loans and had a average loss of 1% on their loans, the new rules require that they, too, write down their loans to what Countrywide could get. In other words, Wells Fargo has to assume that their loans are as toxic as those of Countrywide even if the loans Wells Fargo holds are being serviced regularly. Wells Fargo recently wrote off $4 Billion and is considering another $28 Billion. But they aren’t selling the loans!!! In other words, this bank prefers to hang on to the loans and service them which means they earn approximately 4% after servicing costs on the loans. The write offs would only be realized if one of two things happened. First, Wells Fargo sells the loans. (good luck) Second, Wells Fargo experiences a huge increase in loan defaults. Now when I say huge, I don’t mean relative to past default levels. Unlike the press, I don’t consider a jump from 2% to 3% a huge increase. It is large relative to the figure but not relative to the lender’s portfolio. Nobody, short of the “bomb shelter wackos”, is suggesting that broad portfolios such as Wells Fargo is going to experience losses on their loans of anything over 3%. So their losses aren’t real!!! In contrast, when they earn interest on their loans, the interest income is cash in hand and very real. Real income, paper loss = stock hammered and opportunity.

This analogy doesn’t apply to all institutions. Some banks have stricter debt requirements. For example, one of my old favorites (may my portfolio rest in pieces) is MCG Capital. They, however, cannot allow their assets to drop to less than 200% of their debt. Because FASB requires the write down of their assets regardless of servicing record, the adjustment has a negative effect on their ability to maintain their own debt. In this example, they can be forced to sell off assets at a highly reduced rate which further pressures their capital position, which increases the supply of companies selling assets, which further pressures the asset price, which further reduces their capital position, etc, etc.

The cycle is spasmodic and can only be stopped by letting the FASB rules return to their previous reasonable state. Oh yeah, the government could simply buy all the banks at fire sale prices and then unwind the fabric of the US economy while increasing the size of government forever. Did I mention I was optimistic?