by Ron Muhlenkamp   

I’m writing this letter just after the U.S. Senate and House passed the “bailout” bill. The media and the politicians have labeled the Treasury’s Troubled Assets Relief Program (TARP II) as a bailout of Wall Street. But, in reality, it’s a support for the banking system and is designed to keep the problems in the credit markets from overflowing into Main Street. In the past few weeks, this overflow had begun, making it difficult for some firms to get normal funding from their banks. For this reason, I believe the bill was necessary. 

In this short letter, I don’t have the time to describe all the drivers that got us to this place. We will do that at our seminar on November 18, 2008. But I do want to mention a couple of the main drivers which reinforced each other and drove us to where we are now.

In 2005, the Financial Accounting Standards Board (FASB) issued FASB #157 which states that banks, insurance companies, and brokers must mark the value of the assets to market prices in their quarterly and annual reports. Regulations for each of these industries limit the amount of business they can do and the liabilities they can carry is a multiple of the assets and/or equity. Thus, FASB #157 allowed firms to expand their business as the market prices of their assets moved up, and forced them to contract their business as market prices moved down. This has become self-feeding.

Had we a similar accounting rule in effect in 1989, nearly every S&L and bank in the country would have been bankrupt.  Most of you know that, in the 2005-2007 period, banks and mortgage brokers made mortgages and, therefore, home ownership available to people who could not have afforded a home by prior standards. (You may know that Congress mandated that mortgages be made available to low income people.) As some of these mortgages failed, the market value of the remaining mortgages fell. Any that were owned by financial firms, (banks, insurance companies, or stockbrokers), had to be “marked to market,” forcing the firms to raise capital or sell assets. Most had to sell assets — into a vacuum of no buyers. This caused further mark-down and the spiral began.  Some managed to raise capital. Merrill Lynch got $12 billion from Korea, Kuwait, and private investors. Citigroup got $12 billion from Abu Dhabi; Washington Mutual got $7 billion from a hedge fund, TPG, Inc. Within eight months, each of these investors lost over 30% of their purchase price, discouraging other potential investors.

The Treasury’s Troubled Assets Relief Program (TARP II) just passed by Congress directs the Treasury to buy mortgages from their current holders. This should halt the downward spiral in prices. Anyone who frequents auctions where the seller is forced to sell knows that they can be a great spot to pick up bargains. We think it is quite likely that buying at today’s prices and holding for 3-5 years will make the buyers, including the U.S. Treasury, a lot of money.

Note that the current problem began in the sub-prime mortgage market, then, migrated to other markets.  The people who held and hold sub-prime mortgages had to sell something. As the spiral continued, they had to sell more. This decline spread from mortgages to corporate banks to stocks, both domestic and foreign. As the value of assets got marked down, banks and companies became fearful of lending to each other.  They are fearful because they don’t trust the value of each other’s assets, largely because they don’t know what the market price of their own assets will be tomorrow.  At present, the credit markets are locked up. The TARP II bill is designed to unlock the markets.

We’ve been saying for some time that we see good / great companies selling at cheap prices, only to see the prices get cheaper. If / as we see signs that TARP II is working, we will be putting our cash to work in some of these companies.

The comments made by Ron Muhlenkamp in this article are his opinion and are not intended to be investment advice or a forecast of future events. Copies of past newsletters are available at www.muhlenkamp.com.

As of 9/30/08, the fund did not hold any of the securities mentioned.

Fund holdings and sector allocations are subject to change at any time and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.

The comments made by Ron Muhlenkamp in this article are his opinion and are not intended to be investment advice or a forecast of future events. Copies of past newsletters are available on our web site at www.muhlenkamp.com.