Bailouts, Your Dollars, & the Whole Credit Mess
2008 has been an interesting year.
With the sub-prime crisis, we have seen the extension of credit amongst financial firms come to a halt. We have seen the demise of many financial power houses. We have seen the Treasury infuse massive amounts of capital into the banking system. We have seen uncertainty accompanied by volatility – generating wide swings in market prices and values.
Today we are going to examine how we got here and what really happened with the bailouts. Throughout the presentation, we’ll look at these matters from three viewpoints:
- Consumers – Will we get a break?
- Tax Payers – Will we see a return on the tax dollars Congress is spending?
- Investors – Where can we put our money?
- We have reached some conclusions about what has taken place:
- Wall Street, as we knew it, is gone.
- The Fed and the Treasury are trying to prevent credit problems from infecting Main Street.
- The near-term risk of consumer price inflation is over.
- Mark-to-Market makes it difficult.
- The Fed and the Treasury are investing into the banking system.
Let’s examine each of these statements a bit more carefully.
Wall Street, as we knew it, is gone.
We have all been told by the media that the federal government is bailing out Wall Street. How are they doing in that regard?
At the beginning of this year, there were five public companies that defined Wall Street. Let’s take a look at each of them:
To summarize: When we look at the costs for shelter, fuel, and food, we are within price ranges of where we have been for the last 3-5 years. After having a run up, prices have come back down. So the direct effect on the consumer has been neutralized. What we’re left with is the indirect effect of what is going on in the credit markets.
So what happened? How did we get in this whole mess?
Well, you may be surprised to learn that the U.S. Congress mandated three housing goals for GSEs (Government Sponsored Enterprises), including Fannie Mae and Freddie Mac:
Bearn Stearns peaked at a share price of $172 in January 2007. A little more than a year later, Bear Stearns was acquired by JP Morgan at $2 per share with help from the Federal Reserve. Later, the price resolved to $10 per share.
Figure 2 Lehman Brothers, 2005-2008
Lehman Brothers went bankrupt.
Figure 3 Merrill Lynch, 2005-2008
We bought Merrill Lynch back in 1991 at $5 per share. We starting selling in April 2007 and finished in November 2007 at $55 per share. Merrill Lynch is now at $15 per share; acquisition by Bank of America is pending.
Figure 4 Morgan Stanley, 2005-2008
Morgan Stanley peaked at $70 per share. The share price then went to $10, and the institution voluntarily became a bank.
Figure 5 Goldman Sachs, 2005-2008
Goldman Sachs voluntarily has become a bank. Wall Street, as we knew it, is gone. Yet, the media continues to say that the federal government has been bailing out Wall Street. Well, it certainly hasn’t bailed out shareholders. Why the intervention? Who’s been helped? To learn more, let’s take a look at AIG, the largest insurance company in the world.
Figure 6 AIG, 2005-2008
AIG (American International Group, Inc.) is now below $1 per share.
Did the federal government bail out AIG?
Here’s what the federal government did: It injected capital twice, totaling $150 billion, and is charging AIG 8.5% interest on that amount, even if it doesn’t use the money, and 8.5% plus 3-month LIBOR (London Interbank Offered Rate) on the money it does use. (Currently, this rate is over 11 percent.) And for these privileges, the government owns 80% of the firm. So, if the government “bailed out” AIG, it certainly didn’t bail out AIG shareholders. It made sure that AIG customers were taken care of – that the insurance is still good.
Figure 7 Washington Mutual, 2005-2008
Washington Mutual, which was the largest S&L (savings-and-loan) in the country, plummeted to below $1 per share in late-September 2008. After seizing its assets, the FDIC (Federal Deposit Insurance Corporation) sold Washington Mutual’s $130 billion deposit base to JP Morgan Chase & Company.
Probably the clearest examples are Fannie Mae and Freddie Mac. In the middle of 2007, both entities sold in the $60-range; the share price for each is now below a dollar.
Figure 8 Fannie Mae and Freddie Mac, 2005-2008
As you probably know, one way or another, Fannie and Freddie are involved in underwriting over half the mortgages in this country. These companies also had three sets of securities: bonds, stocks, and preferred stock. Because of their significance, the federal government guaranteed the bonds of Fannie Mae and Freddie Mac – which is why you and I can still get a mortgage. The stock price, however, went below $1 – which means the shareholder did not benefit from the “bail out.” The third class of securities, “preferred’s” were mostly owned by banks. When the government took a position, it did so with “senior preferred” securities, meaning it stepped in front of the existing preferred’s – requiring bank owners to mark down their value.
As a point of local interest, PNC Bank avoided the whole credit mess. This bank did not target sub-prime mortgages, nor did it participate in securitizing (selling) such loans to Wall Street. But, PNC did own some Fannie Mae preferred stock. When the government acquired “senior preferred” securities at Fannie, PNC had to mark down the value of its balance sheet. (As you know, the amount of business a bank or insurance company can do is limited by the amount of equity it has. When assets get marked down, it limits the amount of business that can be done.) So, here’s a bank that did just about everything right, but nevertheless got hurt by the government taking a senior preferred position.
The Fed and the Treasury are trying to prevent credit problems from infecting Main Street.
In each of the examples from Bear Stearns to Fannie and Freddie, we think the federal government stepped in whenever the problems on Wall Street looked like they might become problems for the general public… problems on Main Street.
Notice what the U.S. government has done. It has guaranteed deposits – not just the first $100,000, but up to $250,000 per depositor. It has guaranteed all deposits, including money market funds. It has guaranteed that AIG would stand behind insurance policies. And, it has guaranteed the bonds of Fannie Mae and Freddie Mac. In none of these cases did the federal government bail out shareholders. When it looked like the credit problems on Wall Street would spread to Main Street, the federal government stepped in.
We think what the government has consistently done is to step in to protect American depositors – not investors. We think the government has been attempting to prevent credit problems from going to Main Street; it has not bailed out Wall Street.
The near-term risk of consumer price inflation is over.
Let’s take a look at some of the major household expenses: shelter, fuel, and food.
Figure 9 30-Year Mortgage Rate 2005-2008
If you have 20% down and a decent FICO (credit bureau risk score), you can get a conforming mortgage with a fixed interest rate for thirty years. The interest rate will likely average 6%, which, frankly, we think is fair.
Six months ago, we were all worried about the price of crude oil, the price of gasoline, the price of food stuffs… and we were worried about inflation.
Figure 10 Crude Oil, 2005-2008
Three years ago, the price of crude oil was $45 per barrel; it went up to $145 per barrel in June 2008. Today, the cost is roughly $60 per barrel.
There are 42 gallons of crude in a barrel. So what’s the cost of a gallon of gasoline when the price of crude was at $145 a barrel? $145 divided by 42 gallons is $3.45 per gallon. Add $0.50 for expenses and taxes, and the cost of gasoline is $3.95 per gallon. Do the same math at today’s crude price, and you can see that the cost of gasoline is on its way to $2 per gallon.
Figure 11 Natural Gas, 2005-2008
For most of us, natural gas is used for wintertime heating. The price of natural gas is now below where it was during the last couple of years. Earlier this year, the price had doubled, hitting $13 in July 2008. Presently, the price is closer to $6.50.
Figure 12 Corn and Soybeans, 2005-2008
Prices of corn and soy track together, partly because these crops are grown on the same land. Their prices nearly tripled over the past year.
The last time the price tripled for corn and soybeans was in 1973-74; within eighteen months, half of the price gain was given back. This time around, it took five months and more than half of the price gain was given back.
Figure 13 Wheat and Rice, 2005-2008
For the average family in this country, food is about 14% of the budget. I am told that for the average family in China, food is about 40% of the budget. Well, if 40% of their budget is allocated to food and the price doubles, it does terrible things. The prices for wheat and rice peaked before corn and soybeans. Since the peak, the prices have given most of the gains back. As a result, I am not as worried about the potential impact on the Chinese consumer.
Figure 14 Live Cattle, 2005-2008
The price for live cattle has been basically flat over three years…
Figure 15 Lean Hogs, 2005-2008
… As has the price for lean hogs.
To summarize: When we look at the costs for shelter, fuel, and food, we are within price ranges of where we have been for the last 3-5 years. After having a run up, prices have come back down. So the direct effect on the consumer has been neutralized. What we’re left with is the indirect effect of what is going on in the credit markets.
So what happened? How did we get in this whole mess?
Well, you may be surprised to learn that the U.S. Congress mandated three housing goals for GSEs (Government Sponsored Enterprises), including Fannie Mae and Freddie Mac:
Figure 16 Goals for GSEs
Back in 2004, HUD (U.S. Department of Housing and Urban Development) changed its goals for mortgage finance, defining three levels of borrowers.
Figure 17 HUD’s Goals for 2005-2008
To understand the impact of the new regulations, take a look at the far-right column which shows the Goal Levels in 2001-2004. Prior to revision, 50% of the loans provided by Fannie Mae and Freddie Mac were to be made to people with incomes below the mean in their area. In 2005, that percentage was increased to 52%, and increased incrementally over the years to 56% in 2008.
Think about this. The government wanted 56% of new mortgage loans to go to people with incomes below the mean. It’s important to remember that Fannie and Freddie could not write jumbo mortgages; i.e. mortgages greater than $417,500. For example, Connie and I own a farm and we have a jumbo mortgage, so we would not have qualified. This is significant: Fannie and Freddie could not write mortgages for the top end of the income stream; they were required to write mortgages to the lower end of the scale. The only way more than half the mortgages can be written to people with low- and moderate-incomes is to assume they are just as capable of paying off their mortgage as high-income people, and consider no other risks.
Many have observed it was never mandated that Fannie and Freddie lower their lending requirements / standards. Folks, the only way you can achieve such goals is to lower lending standards. I do accept that the whole mortgage industry, along with Wall Street and pension funds, took this situation to terrible extremes. But the mess started with a mandate from the U.S. government to make more mortgages available to people on the low-end of the income stream. For political reasons, we told Fannie and Freddie to loan more money to people on the low end of the income scale.
Mark-to-Market makes it difficult.
After November 2007, companies, including banks and insurance companies, must “mark-to-market” the value of their assets. This regulation is known as FASB 157 (Financial Accounting Standards Board). What does it mean?
Most of you are familiar with a fixed-rate, thirty-year mortgage. What is the great advantage of a fixed-rate mortgage? Mostly, it is knowing what your payment is going to be next month and next year. It isn’t always the lowest rate – but you know what your mortgage payment is going to be on a consistent basis.
For example, let’s assume you have a house worth $200,000. With 20% as a down payment, you can have a thirty-year, fixed-rate mortgage of $160,000. If the interest rate is 6%, $9,600 of interest is due annually; or $800 every month in interest.
Figure 18 30-Year, Fixed-Rate Mortgage with 6% Interest
Now, let’s change the premise. What happens with an adjustable-rate mortgage? Let’s say the interest rate moves from 6% to 8%:
Figure 19 Adjustable Rate Mortgage – Interest Increase from 6% to 8%
With an adjustable rate mortgage (ARM), the interest payment would go from $800 a month to $1,067; an increase of $267 every month. The extra $267 every month can be a handicap for a lot of people; herein lays the risk with ARMs. This type of repercussion is what many people fear when ARMs are being adjusted…Can people make their new monthly mortgage payment?
But, let’s posit another set of rules – a third type of mortgage. Suppose you had an adjustable-principal mortgage. Let’s suppose that every year the principal amount of your mortgage is up for renewal, and that the maximum you can borrow is 80% of what a similar house in your neighborhood sold for just prior to your anniversary date.
Under this circumstance, what you paid for the house is irrelevant; what you think it is worth is irrelevant; and what the house was valued at last year is irrelevant. Under this circumstance, let’s say a similar house in your neighborhood comes up for sale as part of an estate…and the house you think is worth $200,000 sells at auction for $150,000 just before your anniversary date. 15
Figure 20 Adjustable-Principal Mortgage (APM)
In turn, your bank or S&L would say, “All we can loan you for the next year is 80% of $150,000, or $120,000.” All of a sudden you’ve got to come up with $40,000; (the difference between the original fixed-rate mortgage amount of $160,000 and the adjustable-principal mortgage amount of $120,000). What would this do to your planning and budgeting? Is there anyone here who would purposely get an adjustable-principal mortgage – knowing that next year the 80% you have in principal might be $40,000 less? You would have to create a cushion to stay afloat! Doesn’t that change the game a bit?
Folks, this is called “mark-to-market.” The values of assets held by a bank or insurance company must be “marked” to similar values of assets which have been selling in the recent past. In the last year, such are the rules that every bank and insurance company in the country has had to live with.
As noted, mark-to-market accounting, or FASB 157, came into effect in November 2007. Historically, there have been other ways to value assets. For example, with banks and insurance companies, a lot of the assets are mortgages and bonds. Not all mortgages and bonds always pay off, so institutions set aside reserves for allowances. If no payment is missed during a contract period, assets can be carried on an amortized (par) value based on the original terms and time period. A third way of evaluating assets is appraised value. But, as of last year, financial institutions cannot use amortized or appraised value to value some of the assets – they must use mark-to-market.
I am not going to argue about which of the methods makes more sense. My point is when you shift from one accounting method to another – when you shift from amortized value to mark-to-market – it does funny things to the balance sheets of institutions. As you know, the amount of business a bank or insurance company can do is limited by the amount of equity it has. When assets get marked down, it limits the amount of business that can be done. With mark-to-market accounting, financial institutions must create a cushion to stay afloat. That’s why banks are sitting on money.
The Fed and the Treasury are investing into the banking system.
What’s been happening lately is that the government has been putting money into the banking system and Congress is getting annoyed that banks are not lending it as fast as they would like. Let’s ponder this sentiment a bit more thoughtfully.
The fact that the U.S. Treasury puts $125 billion into nine bank holding companies doesn’t necessarily mean that enough good borrowers will show up the next day to borrow that $125 billion – much less eight or ten times this amount, which is the leverage banks work on.
Secondly, the reason banks aren’t lending to each other is because they have no idea what their assets will be valued at yearend. Consequently, they have no idea what the corresponding banks assets will be valued at yearend, so they need a cushion. This is why banks have been sitting on money – it’s the same thing you and I would do, if faced with an adjustable-principal mortgage.
Here’s an example:
Figure 21 Moody’s Corporate Bonds BAA, 2005-2008
When the yield on 30-year, investment grade BAA bonds goes from 7% to 9.5%, it means the price drops by over 25%.
Let’s explore one more example. How many of you have collision insurance on your car?
With collision insurance, if you wreck your car, the insurance company will pay to cover the expense of fixing or replacing the vehicle. How many of you expect, during your lifetime, to receive more in benefits from the policy than you are paying in premiums? Well, if you study property casualty companies as I have, (and I used to work for one), you’ll find, on average, what insurance companies pay out in claims is less than half of what they take in, in premiums. By implication, during your lifetime, you will pay twice as much for collision insurance as you ever collect. Does that surprise anybody? So why do you do it?
I think the reason people have collision insurance is, if they wreck a car this year, they want to spread payments (for replacement or fixing) over the next five or ten years. They want to spread the loss over a period of time. From an insurance company point of view, when writing an insurance policy, it is spreading risk over time and a population.
The reason an insurance company could do this is because the mortgages and the bonds they held were valued at amortized cost, or priced at par; the price didn’t jump up and down all the time. As long as the interest payments on the bonds and mortgages are being made, the insurance company could value the assets at purchase price (or close to it), or at amortized value – all of which are predictable. If the accounting rules change to mark-to-market, all of a sudden, values are no longer predictable. So, if insurance companies are now having to mark-to-market, you and I can expect our premiums to go up because they will need a cushion within the premium schedule to cover that volatility.
Let’s examine this further:
Figure 22 Brittle Bounce
Published by Markit, Figure 22 shows a benchmark credit-derivative index based on tranches of sub-prime mortgages. As you know, various sub-prime mortgages were lumped together, sliced into tranches, and sold to the public. In this case, the credit quality was rated as AA; the loans were originally packaged during the first half of 2006. In 2007, the index price began to drop. By July 2008, the value dropped to $0.57 on the dollar.
Now, let’s turn our attention to a “Triple A” (AAA) rated credit.
Figure 23 Markit AAA Credit
When Henry Paulson, Secretary of the Treasury, stated that $700 billion was going to buy distressed assets, most of us thought AAA distressed assets were among the ones he was talking about. Sure enough, just after launching TARP (Troubled Assets Relief Program) on October 3, 2008, the index price on AAA credit issued during the second half of 2007 went from $0.42 on the dollar to $0.52. Last week, however, Secretary Paulson changed direction and started putting the money directly into banks. As I speak, the chart is two weeks old; the index value is now at $0.36 on the dollar.
What happened?
Folks, have you ever gone to an auction? On an item worth $100, the auctioneer may start with asking for a bid of $100, and have to work his way down to $20 before somebody makes a bid. Remember, what opens at $20, may well sell at $85 or $90. (A good auctioneer typically has a reliable sense of fair value.) What Paulson had said, was the U.S. Treasury was going to make some opening bids and, on that basis, a few other people made some opening bids. A couple of weeks later, however, Paulson abandoned the auction by redirecting the money. The opening bids dried up and the index price is now $0.36 on the dollar.
Let’s take a look at a “Double A” (AA) rated credit:
Figure 24 Markit AA Credit
As with AAA credit, the index price came up a bit after the initial announcement from the Treasury, and then retreated with the re-direction of the money. These AA assets started at $1.00 are now priced below $0.11 on the dollar.
CreditFigure 25 Markit A Credit
“Single A” credit is now trading at $0.06 on the dollar.
Folks, this is the impact of mark-to-market where you must price to the latest lowball bid.
Let’s say someone in the audience is asking $300,000 for their house. What happens when I offer $150,000? Let’s say, today, I will write a check for $150,000; [laughter from audience]. Folks, I have been using this example for the better part of the year, and I have yet for anybody to sell me their house when I make them a bid for half of what they are asking. It’s because they know – and I know – I am giving them a lowball bid.
Right now, however, there is any number of stocks selling for half of what they did a year ago, and people think those are fair bids. Why is it when somebody makes a lowball bid on a house we say, “Gee, that’s a lowball bid; I know it is worth more than that.” But when GE (General Electric) sells for $18 a share, down from $35 or $40, people say, “My goodness, the price has gone from $40 to $18. It must be going to $10!” Maybe it is just a lowball bid. Maybe somebody has to sell.
What we do know is a lot of hedge funds have been told by their lenders that they must go from ten-to-one, or even twenty- or thirty-to-one leverage, to perhaps half of that. What we do know is a lot of funds are getting redemptions. We have been getting redemptions. It has an effect on what we do. If you get redemptions as a money manager, you have to sell something. If you can’t sell what you want, you have to sell what you can. Forced selling compounds the effects of mark-to-market, generating a downward spiral. And nobody wants to step up to make an opening bid.
Think back to what happens at an auction. If you’re in my business and you see this going on, are you going to make an opening bid? Or, are you going to wait a week…and, then, another week? There have been people who have had to sell – no one has had to buy. As a result, we are seeing the best values we have seen in a lifetime, because no one has had to step up to buy, and no one has an incentive to make an opening bid.
Let’s take a look at another kind of lending, commercial paper.
Figure 26 Commercial Paper Outstanding, 2001-2008
Commercial paper is simply lending directly from one company to another without going through a bank. The media is suggesting that commercial paper is drying up. The Federal Reserve Bank of Minnesota, however, has a working paper, Facts and Myths about the Financial Crisis of 2008, (#666), suggesting the opposite. It presents findings that the commercial segments of our economy (the non-financial) are holding up.
Did you notice after 1989 and 1990, when a third of all S&Ls went bankrupt, that the surviving S&Ls didn’t pick up the business – it went to mortgage brokers? Did you notice that in ’89 and ’90, when a number of banks went out of business, the remaining banks did not pick up the business? A certain amount went to Merrill Lynch which made checking accounts available to their customers.
When I worked for an insurance company on a daily basis, we would get numbers on what our cash balance was and we would buy commercial paper from GMAC, Ford Motor Credit, Caterpillar Tractor, etc. We would lend money directly to these firms without going through the banking system. This is what is going on today. Remember: If you are Caterpillar and you have quantities of inventory, it is not subject to mark-to-market. But, if you have bonds or mortgages (either for your distribution system or somebody else’s), they do get marked-to-market. So while commercial enterprises aren’t subject to the mark-to-market accounting rule, financial institutions are trying to build a cushion this year for the mark-to-market values. So the decline in commercial paper outstanding is amongst financial firms. Non-financial commercial paper has been stable.
Figure 27 Deposits, 2001-2008
Since 2001, deposits have kept climbing. In fact, lately, they are kicking up. Perhaps, this is because people are cashing in mutual funds and depositing money in the bank.
It appears from Figure 28 that three-month LIBOR (London Interbank Offered Rate) and three-month T-Bills track together up until late this year, when T-Bill rates went down and LIBOR ran up.
In the U.S, when people get fearful, it seems they are willing to take an almost zero return for the comfort of Treasuries. This is not the case with LIBOR. A number of European countries appear to be backing away from mark-to-market; nevertheless, there is a seize-up in the financial system and they are trying to deal with it.
Let’s take a look at what is going on with the S&P 500 Index:
Figure 29 S&P 500 Index, 2005-2008
If you are an investor in a hedge fund and want to pull money out at the end of this year, you may have been required to let the fund managers know at the end of September. Notice that in the first two weeks of October 2008, the market dropped about 20%. I think the drop can be attributed to hedge funds receiving redemption notices and needing to sell. Almost all markets dropped then; it didn’t matter where you had invested. Foreign, domestic, stocks, bonds…all securities were affected. A second round of redemption notices was due by November 15; so far, it’s been a non-event. We should know between now and year end whether, in fact, all redemptions have been passed through – but we think prices dropped like a rock due to forced selling back in October.
Additionally, hedge funds, along with banks and Wall Street firms, have comprised what some have called a “shadow banking” system. As you know, the Federal Reserve can create money simply by printing it. The money created by the Fed can be further leveraged by banks by lending 8-10 times what they have on deposit. The “shadow banking” system created still more money.
Here’s how:
Instead of a thirty-year mortgage which is held at a bank or S&L, the mortgage gets pooled with other mortgages and subsequently sold (securitized) to another institution. The originating bank gets its money back and, on the same dollar base, can now write another mortgage. This action doubles the velocity of the money – that is, the money turns over much faster in the economy. When coupled with the amount of leverage hedge funds were willing to absorb (often twenty- or thirty-to-one), the velocity of money increased still more.
Consider the case of Carlyle Capital Corp., which I discussed in Memorandum #86. This was a fund which functioned as both a borrower and a lender. It lent money into the mortgage market by buying mortgage-backed securities, and borrowed money from other sources to fund their purchases. (This model only works if the returns from lending exceed the cost of borrowing by more than the expenses of running the business.) What happened was, as spreads narrowed, Carlyle should have backed away from the business. Instead, they increased their borrowing until it exceeded 30 times the equity in the business. In this scenario, if prices drop by 3%, their equity is wiped out, and they’re out of business. And the result…Carlyle went bankrupt — defaulting on $17 billion worth of debt and ceding the collateral to their lenders. The lenders, in turn, sold this collateral in the open market, resulting in the decline in the market value of existing mortgages. Folks, this example is fairly typical of what happened to a lot of firms.
When the Fed starting squeezing interest rates in 2005-06, the shadow banking community continued creating, or leveraging, money at a much faster rate. The velocity of money kept growing until July 2007 and, then, fell off a cliff. Velocity collapsed. Since then, all the hedge funds are getting the word, “you’ve got to deleverage.” Much of the junk in mortgages has gone by the way, and a lot of pension funds – which were begging for these products – well, they quit begging. So the leverage (money) created by the “shadow banking” system has collapsed.
In response, the U.S. government is now investing $125 billion in nine of the largest banks across the country, including Citigroup, Wells Fargo, Bank of America, Morgan Stanley, Goldman Sachs, JP Morgan Chase, State Street, and Bank of New York Mellon. Merrill Lynch will also receive an investment. (I say “government” because both Henry Paulson and Ben Bernanke, the respective heads of the Treasury and Federal Reserve, are acting together.) Several of the banks responded, “We don’t need it; we don’t want it.” Nevertheless, it was not a choice. The nine largest financial institutions in this country were forced to accept the capital. But why are the Treasury and Fed insisting? It is because the velocity of money has collapsed. Irving Fisher, an American economist, developed the equation:
Let M = money; V = the velocity of circulation of money;
P = price; Q = quantity of real output (goods).
This equation says the “change in money x (times) velocity = change in price x (times) quantity.”
Historically, if money grows faster than the quantity of goods, the price of goods goes up to reflect the change. That’s called inflation. The assumption has always been that velocity is stable – mostly, because it’s difficult to predict. In fact, for most of the past thirty to forty years, velocity has been relatively stable. But during 2004-07, it grew rapidly and, in the last year, it has collapsed.
So, all of the money that the Treasury and Fed are putting into the banking system is to offset the collapse in velocity. Our government is trying to prevent the credit problems which originated on Wall Street from infecting Main Street! This is why it is investing money directly into the banking system. The government is buying preferred stock in good companies. So, as a tax payer, we may see a decent return on these investments over time.
The trouble is, we have an idea how much money is in hedge funds, but we don’t really know. We have an idea how much money there is in private equity, but we don’t really know. The government is trying to correct all of this in a year, but with forced selling and mark-to-market accounting, there has been a downward spiral.
Did you notice, however, when Paulson first said he wanted $700 billion for buying distressed debt that Warren Buffet said he’d like to buy $7 billion of the deal? I find it fascinating that while the public is engaged in panicked selling, Paulson and Buffet want to buy. In my terms, they want to make an opening bid at the auction. So far, however, we have seen forced sellers; there are no forced buyers. Mostly this is due to the combination of the shifting rules and mark-to-market accounting, which we’ve seen has been driving prices lower.
Summary
We are seeing the best values in stocks in years. We are now seeing some very good companies selling for dirt cheap prices. You have heard me say that we try to buy Pontiacs and Buicks when they go on sale. Today, the Cadillac’s are on sale. The Cadillac’s are on sale below Chevy prices. This means that over the long term, we should make good money. But, I just don’t know when it starts – and I can’t tell you whether stock prices will be cheaper next month.
The comments made by Ron Muhlenkamp in this essay are his opinion and are not intended to be investment advice or a forecast of future events.