Tuesday, December 9, 2008

Unintended Consequences

I have woefully neglected this blog. I want to get things going again with some quotes from interviews today on Bloomberg Radio and a story on Market Watch.

Mohamed El Arian, co-head of Pimco
What surprises you?
“The extent to which liquidations are still ongoing and more generally the deleveraging."
What do you want to buy in this environment?
“The sectors we envisage as under the umbrella of government action. You're looking at the mortgage market and the debt securities issued by the large banks. Those in our view offer the best risk adjusted returns."
Michael Darda, Chief Economist at MKM Partners
"This economy is (growing) far below potential.. That's probably going to be the case through the entirety of 2009."
“We looking at the fall of next year as the earliest the economy will bottom.”
Just for good measure, Darda added the unemployment may peak at a level "substantially higher" than his official forecast of 8.2%. He doesn't expect employment to show signs of improvement until 2010.

Roel Campos, Former SEC Commissioner & Obama Advisor

"We're looking for disclosure of positions, with a small delay, after a short sale is made."
Campos is seeking to have the next SEC chairman introduce new rules requiring short sellers to publicly disclose their positions in a manner that is similar to how equity investors are required to reveal their equity stakes.
(This according to MarketWatch.)

What it Means

These quotes illustrate points I have made earlier, but they are worth repeating.

First, as El-Arian says, the liquidation of fixed income assets remains a major problem. My contention has been that the entire credit market has entered an outright bear market. After years of complacency, it's swung in the opposite direction to utter paranoia and fear. People are more willing to earn 0% or slightly less in "risk-free" Treasury securities than investment-grade corporate bonds or mortgage-backed securities that are trading at such cheap levels that they're worth the risk.

My worst fear, as expressed in this blog entry, is that the overall credit market would enter a state of liquidation when everything gets sold. You might say "so, what, I don't own bonds ... I only own stocks." But stocks are equity securities that represent the "residual value" of a company. Once the creditors are paid back, shareholders get everything that's left.

That's great when asset prices are rising and credit is easy. Now that we're in a period of credit contraction, it will be increasingly difficult for companies and consumers to roll over debt. And, unlike stocks, debts come due. Companies have to pay back specific amounts of money at a certain point in time. If they can't borrow it again, they get liquidated or are forced to sell new shares. Both options are terrible for stock investors.

El-Arian's second comment is equally distressing. He says the best place to invest now is in areas guaranteed by the government. It should send a chill through anyone who believes in free-market capitalism that one of the great investors of our time doesn't want to buy any asset classes many people now claim are "cheap," such as mortgage-backed securities or investment-grade corporate bonds.

Both of these comments substantiate observations I have been making over the previous few months. Basically, we are in critical danger of the credit market bifurcating into a class of "touchable" and "untouchable" assets. Investors will gravitate solely to debt sponsored by the government and shun everything else. That will eviscerate seemingly healthy companies that need to refinance maturing debt, forcing them to sell assets, raise capital or seek bankruptcy protection in the midst of an already terrible environment.

This is a problem I raised personally with El-Erian colleague Paul McCulley as soon as the government said it would use the FDIC to insure financial-sector debt in October. At the time, McCulley agreed with my concern. El-Erian validated it today: “Every time the government intervenes in a certain sector, another sector gets destabilized because it hasn’t been included," he told Bloomberg.

In other words, we're looking at an environment where the only the government -- or its favored clients -- can borrow money. (Since the FDIC backstop has been put in place, lenders such as Citi, Bank of America and even KeyBank have utilized the it to issue tens of billions of dollars in debt. One might add it's terribly unfair that the companies that made the biggest mistakes now enjoy government guarantees, while those that "did nothing wrong" are forced into bankruptcy.)

Darda advances this point by saying the economy will expand below its potential growth rate. In other words, the private sector will contract, forcing the government to step in and employ people, factories and offices. (Factories and offices, after all, need to eat, too. Just like people, they have debts to pay.)

My concern is that as the private sector goes into cardiac arrest, people will increasingly look to the government as the ultimate consumer in the economy.

To sum it up, we're facing a situation where the government is the only party that can borrow. That means pretty soon, it will be the only party that can spend and hire. In other words, it will be an economy by the government, of the government and for the government. It won't take long before resources are misallocated and politics, rather than economic considerations, drive the decision-making process.

The Accidental Statist

If Americans wanted socialism, they would have elected Ralph Nader president. One of the great ironies of the current situation is that so-called conservatives in the Bush Administration and Bernanke Fed are clumsily nationalizing the entire financial system.

Where does this leave us going forward? The comments by Campos about disclosing short positions might seem innocuous enough. He wants to disclose short-selling positions. What's wrong with that?

1-It will be viewed as an attack on short sellers.

2-It won't accomplish anything except scaring people away from the market. There are many problems with the U.S. financial system, but short selling isn't one of them. A much better use his time might be to address how the SEC allowed such large amounts of financial instruments to be churned out like sausages over the last decade. First it was tech stocks, then it was off-label mortgage-backed securities and collateralized debt obligations.

3-It's a wholly political move. Short-sellers didn't cause the banks to fail, or make people default on their mortgages. Banks and regulators are responsible for that mess. Short-sellers were right about the industry's problems, and they shouldn't be punished for their perspicacity.

4-How will it work? Many traders sell a stock short and cover their position the same day. How do you account for them? What happens if they use other ways to bet against stocks, such as buying inverse ETFs that move in the opposite direction as share prices?

This kind of disclosure would do little more than drive more trading outside of the USA and undermine our financial system. Shooting the messenger is never a good idea. If short sellers are right or wrong, the market will reward or punish them. The SEC has dropped the ball for a long time in this country. There are many more productive places they can spend their time.

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