Health Care Reform Stalling

President Obama’s vision may still be carried out – but only in part.... and maybe not at all.

The nearly 100 year saga to provide health care to all Americans, free of charge, seems likely to make some progress, but far less than many expect. The Administration’s goal of expanding government sponsored health care to the 30-50 million uninsured seems likely to result in another round of limited modification of the current private system. This suggests that health care stocks, on average, are likely undervalued.

Compromises, compromises
The most controversial aspects (and where the substance lies) of the bill seem likely to be watered down. Part of that has to do with cost; part of it has to do with appeasing the private sector. The Senate and House must reconcile different versions of the bill. In the House version, 95% of Americans would be eligible for health coverage; in the Senate version, 97% of Americans would qualify.

A government-run option now seems off the table
The most challenging task for the bill’s proponents has been explaining how anyone could compete with a truly functioning public health option. Private insurers have portrayed themselves as in a struggle for their lives and this legislation as tantamount to completely socializing the health care sector.
Most polls recent and historic strongly suggest that Americans prefer private insurance and generally like their current health plan - which suggests that public support for a public option will be lukewarm - as most Americans would prefer not to need it. (Must be something about their experience with other government services...) Consequently, an increasing number of Democrats have started to break ranks.
Last week, Senate Finance Committee members Sen. Max Baucus (D-MT) and Sen. Chuck Grassley (R-IA), worked in late June to whittle down the House’s $1.6 trillion version of the bill to less than $1 trillion. Baucus, who is Chair of the Committee and Sen. Kent Conrad (D-ND), another Committee member, have let it be known for several days that talk was shifting away from that concept of a "public alternative" in the Senate and toward ‘nonprofit cooperatives’. This is likely a consequence of poll numbers that show weak public support rapidly deteriorating as the $1.6 trillion+ price tag became increasingly discussed (and criticized) in the media.
However, the House version of the bill still includes the government-run plan component – which is not a good sign for proponents – as this means negotiations will need to be complicated and contentious with the Senate. This will allow for attention to pass on the issue. The parallels between current events and the Clinton Administration's 1993 efforts are uncanny. Death by debate and a transition to greater fiscal discipline seem in the cards here.

And so does a mandatory employer offering…
As originally conceived, most major backers saw the private sector as bearing the majority of the burden in any major reform. Sen. Clinton’s (D-NY) presidential campaign plan largely proposed that businesses would pay federal fines in the future if they refused to provide health coverage to workers.
Increasingly concerned about poll numbers expressing greater concerns about economic issues, and in the face of a resurgent lobbying effort by industry, congressional Democrats are concerned about seeming anti-business. What employer expectations remain seem to be rapidly deteriorating. According to Sen. Conrad, the Senate version of the bill would now ask businesses to shoulder a portion of the cost of Medicaid coverage received by their workers, or 100% of the Medicaid tab for certain workers poor enough to qualify for a tax credit that could help them buy health insurance.
If the bill passes, the amount of employer-provided health benefits exempt from income taxation might be limited. Sen. Max Baucus (D-MT), current chair of the Senate Finance Committee, has suggested a $15,000-$17,000 ceiling on that tax exclusion, which would likely have a minimal impact on employers at present (at least outside of the executive suite.)

Reforms to Medicare are also losing steam from unlikely bedfellows…
Ironically, the Administration has helped ally two old enemies – health care companies and physicians. President Obama’s June 15th speech to the American Medical Association in Chicago, while at times incurring thunderous applause, seems to have had little effect in generating new support from doctors.
Ultimately, physicians understand that greater government involvement in health care will eventually result in loss of prerogatives and income and this places them firmly (and permanently in the camp of the private sector.) The AMA’s resistance is a product of reformers’ efforts to require that doctors participating in Medicare also be required to participate in the new government plan.
The Administration has, as part of it's package, set goals of ending ‘overpayment’ to Medicare Advantage, which it has claimed would save the government $177 billion over the next ten years. In that same time frame, it also wants to use Medicare reimbursements to reduce preventable hospital re-admissions – for a projected $25 billion in additional savings. The reforms would also give Medicaid members a bigger prescription drug discount, while reducing that discount for high-income Medicare members. But all of these changes will ultimately result in less flexibility in Medicare benefits, particularly for upper middle class Americans who access them most frequently. This erodes some of the grass roots, fundraising support of the Democrats and encourages apathy in the ranks.
The popularity of Medicare Advantage, and the AMA’s hostility to linking the plan with Medicare (while officially providing statements suggesting endorsement) are helping to derail any meaningful proposals on this front as well. And while drug companies like the increased benefit – managed care organizations are resentful of efforts to destroy Advantage.
In testimony before the House energy and commerce panel, Blue Cross and Blue Shield Association senior VP Alissa Fox contended that any cuts in Medicare funding “would cause millions of Medicare Advantage enrollees to lose their coverage and lead to significant reductions in benefits or increases in premiums for millions more.” In addition, Blue Cross, Blue Shield and the industry-sponsored America’s Health Plan recently presented a letter to the ailing Sen. Ted Kennedy (D-MA), referencing a study that found the average family of four pays $1,700 a year more than they should in health insurance premiums due to Medicare and Medicaid underpaying hospitals and physicians.

The problem is taxes…
Obviously, tax increases would fund the majority of reforms. More specifically, the President has talked about cutting back the value of the itemized deductions available to the wealthiest American taxpayers. But recent revolts (tea parties and the voters in California’s response to budget propositions seen as “tax increases”) have got many congressional Democrats scared and looking for alternatives – causing a breaking of ranks and division between the two houses. House Ways and Means subcommittee chair Rep. Richard Neal (D-MA) said other ideas a payroll tax and a value-added tax. The Senate seems to prefer the idea of taxing employee health benefits.

Something coming, but likely very watered down
This chapter in the saga of health care reform is hardly over, but we’re already seeing signs of capitulation by the President. “We are still early in this process," he noted Thursday. “We have not drawn lines in the sand.”
Expect those sands to shift further. Much further.

Roth IRA Conversions: Coming in 2010!

Next year, anyone may convert a traditional IRA to a Roth IRA. No income limits will stand in the way of the conversion.

Why it might be a good idea
A Roth IRA permits tax-free growth and tax-free income distributions in retirement (assuming you are age 59½ or older and have held your Roth account for 5 years or longer). You can contribute to a Roth IRA after age 70½, without having to take mandatory withdrawals. While contributions to a Roth IRA aren’t tax-deductible, the younger you are, the more attractive a Roth IRA may seem.
However, older investors have reason to go Roth as well – especially if they don’t really need to withdraw IRA assets or would plan to reallocate their IRA holdings towards fixed income investments and other tax inefficient tools (e.g. Mortgage Backed Bonds, High Yield Funds, Hedge Funds). Roth IRAs are particularly well-suited to fixed income investments, as the consequences of potentially lower returns are ameliorated by the low taxation of those returns, either when the funds are earned or withdrawn.
Also, under present tax law, converting an untapped traditional IRA to a Roth will shrink the size of your taxable estate, and careful estate planning could foster many years of tax-free growth for those assets.
Currently, if you pass your Roth IRA to your spouse when you die, they can treat the inherited IRA as his or her own and forego withdrawals. So those Roth IRA assets can keep compounding untaxed across the rest of their life.
If your spouse then names a son or daughter as a beneficiary, that heir has the choice to make minimum withdrawals according to his or her life expectancy, all while the assets continue to compound tax-free. Currently, withdrawals from an inherited Roth IRA are not subject to income tax.

Why it might not be a good idea
The IRS regards a traditional IRA-to-Roth IRA conversion as a distribution from a traditional IRA – a taxable event. You’ll need to pay taxes on the entire amount of the conversion.
But, with the recent carnage in the markets, many IRA values are (hopefully) at a very low point. That translates to paying less tax on eventual gains. In addition, there’s strong reason to believe that income tax rates will increase in the coming years – another reason why now may be a good time to convert. (Another alternative is to do a partial Roth IRA conversion if converting the full amount would send you into a higher tax bracket.)
Using IRA assets to pay the conversion tax isn’t advisable. If you’re younger than 59½, you’re looking at a 10% penalty on the amount you withdraw, and you’ll lose the chance for tax-free compounding of those assets within the Roth IRA. What this means is that you should generally be comfortable with spending funds out of a taxable account.

Why you might want to fund a Roth IRA this year
In 2009, any withdrawals from a traditional IRA can be used to fund a Roth IRA. In years past, mandatory withdrawals from a traditional IRA typically couldn’t be deposited into a Roth IRA. But the federal government has suspended mandatory IRA withdrawals for 2009. Any IRA withdrawals made in 2009 are thereby elective withdrawals. So, if your adjusted gross income (AGI) is $100,000 or less, you have an option to fund a Roth IRA with a withdrawal from a traditional IRA – at least through the end of 2009.
In 2009, you can fund a Roth IRA with after-tax contributions to a 401(k), 403(b) or 457 retirement savings plan. This year, you can take those contributions and convert them to a Roth IRA tax-free, provided your AGI is $100,000 or less. Additionally, there is no limit to the conversion amount.

A potential tax break for those who convert in 2010
If you do a Roth conversion during 2010, you can choose to divide the taxes on the conversion between your 2011 and 2012 federal returns.
Be sure to consult your tax advisor and financial advisor before you proceed. (This is definitely a team effort, as the issue of expected returns is a major factor in the analysis.) In fact, you should generally consult your advisors before you arrange any rollover, trustee-to-trustee transfer, or same-trustee transfer of your IRA assets. In any year, you should fully understand the potential tax impact of a Roth conversion on your finances and your estate. Also, remember that while the income limit on Roth IRA conversions will go away in 2010, the income limits on Roth IRA contributions still apply next year and for the foreseeable future.

The Administration's "Overhaul" of Wall Street

Since September 2008, the federal government has committed $10.5 trillion to fixing the economy – bailing out Citigroup, Bank of America, AIG, Freddie Mac, Fannie Mae, Chrysler and General Motors in the process. To try to prevent further crises of this nature, President Obama is proposing a “sweeping overhaul” of the U.S. financial system on a level unseen since the 1930s. While there are some substantial changes structurally, the new proposals stop far short of what some (including myself) feared, and others (also including myself) hoped. For most working in finance, the changes under the PATRIOT Act were far more significant. Proably the best way to think of it is an expansion of the role and power of existing federal bodies.

Expanded Powers for Existing Agencies
If enacted, Obama’s plan would hand more power to the Federal Reserve, the Treasury and the Federal Deposit Insurance Corporation, fuse two federal agencies into a single regulator of the nation’s largest banks, create a new agency to regulate consumer financial products, police hedge funds and private equity funds, and rein in the use of mortgage-backed securities. Hedge and Private Equity regulation are likely to endure the most major effects and the legislation is likely to face substantial resistance from senior lawmakers associates with the industry like Charles Schumer (D-NY) or Nancy Pelosi (D-CA).

An Expanded Fed Mandate
Under the plan, the Federal Reserve would become the top watchdog of the U.S. financial system. It would regulate the banks, brokerages, insurers and hedge funds deemed too big to fail, see that they are keeping enough capital in reserve, and respond quickly in a crisis. The goal is to avoid another Bear Stearns or Lehman Bros. debacle, and the system-wide shock that could follow.
The Treasury could get veto power. Treasury Secretary Timothy Geithner would chair a regulatory council to work side-by-side with the Fed as it monitors the biggest financial firms. This council could potentially veto emergency loans made by the Fed to financial companies.3
The FDIC could expand its reach. It would gain the ability to seize and unwind not only banks, but other kinds of financial firms.

Goodbye (Good Riddance?) OTS
The Office of Thrift Supervision would merge with the Office of the Comptroller of the Currency. This revamp would create a new entity, a National Bank Supervisor to monitor all deposit-taking thrifts. Under current rules, some banks may essentially select their regulator, leading to what Sen. Chris Dodd (D-CT) has described as "regulatory arbitrage".

A New Regulator Cometh
That’s the Consumer Financial Protection Agency. This new office would regulate credit cards, mortgages and other consumer-marketed financial products. If would set guidelines for banks and bank holding companies, and if they got out of line, it would punish them with penalties and fines.

More Regulation of Accredited Investment Pools
Under the plan, all private equity and hedge funds would have to register with the Securities and Exchange Commission, and throw open their books when regulators demand. The specifics of this (and how effective new regulation actually is) will depend upon how the SEC uses this power. Many (including myself) are concerned that the SEC isn't sufficiently suspicious of the funds and may not regulate them adequately.

Finally Regulating Derivatives
This has seemingly taken forever. Over the counter derivatives would now be run through a central clearinghouse, similar to how exchange traded options and futures are today. Lack of transparency and regulation (in my opinion) are what got us here. The specifics are still unclear on how this would be executed, but a gradual adjustment is probably warranted.
To avoid future bad faith in the securitization of various assets (including mortgages) - banks that package and sell mortgage-linked securities (and other debt-linked securities) would have to keep at least 5% of those securities on their books. (An idea floated by Greenspan in the 4th quarter of 2008). In fact, all financial firms that originate a security would have to retain 5% of the “securitized exposure” and maintain an investment interest in that security even if it is resold. The idea here is to discourage the promotion of exotic home loans and other complex financial products that were half-understood by investors and borrowers. This is something of a giveaway to the larger investment banking houses and is likely to be treated with hostility by many smaller entities.

When?
As I said, the reforms are generally not too substantial, but certainly will ruffle feathers. It will likely take several months for any version of the Obama proposal to become law. The plan notes that the Fed has “the most experience to regulate systemically significant institutions.” But some Capitol Hill opinion leaders are especially concerned about expanding the Fed’s powers. Chris Dodd is "unconvinced". “Giving the Fed more responsibility at this point … is like a parent giving his son a bigger … faster car right after he crashed the family station wagon.”
“You cannot convene a committee to put out a fire,” Treasury Secretary Tim Geithner noted June 18, defending the idea of the Fed as the “first responder” to any future financial crisis. But Sen. Richard Shelby (R-AL) pointed out that the Fed could end up regulating “insurance companies, hedge funds, asset managers, mutual funds, and a variety of other financial institutions that it has never supervised before.” Rep. Jeb Hensarling (R-TX), a vocal critic of last fall’s Wall Street bailout, says the plan “disappointed” him: “They essentially leave all the old regulatory infrastructure in place, and then they simply add on to it.”
Consequently, it's likely to be a long, hot summer.

Some Good Tax Legislation for a Change

There are a couple of pieces of tax legislation that would be particularly valuable, not just for our clients, but long term investors and retirees in general. Email your Representatives and Senators (Better yet, write a letter.)

HR 882

Unfortunately, for quite a few Americans, a longer time horizon to retirement is very likely. Sponsored by Rep. Peter King (R-NY), HR 882 proposes to increase the required age for distributions from qualified retirement plans to 75 from 70½. The effective date would be for years beginning after the date of enactment. Thus, if the bill were to become law this year, the age 75 rule would be effective for 2010 and thereafter. The bill would also provide for contributions to traditional individual retirement accounts to the year prior to age 75 rather than the present rule of 70½. This would provide needed additional years of saving and accumulation for many Americans and would encourage longer holding times for investments.

HR 883

Also introduced by Rep. King, this bill repeals that vile and silly increase in income taxes on Social Security benefits. The 1993 increase added the provision that required up to 85% of Social Security benefits be taxed, based upon a complex two-tiered formula. The 85% inclusion rate would be repealed. The maximum inclusion rate for Social Security benefits would be reduced to 50%. The proposed effective date is 2009 for calendar-year taxpayers. Lowering taxes on benefits will have the immediate effect of reducing the drain on retiree portfolios, while allowing some individuals greater flexibility in saving for retirement. Also - taxing government old age pensions never makes any sense.

SR 978

Sen. Blanche Lincoln's (D-AR) bill proposes to increase the limitations on capital losses applicable to individuals. The proposal would increase the annual capital loss limit for individuals to $10,000 from $3,000. The proposed effective date is for tax years beginning after Dec. 31, 2008. Therefore, the proposed increase would apply for the entire 2009 tax year for calendar-year taxpayers. The proposal would also provide for inflation indexing of the $10,000 capital loss limit beginning in 2010. This make it more advantageous for younger investors to take greater risks (by making losses more 'valuable'), make portfolio rebalancing easier for the middle aged (and let people diversify their risk more regularly) and let financial advisors generate more interest income for clients (thus allowing older investors to invest more conservatively).

KKR and Fidelity Doing an End Run Around the I-Banks

As many of you know, I've felt for some time that the IPO market has remained in the doldrums largely because of the incompetent, corrupt and oligopolistic management of the process by investment banks.

This can be attributed to both the regulatory environment, which has justified very limited IPO distributions to retail investors on the grounds that there's less liability with institutional clients such as mutual and pension funds, and the argument that retail investors are more likely to "flip" (immediately sell) the shares they receive.

The evidence of the latter is scant (there's no way to track it, as institutions immediately transfer the shares they buy from brokerage firms to custodians elsewhere), but the circumstantial data strongly suggests that institutions are among the worst flippers.

This monopsony (opposite of monopoly) of institutional investors probably has been driven by a quid pro quo with brokerages where IPO allocations are driven by a willingness to pay more for standard brokerage transactions that could be conducted elsewhere far more cheaply.

The limited number of buyers has (in my opinion) probably created a false sense of lack of demand by investment banks, when it's really a result of the financial crisis, against a backdrop of secular decline in mutual funds (to ETFs) and pension funds' eschewing of any risk in the wake of Madoff. Individual investor interest in speculation hasn't declined as much as many believe, as evidenced by the growth in leveraged ETFs and other speculative retail products.

Probably in response to the success of firms like SharesPost, Second Market and Advanced Equities in selling shares of private companies to individual investors, KKR, the well-known private equity firm, has decided to start a marketing process through Fidelity Investments - essentially doing an end run around investment banks and selling shares directly to smaller investors.

Expect a great deal of consternation about this from various parties that are "concerned about the risks to smaller investors", but who are really shills attempting to protect the investment banks' monopoly. If this works, it will represent a significant first step in how funds are raised. In many respects this will be a return to an earlier era (pre 1990s), where retail played a much greater role in IPO distribution.

I see this as an extremely positive development, from both the perspective of an advisor with clients who are looking for liquidity from their "perpetually pre-IPO" company shares and who is looking for long-term investment opportunities from these new companies.

$250,000 Bank Deposit Account Insurance Limit Extended

While it's looking increasingly less relevant, the recent extension of the $250,000 limit on interest bearing deposit accounts is still comforting. (It's important to remember that non-interest bearing deposit accounts are currently under unlimited insurance until the end of the year.) What this means is that under each title FDIC coverage applies for up to $250,000 - which would allow a household to hold interest bearing cash at an institution and exceed that limit - as long as the accounts are titled correctly.

The coverage was extended under the Helping Families Save Their Homes Act of 2009, which was signed by the President on May 20th. Included in the legislation was a provision that postpones until January 1, 2014 the expiration of the $250,000 limit on Federal Deposit Insurance Corp. (FDIC) insurance for bank deposit accounts. The limit was raised in 2008 from $100,000 per depositor at a given institution, and had been scheduled to revert to the previous $100,000 limit on December 31, 2009.

The legislation covers all account categories other than: (1) IRAs and certain other retirement accounts, which will continue to be covered up to $250,000 per owner after January 1, 2014, and (2) non-interest bearing transaction deposit accounts, which temporarily have unlimited coverage and are insured under the Transaction Account Guarantee Program, which is still scheduled to expire after December 31, 2009.

The Act also extended to January 1, 2014 the National Credit Union Share Insurance Fund's $250,000 share insurance coverage of accounts at credit unions.

Please give us a call if you would like to review your current cash accounts and their insurance status.

The New Rules for Credit Cards

There's recently been a great deal of attention paid to the new Credit Card Accountability, Responsibility and Disclosure Act ("CARD Act").
Edward Yingling, president and CEO of the American Bankers Association, recently warned that now “less credit will be available generally, which means some consumers and small businesses will not be able to obtain credit cards at all, particularly younger people and start-up small businesses.” But Sen. Chris Dodd (D-Conn.), the driver behind CARD in Congress, thinks such claims sound “a little like Chicken Little.”
I am inclined to agree with Sen. Dodd and describle the industry's statements as exaggerations and a the banking sector's innate hostility to any further regulation; Most of the changes seem reasonable, with some slight exceptions. And, while I don't think this is much of a concern for our clients, this seems like a good time to review the changes that the CARD Act will bring as it's phased in over the next year:
Limited interest rate increases. If the credit card company wants to hike interest rates, it will now have to inform a customer at least 45 days beforehand and provide a written explanation.
New restrictions on retroactive rate increases. Under the new law, the interest rate on an existing balance cannot increase unless the customer is more than 60 days behind on a payment. Even if that happens, the credit card company will have to restore the prior, lower interest rate if they pay the minimum balance on time for the six months that follow.
Statements mailed 21 days in advance. This was a particularly sleazy practice by card issuers, but an irresistible temptation for larger entities. The new rules say that your monthly bill has to be mailed to you by the credit card company at least 21 days prior to the payment due date.
Pay before 5:00pm EST and you are on time. Another questionable practice that will go the way of the Dodo - Now all credit card payments made before 5:00pm Eastern Standard Time will be considered paid on that day. If your payment due date falls on a holiday, a weekend, or any day on which the credit card issuer is closed for business, your payment cannot be subject to late fees.
Borrowers can choose to attack the highest interest rates. Certain kinds of transactions could have different rates some credit cards. Under the new law, a borrower will be able to apply any payment above the minimum to your highest-rate balance.
More protection for teens and young adults. The new legislation bars companies from issuing cards to most people under age 21. Those younger than 21 will only be able to use a credit card under one of the following conditions:

• They can prove they have the means to pay the debt (or their parent or guardian promises to pay it off if they default)


• They are emancipated minors


• They are designated secondary cardholders on a parent or legal guardian’s account

Restrictions on cards issued to college students. College-age Americans will still be able to get credit, but within reason. Account limits will be either 20% of their annual income or $500, whichever is greater. So this market will grow less attractive for credit card companies.
An end to universal default. If you make a late payment to one credit card issuer, other issuers will not be able to hike your rate as a consequence.2
Cardholder permission for over-limit fees. Credit card companies now have to get your OK before they can process a transaction that would put your account over its limit.
Why are credit card companies crying? As I stated earlier on - all industries resist regulation as an innate response, but there's some reason to believe that it will hurt larger players in the card industry. Cut out all the nickel-and-diming, and credit card issuers will be left with lower revenues. So where are they going to get the money back? Think reduced rewards for cardholders, new and inventive annual fees and card services linked to balances held at depository institutions.

FTSE Launches More Environment Indexes

FTSE Group is expanding its FTSE Environmental Opportunities Index Series with the addition of nine new indexes designed to appeal to investors seeking to access the growing low-carbon economy.
We've had a number of clients express interest in low-carbon investment strategies that still provide a high level of diversification. This seems like a promising development for clients that want to play the "cap and trade" trade or who want to be "part of the solution" without over-concentrating...

California: After Pain, A Formal Feeling Comes

Please accept my apology for a somewhat gloomy entry today, but recent events have led me to be concerned about impact on the municipal bond market; California's financial situation is dire and will likely result in a significant deterioration in it's credit status in the near future. This presages tough choices to follow elsewhere.

With tax receipts falling way below expectations, California is facing a budget deficit that's likely in the $20-30 billion range for the current fiscal year's $111 billion budget. In order to prevent reductions in public services, the state legislature and the governor have implemented ballot initiatives that would allow for the redirection of mandated funds (Propositions 1A through 1F) to cover underfunded programs. However, it appears California voters are likely to defeat the initiatives. The

Should there be an adverse outcome on May 19th. The LA Times and the Wall Street Journal are reporting that the politically powerful public sector unions and the Administration are making matching funds conditional on no significant state government layoffs.

Likely, the explicit argument presented by the Administration and unions will relate to controlling unemployment (a powerful argument depending upon one's perspective on these things). The administration's opponents will argue that reductions in government spending are required. Both sides regard this situation as dramatically important.

It's reasonable to expect California to bend to the will of the unions regardless of the outcome of the ballot initiatives. In addition to their softer influence within government, their membership votes and their resources are formidable.  This will result in a combination of tax, fee increases (some of which are already coming as a consequence of budgetary issues that have plagued the state since 2001) and a downgrading of California's debt by the major ratings agencies. Whatever the outcome, the various accounting gimmicks that have been used will not substantially prevent significant downgrades in public services. 

It's realistic to expect that, barring the press exerting substantial pressure on Moody's or S&P, the rating agencies will be unwilling to anger politicians and public unions by initiating a ratings downgrade during the crisis, but they will certainly do so once the matter is resolved. This pattern was established earlier during the banking crisis. Barring some miracle, later this year, California will find itself firmly . This will cause bond prices to fall, the state's borrowing costs to increase and more unpleasant budget cuts to follow. Expect maintenance to suffer dramatically in most public buildings and services.

After Pain, a Formal Feeling Comes

The primary challenge facing California legislators is they stand between a rock and hard place. The rock,

Schwab Reduces Mutual Fund Expense Ratios

In an encouraging "Long Term Greedy" move I respect in companies, Charles Schwab has reduced it's expense ratios across several of it's funds, bringing the majority of it's equity index funds in line with the costs of previously cheaper ETFs. This should have the effect of allowing them to capture substanial index assets and make themselves competitive with Vanguard for younger customers.
As Schwab Institutional is our preferred custodian, the higher expenses of Schwab index funds had always irked me. It's nice to have improvement on that front and it makes me considerably more interested in using Schwab's funds as long term investments for clients of all sizes.

Extra! Extra! Stress Test Results Revealed!

Federal regulators have now released their “stress test” evaluations of America’s 19 largest banks. How many of the 19 thrifts are adequately capitalized? Which banks will be directed to boost their capital, and where might that capital come from? 

Information has been leaking for weeks and the Administration explicitly mentioned Citi (C)and Bank of America (BAC) and needing more capital. But, now we have the official report and the Federal Reserve’s opinion.

Nine banks won't be required to raise more capital. The banks in the best shape: American Express (AXP), BB&T (BBT), Bank of New York Mellon (BK), Capital One Financial (COF), Goldman Sachs (GS), JPMorgan (JPM), MetLife (MET), State Street (STT) and US Bancorp (USB). The government says these banks do not need to raise money from new investors.

Ten others need to raise capital or face effective nationalization. These banks need to raise new capital or bolster capital reserves by the following amounts: Bank of America (BAC) ($33.9 billion), Citigroup (C) ($5.5 billion), Fifth Third Bancorp (FITB) ($1.1 billion), GMAC LLC ($11.5 billion), KeyCorp (KEY) ($1.8 billion), Morgan Stanley (MS) ($1.8 billion), PNC Financial Services (FNC) ($0.6 billion), Regions Financial (RF) ($2.5 billion), SunTrust Banks (STI) ($2.2 billion) and Wells Fargo (WFC) ($13.7 billion). 

The only real surprise here was Wells Fargo, which as early as last weekend had Warren Buffet singing the company's praises at the annual Berkshire Hathaway investor meeting.

The government has given the banks that do need capital up to six months to raise it – and one month to come up with a plan to do so. June 8 is the plan deadline and November 9 is the deadline for raising money. Some may raise all the capital they need by converting government debt into private stock. But this will mean making the government a major or majority shareholder.

Under the conditions of the tests, the Fed wanted to see at least 6% of their assets in in the most liquid ("Tier 1") capital and at least 4% in common equity by 2010 under the two economic scenarios posed. Tier 1 capital includes common shares, most types of preferred stock, and TARP funds. 

The worst case scenario assumed a fairly high rate of foreclosure, but also expected high levels of profitability by the banks through a worsening climate, which is a somewhat controversial position. What is probably the most compelling criticism of the tests though is that the different risk management models of the banks themselves (which were presumably pretty flawed to begin with) are what have been relied upon to reveal the expected capital position of the banks in these two scenarios. 

Ultimately, the great weakness of the Treasury's approach is that, if the last year has taught us anything - attempts to model a realistic "worst case scenario" for anything over a very short period is virtually impossible. This is not what the Stress Tests really are about anyway - they are an orchestrated effort to restore investor confidence and change sentiment. It is apparently, so far, effective, in that it has substantially reduced bank debt interest rates in the private markets.

Banks that need to thicken their capital cushion can do so by 1) selling selected assets, 2) raising new common equity from current shareholders or new investors, 3) applying any earnings that top analyst expectations toward their capital bases, or 4) converting preferred shares into common stock. Step 4 is actually a cash conservation move – converting the preferred shares wouldn’t actually boost overall capital, but it would allow banks to eliminate preferred stock dividends.

Consolidation is likely. Several analysts project the smaller banks among the 19 – thrifts such as SunTrust, Fifth Third, Regions Financial and KeyCorp – could end up merging with larger banks.

The Treasury is the lender of last resort. The government has instructed the banks to go to the private sector first before asking for any more federal money. Treasury Secretary Tim Geithner projects the “vast bulk” of thrifts needing more capital can capably raise it “through private sources”. The still-developing Public-Private Investment Program (PPIP) could offer a way. But, its reasonable to expect that Citi and Bank of America will find it very challenging to raise significant capital in this environment and will likely have to accept strong US government influence on their boards.

Stress tests have occurred for years in the banking world; the findings of such tests are commonly kept private. The government revealed these results with the goal of maintaining the public’s faith in the banking system – as if to say, “Here is the open book and here is how we are directing the banks to make things better.” 

Some analysts wonder how credible the results are. After all, what would the government have to gain by saying a big bank was in big trouble? Investors would flee, and the Treasury would have to shell out more TARP money. Other analysts note that generating capital and bettering the balance sheet doesn’t address the problem of removing toxic assets from the books of these banks. 

On the other hand, the announcement of the stress tests did lessen the anxiety among investors this winter, when Wall Street fretted about the possibility of bank nationalization. The announced results do not look as negative as some investors had expected. Interviewed May 6 on Charlie Rose’s PBS program, Secretary Geithner noted that there are “very significant cushions in these institutions today, and all Americans should be confident that these institutions are going to be viable institutions going forward.” 

The Tax Man Cometh (And Right Soon)

In February, the President introduced his plan for the federal budget – a budget created with the vision of expanding government and inching towards a universal health insurance for all Americans, and with consequences for estate and income tax for affluent Americans. Since his campaign, he has also repeatedly committed that taxes will not increase for families making less than $250,000 annually.

Given this situation, the question becomes: How to plan for the implications of this new policy direction? If taxes won’t rise for the middle class and working class, where will the money come from? The all-but-certain answer: through increases in corporate income taxes and increases in the top tax rate.

In the President’s budget, the sun would set on tax cuts given to high-income earners during the Bush years. Families earning more than $250,000 and individuals earning more than $200,000 would have tax rates they faced during the Clinton administration.

Taxes are slated to go up in 2011. The 2001 and 2003 tax cuts would expire and the highest two tax brackets would return to 36% and 39.6%, and the capital gains tax rate would head back up to 20%. The administration believes this could raise $637 billion over the coming decade.

Estate taxes will likely increase. 2010 was to be the year of 0% estate tax – the great reprieve before estate taxes as high as 55% would hit in 2011. That was what was supposed to happen but now it may not. President Obama wants the estate tax picture to remain as it is now, with estate tax rates of up to 45% kicking in above a $3.5 million exemption (which would be indexed to inflation for future years). In late April, a Senate proposal aimed to lower the estate tax rate and raise the exemption, but this fell by the wayside in budget negotiations with the House. So it appears the estate tax is here to stay, but it will apparently not reset to 2001 rates.

Corporate taxes will increase. Among the ideas being considered: a requirement that investment partnerships (i.e. Hedge and Private Equity Funds) pay regular income tax rates rather than capital gains tax rates; revoking methods of inventory accounting that can help to cut business taxes; and further restricting corporate options for automatic deferral of federal taxes on overseas income. Treasury Secretary Tim Geithner has claimed that planned tax increases would only affect only about 2% of filers with business profits; the nonpartisan Joint Committee on Taxation puts the figure at 3%.

Legislators will compromise. On April 29, the House and Senate approved a $3.5-trillion outline of the proposed federal budget, but it did not include all of what the President wanted. (No Congressional Republicans voted for the budget resolution, and among them, Sen. John McCain denounced it as “generational theft”.)

An important tax-linked question wasn’t answered: how to pick up the cost of making quality healthcare accessible to more Americans. The President wants to leave more money for that mission by capping tax deductions at 28% for families earning more than $250,000 a year, as opposed to the current 33% value. Charities and homebuilders would hate that idea, and figure to lobby Congress if it advances.

The Obama administration also wanted to remove subsidies to farms with annual sales of more than $500,000, and have the opportunity to bill insurance companies for treatment of injuries linked to military service. Neither idea survived budget negotiations in Congress.

Under the budget blueprint that was approved, the $400/$800 “Making Work Pay” tax credit – which Obama wanted to make permanent – would disappear after 2010.

Changes call for conversation. This is an excellent time to consider what might happen to your financial picture as a result. Let us coordinate with your tax advisor to discuss this.

Tax Season Follow-Up: Overwithheld? Underwithheld?

Did you owe tax on your 2008 federal income tax return? If so, you might want to consider increasing the amount of federal income tax that's withheld from your paycheck by completing and filing a new Form W-4 with your employer. (If you're self-employed, you'll have to bump up your quarterly estimated tax payments.) Not having enough withheld can result in more than just a cash crunch at tax time--it can mean penalties and interest.

On the other hand, receiving a large federal income tax refund can be an indication that you should adjust your withholding as well. Why? A large refund essentially means that you're providing Uncle Sam with an interest-free loan during the year. Think of it this way: if you received a $4,000 refund, in 2008 you paid approximately $333 more each month to the federal government than you had to. Sure, you get that money back in the form of a refund when you file your federal income tax return, but the government doesn't pay you interest on those funds.

If you had taken that $333 every month and instead invested it in an account that earned exactly 3% annually, you would have an extra $80 by the time your return was due. And, depending upon how you invested the funds, you would be able to access those dollars during the year if you had the need.

If overpaying the government during the year is the only way that you can force yourself to save, go right ahead. Just recognize that there's an opportunity cost when you overwithhold. Consider investing those dollars instead; if your employer provides a 401(k) plan, think about increasing your contribution to the plan. Alternatively, you might be able to use payroll deductions to make IRA contributions. Like withholding, these contributions would come directly out of your pay; unlike withholding, though, the funds would be working for you instead of for Uncle Sam.

The Stress Tests: Establishing new standards for banks

On April 24, the Federal Reserve revealed some of the details of the “stress tests” that will comprehensively analyze assets on the books of 19 notable U.S. banks. The results are expected to be released on Monday, May 4.1 (The banks already know the results in private.)

What the Fed white paper had to say was hardly surprising. While mentioning that “most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized”, it conceded that the recession and resulting market upheaval “substantially reduced the capital of some banks.”1 Which ones? We’ll find out the week of May 4.

Why is the government doing this? It wants to determine which banks might have the greatest risk of failure if the recession worsens. Can certain banks survive worst-case scenarios?

No banks will “fail” the test, but some could receive more TARP money as a result – which could mean a lot more money poured into TARP.

How realistic are the stress test scenarios? Even if the government uses computer-generated models to make economic projections, how accurate will they prove to be? Some economists and analysts think things could get worse, but many feel the economy will improve in coming months. Others have questioned the testing criteria. Many wonder if releasing too much information might diminish public confidence.

The first scenario assumes a 2009 with -2.0% GDP, unemployment hitting 8.4%, and home prices dropping 14%, then a 2010 with +2.1% GDP, 8.8% joblessness and home prices down 4%. The second scenario is rougher: -3.3% GDP, 8.9% unemployment and 22% lower home prices in 2009, then +0.5% GDP, 10.3% joblessness and a 7% downturn in home prices in 2010.3

The administration says the tests are all about the goal of stabilization - a cautionary move that could help banks avoid any chance of nationalization. In fact, any banks directed to increase their “capital buffer” will have to turn to the private sector first before going to the government. Recent evidence in the form of a Goldman Sachs bond offering of $5billion is that this may in fact be possible for certain firms, but it seems unlikely that what capital is available to banks is sufficient for some. So far, unconfirmed reports are that Bank of America (BAC) and Citigroup (C) are going to be required to raise an additional tens of billions of dollars from investors.

Bank of America's Lewis - Everyone's Scapegoat

While there is much to dislike about Ken Lewis, his decision to continue last December with the Merrill Lynch merger isn't one of them.

A recent editorial in the Wall Street Journal expresses the now standard view that Bush Treasury Secretary Hank Paulson and Ken Lewis, CEO of Bank of America, inappropriately allowed for the interests of the global financial system to trump those of BofA's shareholders by forcing the merger with Merrill Lynch after it was abundantly apparent that the company was in serious trouble and the Bank was overpaying for ML.

It is absolute hypocricy to pillory Lewis, given that if he had chosen to withdraw from the deal, the media, Congress and probably the WSJ itself would have assaulted him for his lack of patriotism and self interest. Indeed, it's hard to imagine that back in December (when we were all still terrified of Great Depression II), a collapse of the deal wouldn't have caused even greater instability than we experienced. But, now, all these months later, we've forgotten that the rulebook - whether it was the laws regulating finance or more fundamental Laws of Finance - was being thrown out as we "all became Keynesians" (I didn't) and it was very hard for anyone (especially the CEO of a money center bank) to know what was the "right" thing to do.

What this recent debacle suggests is that media and Washington elites now feel sufficiently confident that the financial system can absorb the kind of self-serving witch hunt that now is apparently unfolding. Perhaps we should find that encouraging. I hope they're right!

Liquidity without an IPO

Recent developments in the private equity markets are extremely encouraging for our clients who hold shares in companies that expected to IPO in the last few years. , but couldn't because of market conditions.

While exchange funds for private equities have existed for quite some time, (ex. the fine people at EB Exchange Funds seem to be doing a solid job providing that option) diversification isn't liquidity. And what liquidity options did exist, were limited to large blocks of equity.

Now companies like secondmarket and SharesPost seem to be making liqudity a possibility at a much lower level of shares than before.

Here is a NY Times article profiling Second Market.

The Begining of the End for Retail

Rather disturbing new iPhone application for retailers

Reselling Toxic Assets to Retail Investors

According to CNN/Money, the Treasury is exploring options to re-securitize (again!) toxic asset backed securities and make them available for purchase by retail investors. This is a political response to concerns raised by some that hedge funds and other institutions are the only potential beneficiaries of the government's public-private partnership program (TANF). Formany investors, this may be an attractive investment vehicle. If given the opportunity - I would certainly examine the alternative closely for clients. But the political liabilities - both in the short and long term mean that there will be so much hand-wringing over this that the Administration is likely to make the vehicle fatally flawed. The question is whether the consequences of the flaw will fall on the government or investors. If, like TIPS, the vehicle is flawed in favor of the investor - this may, in fact, be an outstanding opportunity. Let's keep our fingers crossed. Stay tuned!

The Ultimate Toxic Asset?

Came across an entertaining little article that I think illustrates the challenges facing banks in the current environment.
According to Bloomberg, the now-bankrupt Lehman Brothers has an extremely pricey but hard to value asset on it's balance sheet - enough uranium cake to make an nuclear weapon. Apparently they entered into the highly restricted (and lucrative) market for weapons-grade nuclear material shortly before their collapse.
Now that the short list of potential buyers knows that a bankrupt firm is sitting on a decent chunk of it, the market has effectively collapsed.
According to Bloomberg:

Lehman “tested” the uranium market after its bankruptcy filing in an effort to raise cash, pulling back after it did because “everyone was low balling,” Marsal said. With $10 billion in the till today from other asset sales, Lehman isn’t in a hurry any longer to sell uranium, he said.

Sound very much like the problem with banks and sub-prime mortgages?

Reminder: Treasury Guarantee Extends Until Jan

On March 31, 2009, the Department of the Treasury extended its temporary guarantee program for money market mutual funds through September 18, 2009. The program, which had been scheduled to expire on April 30, 2009, guarantees a participating money market fund's $1 per share value through September 18, 2009 for assets held in a fund as of the close of business September 19, 2008, or to shares held in the fund when a guarantee payment is made, whichever is less. Investors cannot acquire Treasury protection for investments made after September 19, 2008, and closing or transferring an account would mean losing the guarantee for those assets.

Encouraging Bit of News

According to the Wall Street Journal, AIG's Financial Products Division has indicated that it expects to have completely closed out its CDS exposure by the end of the year. As this division is largely responsible for the problems at the insurer, it's encouraging that we only have another six or so months of hand-wringing over this insanity.

The article goes on to discuss the ongoing question of whether they will be able to retain the personnel who got the company (and the American taxpayer) into this crisis. The logic is that they will be needed to unwind the complex web of obligations they've created. While I don't know the answer to this question, it seems to me that given the process of terminating the contracts seems fairly straightforward and their "expertise" isn't exactly required. Is there something I'm missing here?

Making Home Affordable (MHA) plan

Over the last few months, there have been dramatic differences in the interest rates being charged on "conforming" (up to $417,000) vs. "non-conforming" (over $417,000) mortgages. This relates to the federal government's subsidy of mortgages through Fannie Mae and Freddie Mac. Recent legislation aims to bring down interest rates on mortgages that reflects the higher average home prices in higher income areas.

In summary - I think it's highly likely that we'll see mortgage rates drop for loans up to $729,000 in California and New York over the next few weeks. In response to the many questions we've received on this, we thought the following information might explain how the government is indirectly and directly driving down rates through what is collectively known as the "Making Home Affordable Plan" (MHAP).

The MHAP is made up of two plans:
The Home Affordable Refinance plan provides access to low-cost refinancing for responsible homeowners suffering from falling home prices.
The Home Affordable Modification plan will assist homeowners in danger of losing their homes to foreclosure. The Home Affordable Refinance plan: While mortgage rates are now at historic lows, many homeowners with mortgages owned by Fannie Mae or Freddie Mac are unable to refinance their higher-rate mortgages because they have lost equity in their properties due to falling home prices. Under current rules, Fannie Mae and Freddie Mac cannot guarantee a mortgage that exceeds 80 percent of the home's value. The Home Affordable Refinance plan removes this restriction, allowing certain homeowners to refinance their mortgages. A homeowner qualifies for this refinancing if:  The property is owner-occupied and the existing mortgage is current  The existing mortgage is owned by Fannie Mae or Freddie Mac  The new mortgage balance will not exceed 105 percent of the home’s current value  The mortgage balance must not exceed $729,750 for single-family homes This plan runs until June 1, 2010. The Home Affordable Modification plan: The Home Affordable Modification plan will assist responsible homeowners who are now struggling to afford their mortgage payments and who cannot sell their homes because prices have fallen significantly, in many cases making the value of the property less than what is owed on it. The intent of the program is to offer loan modifications that will bring a homeowner's monthly payments to sustainable levels. To qualify, a homeowner must:  Be an owner-occupant  Have a mortgage created on or before January 1, 2009  Be in financial hardship or in imminent danger of financial hardship  Have a current mortgage payment (including taxes and insurance) that exceeds 31 percent of monthly gross income  Have a loan amount that does not exceed $729,750 for a single-family home (however, the loan need not be owned by Fannie Mae or Freddie Mac)  Apply by December 31, 2012 Homeowners with total "back-end" debt (including housing debt, car loans or leases, and credit card debt) equal to or greater than 55 percent of their gross income must enter a HUD-certified credit counseling program as a condition for loan modification. Lenders must reduce the borrower's monthly mortgage payment to not more than 38 percent of his or her monthly gross income. The U.S. Treasury will then share the costs of reducing the payment dollar-for-dollar to a debt-to-income ratio of 31 percent. This may be accomplished by capitalizing arrearage, dropping the interest rate to as low as 2 percent, extending the loan term to up to 40 years, and/or forbearing principal. (Principal forbearance will result in a balloon payment due on the loan's maturity date, upon sale of the property, or upon payoff of the interest-bearing balance.) The modified payments must be kept in place for five years, and then the interest rate can be stepped up by no more than one percent per year to the 30-year fixed conforming loan rate in place at the time of the modification. Loans that are delinquent or that are in imminent danger of default are subject to a net present value (NPV) test. This test compares the NPV of cash flows expected from the loan modification to the NPV of cash flows expected in the absence of modification (e.g., through foreclosure). If the NPV due to the modification scenario is greater, a Home Affordable Modification must be offered to the borrower. No modification fees may be charged to the borrower and unpaid late fees to the borrower will be waived. The following incentives are offered to accomplish modifications: • Mortgage servicers are offered an up-front fee of $1,000 for each delinquent loan modification meeting the guidelines. As long as the borrower stays current on the loan, the servicer will also receive a Pay for Success payment of up to $1,000 annually for 3 years. • Mortgage servicers will be paid $500, and mortgage holders will be paid $1,500, for each at-risk loan modified before the borrower falls behind on payments. • Borrowers who make timely mortgage payments will receive Pay for Performance principal balance reduction payments equivalent to $1,000 a year for up to 5 years. • To encourage lenders to modify more mortgages, cash payments to partially offset probable losses from home price declines will be made on each modified loan that remains active in the program. Additional incentives will be provided to extinguish junior liens on homes with modified first-lien loans. Compensation will also be provided to facilitate short sales or deeds in lieu of foreclosures for borrowers who fail to qualify for, or default under, modified loans. I hope that this has been helpful. Please feel free to contact us with any questions or if we can be of any assistance in refinancing your mortgage.

Stimulus package breakdown.

Here's a detailed breakdown of the legislation signed by the President this morning.

American Recovery & Reinvestment Act of 2009

Source: Speaker of the House of Rpresentatives Office (2009)

Despite the tremendous amount of excellent commentary out there on the stimulus, I've received quite a lot of requests for my opinions on the stimulus package, recently passed congress and expected to shortly be approved by the President.

About 1/3 of the package includes tax cuts that are either continuations of existing "temporary fixes" or were heavily advocated by both parties in the recent election (e.g. AMT reindexing, R&D Tax Credit, etc). For all intensive purposes, the absence of these "cuts" would have been anti-stimulative, because they were already expected. What this means is that there are unlikely to be too many surprises come tax time for people receiving incentive stock options, who are dependent on special exemptions or whose income places them in AMT.

Another 1/3 is devoted to welfare (unemployment, health insurance focused, not any specific enhancements for TANF) programs and financial support for municipalities. It is likely only the beginning. Due to demographic factors and an unwillingness to make hard choices, most municipalities are in difficult situations where they will either be forced to cut services or increase taxes. While each state and city will have their own unique experience, there will be generally difficult choices for most governors and mayors. I expect to see future fiscal crises emerge, with the most extreme cases receiving federal assistance.

These funds aren't likely to have a substantial impact on this recession. The money will likely be spent after it's over. The basis for the argument that the stimulus package will generate activity ("create jobs") is that it will generate expectations which will stimulate investment and spending. Given the relatively small sums of money involved (it's a $14 trillion economy), it's hard to imagine the package having that much impact under any circumstances.

Thus, it is difficult to find much of significance from an investment standpoint regarding the current spending package.

In my opinion, what is of much greater significance, and requires a much more clear direction, is the US Treasury's strategy of restoring investor confidence in the financial sector.

As Bad as the 1958 Recession?: That works...

As we look back at the preliminary GDP reports from the 4th Quarter, it's easy to see that we're in a recession. It appears that in the last two quarters, there was negative economic growth. Growth in the 3rd quarter was somewhere around negative one percent and the economy contracted somewhere between 3 and 5% in the 4th. As the pattern of unemployment shows, we're looking at a particularly ugly environment with unemployment north of 7% and it's hard to imagine it getting much better for at least another quarter or so. Unadjusted for inflation, this is probably the worst since recession since the one in 1957 and 1958.

Unemployment 2006-2008

Source: Bureau of Labor Statistics

A google of "1958 Recession" gives you pretty little to go with, so I was inclined to start researching a period that is surprisingly little discussed and has been little discussed recently. Data collection was perfectly fine during the period (all of the major economic institutions from whom we get data today existed at the time) and most easily accessed data series goes back to the 20s, but there aren't many stock indexes that go back that far, so I suppose that it's not as interesting to most of my colleagues. So, after a series of frustrating discussions with people who worked on Wall Street through the 1957-1958 period, but who seemed to regard the period as unremarkable, I began to review some of the literature.

The similarities between that and the current recession are downright remarkable. Like ours, the 1957-1958 recession was truly global. The downturn was experienced virtually everywhere and was hardest felt in emerging economies, like today. It appears to have largely originated a rapid retrenchment of the consumer in response to higher levels of household indebtedness, which led to a dramatic drop in the real estate markets - and which spread to other sectors.

1957: Tough Year

As one reviews the 50s, one of its most striking characteristics of the era was it's economic volatility. Despite its' reputation for "swellness", the 1950s were actually dominated by choppy economic growth and what would (at least by today's standards) be considered periods of uneven growth and unemployment. Why it's remembered so fondly is probably relative. To a population, most of whom could remember the Great Depression, regular 1-3% shifts in employment were probably a bit more palatable than they would be to those of us living through two decades of moderation.

By '57, the country's postwar energy and consumer expansion was effectively spent. A certain amount of over-investment was to be expected in the 13 years following World War II. Americans had built the first wave of Levittowns and the cars to get there. Suburban sprawl was producing tremendous negative effects, necessitating new environmental regulations and reducing demand for new real estate. (Various indignities like the elimination of backyard incinerators were weighing heavily on the national psyche by forcing Los Angelinos to actually pay to dispose of garbage.) The geniuses at Ford had released their new flagship vehicle for their 1958 line; the Edsel. Auto sales declined 31% and unemployment in Detroit reached a whopping 20% in 1957.

On October 14th 1957, American technological leadership came in to question, and it's foreign policy policy position was dramatically reduced by the Soviet launch of Sputnik. The device was more than a beeping steel ball - it was a message to the world - the United States is no longer the sole superpower. By the end of the year, housing was in full collapse, the economy contracted at a 4.2% rate in the 4th quarter and a staggering 10.4% in the first three months of 1958. (It's important to note that the most recent decline was a reported 3.8%)

Obviously, this was viewed with a great deal of alarm by virtually everyone - particularly a population and congress whom could remember the stock market crash and the Great Depression.


The political pressures were no different than today. As a Time magazine article written at the end of 1958 observed:

The immediate reaction of many politicians and businessmen was to call for the classic remedies. They cried for tax cuts, a mammoth government make-work program, many more billions for old-age pensions and unemployment aid.

But unlike the previous and current administration, the response by the President Eisenhower and then Chairman William McChesney Martin was pretty much cold-hearted, refusing to engage in any kind of fiscal stimulus. Eisenhower presented a fairly modest (a slight deficit) budget in 1957 and even instructed Treasury Secretary Humphrey to make a statement about the importance of balanced budget at the press conference for it. Despite the top income tax bracket being 91% (vs. 35% today), neither Senate Majority Leader Lyndon Johnson or Ike considered tax cuts.

Again Time:

All year long the Eisenhower Administration staunchly resisted temptations to buy its way out of recession, although it speeded (sic) up and enlarged present housing and social security programs as antirecession measures. It gave the economy's carefully built-in stabilizers a chance to work and relied on the nation's own basic good health to recover from the slump.

The view expressed at the time was that recession was a part of the natural order. Martin actually had the cajones to observe to journalists;

During a boom, waste and inefficiency creep in naturally. It's hard not to believe that recession does a lot of business a lot of good.

It's difficult to imagine any major politician expressing that view today without being thrown in the same pit as former Senator Phill "Nation of Whiners" Gramm.

Regardless of whether the best thing to do was to engage in a dramatic level of deficit spending to rescue the economy, what followed all this inaction and insensitivity was that unemployment, after peaking at 7.4% in 1958, began to rapidly drop - before settling at a rate that was about 1% above the pre-recession rate of ~4%. Inventories came down, and growth resumed.

Unemployment 1956-1959

Source: US Bureau of Labor Statistics

In short, things got better without a stimulus package.

The parallels aren't perfect. Another difference between the 1957-8 recession and that of 2007-present was that stock market performance remained solid throughout the period. Part of this was equity valuations remained high. In 1958 the P/E ratio of the S&P 500 was 21x earnings, as opposed to the 14x in the current market. What was the difference? Leadership and the public opinion that it engenders. In many ways, the recession of fifty years ago is what we all hope this one will be, but we don't seem to be learning much from that experience.

There are important differences between the recession of 1957-8 and the one of 2008-9(?), particularly the presence of the financial crises and the ineffectiveness of monetary policy. Certainly some of what has been done has been required. But, I must admit to being disappointed that there aren't more people observing this period and discussing whether the best thing might be to follow Ike and Martin's lead -- to do nothing, but evoke confidence in what what what referred to at the time as the "built in stabilizers" of the system - unemployment insurance, patient monetary policy and the inherent predisposition of our system to growth. Certainly, at this point, this perspective deserves some consideration.

Why Big Banks Aren't Lending

Many thanks to a friend for passing along this chart from JP Morgan showing how much the world's largest banks have seen their equity collapse in recent months. This illustration not only shows how much the landscape has changed from the recent crisis, but also how universally banks have been crushed.

The tragedy is that by propping up these banks that are languishing under their a perpetually shrinking net worth, the federal government is jamming up the capital that could be lent out by other, smaller institutions.

How Much Debt Can the US Absorb?

Source: International Monetary Fund, World Economic Outlook Database, October 2008

This really is the trillion dollar question. All of the debt generated by the stimulus is being financed at very low rates, but eventually rates will start to creep up on their own. Part of the challenge in determining the number is because the US began the financial crisis with a level of debt equivalent to what we had at the end of World War II and part because Japan has already shattered any prior records for a stable country in peacetime. The US is a member of a club of delinquents; virtually every major economy's government has increased levels of debt in recent decades.
Source:Budget of the United States Government: Historical Tables Fiscal Year 2008

Market Commentary

2009 is not starting in an encouraging way. Virtually every investment class has been down in the first three weeks of the year. As we are again seeing weakness emerge in the markets, driven by poor employment and profit reports emeging from the 4th quarter, it seems appropriate to discuss my long term perspectives on the markets and explain their influence on my decisions and advice.

Broader Economy
The current US economic environment is highly uncertain. But, the intermediate term environment (5+ years) is generally quite positive.

We are currently in the worst recession since the end of the Second World War. It was largely caused by declines in the housing market and poor risk management at the largest global banks, coupled with a decline in consumer confidence. What has made this particularly ugly has been the seizing up of the credit markets and the Bush Administration’s inconsistent responses, which have undermined confidence in even the most conservative of investments.

High levels of press coverage of economic news and the recent election cycle caused a massive retrenchment by consumers, who drive the global economy. This has had the beneficial effect of transforming Americans from net spenders to savers, but the positive effects of this will take years to truly manifest themselves. This trend towards prudence has been devastating for the sales of high end retailers, homebuilders and auto manufacturers.

Unemployment rates are being driven by the massive dislocations in the financial, real estate and manufacturing sectors, but still remain below levels seen in the recession of the early 1990s. Unemployment rates in the 10+% range have been seen in several industrialized economies over the last 20 years, with eventual declines occurring once the recession ends. Because of technological and trade related forces, there remains a high level of probability that we see a “jobless recovery” with recessionary conditions, as employers seek cost saving technological solutions and restructure their budgets.

We are currently experiencing deflation, which is generally worse than inflation as a long term phenomenon. This deflation should be countered by the massive economic stimulus package being considered by congress, coupled with extremely low costs to borrow, which generate considerable problems with inflation once the current crisis ends.

Housing Markets

The environment for real estate remains extremely negative.

Housing is unlikely to recover to its highs achieved in 2005-2007 any time soon. The decline and recovery are likely to follow a much longer path, as houses are much less liquid than stocks or bonds. While mortgage rates remain persistently low, mainly due to radical government intervention, people simply aren’t buying. At the core of the problem is that the ratio of house prices to annual income has increased dramatically in recent decades, making it very unclear what ‘cheap’ means. A decade-long housing recession, followed by several years of slow growth may be possible in this space.

Investments in real estate can make sense as a “play for yield”, but I am reluctant to devote a significant percentage of client portfolios to these types of securities. Incomes need to increase relative to home prices in order to absorb excess supply, which seems to exist across the spectrum.

US Stocks

By most measures of valuation, US stocks look underpriced.

The current environment is extremely attractive to long term (5+ years) purchasers of US stocks. In the shorter term, the environment is very unclear.

The best values appear to be in the large cap growth space – in particular, companies with relatively low debt levels and solid brands. These firms will benefit from relatively low borrowing costs once the current panic is over. Value companies – which seem to be generally over-leveraged, are concerning. Dividend rates, while unlikely to be sustained at current levels overall, are extremely attractive to current income investors for the equity portions of their portfolios even at levels of yield lower than present.

International Stocks

International stocks, like US equities, look attractive, but considerably less so, due to currency issues and less transparency in terms of accounting. Virtually every problem, long and short term, that the US has, the Japanese and Europeans have worse. There are, however, some foreign markets that look particularly enticing – particularly so in Latin America and Southeast Asia.

Both developed and emerging markets performed far worse, relative to US equities, in 2008. There are several reasons for this, but in large part the declines were driven by mad dashes to build cash positions – selling anything that could be sold – and, from US investors’ redemptions.

Prominent exceptions are Australia and Mexico, where valuations and macro economic factors are extremely encouraging. China remains an appropriate holding for long term aggressive investors, as do the Emerging Markets generally.

Bonds

Bonds are an attractive investment outside of US government securities, which are extremely overvalued and pay an unacceptably low rate of interest. The most attractive bonds are those issued by banks and other financial institutions, but they are also the most risky.

The bond markets were extremely volatile and highly varied in how they performed in 2008, US Treasury bonds had one of their best years on record, but corporate bonds (a space dominated by financial companies) performing extremely poorly at the end of November and recovering rapidly at the very end of the quarter. For this reason, most bond mutual fund managers seem to have dramatically underperformed the Barclay’s Capital (formerly Lehman Brothers) Aggregate Bond index, as they generated cash to cover redemptions by selling (and thus, underweighting) investment grade corporate issues.

Due to their extremely high yields, I am inclined to invest in corporate bonds (although less so, in light of their recovery), high yield and preferred stocks, while keeping conservative clients core fixed income portfolios in short term bonds, money market funds and other investments unlikely to be affected by an eventual (and likely dramatic) increase in interest rates.

Commodities

Commodities performed extremely poorly in 2008. They are unlikely to (as a group) experience a dramatic comeback in 2009.

I am inclined to keep commodities exposure to a minimum because it is likely to be a poor investment long term (mainly due to technological factors) and because they have demonstrated that they do not possess the diversification benefits that their advocates saw in previous markets.

Gold reversed its negative post – Lehman trend, and I think that a powerful case can be made that it is a good long-term bearish investment. Oil seems like a better investment, however, given its centrality to the global economy and the fact that it’s price lies well below what most industry insiders seem to feel is an appropriate long term level. In general, however, I feel that commodity exposure should be viewed as speculative and should be limited.

Conclusion

This is the most challenging market for any current participant. We are currently experiencing uncertainties that are as substantial as at any time in the last 50 years. I encourage everyone to maintain perspective (as you all pretty much have – thank you very much) and remember that recessions, market declines and financial crises are part of the natural order.

That having been said, these are particularly challenging times and it is always a good time to talk, evaluate and review risk tolerance. As we reach out to clients over the next few weeks, please don’t wait for us to get in touch with you if you would like to review your portfolios. As we always have, we will get through this challenging environment.

Thank you again for your business.