For “The Greater Good”
January 30, 2012
Good morning. The market was virtually unchanged in a slow week of trading last week, with the SPY up .31 (.2%) to close at 131.82. Still, that increase added to the gains so far this year, which now stands at 4.8%, a healthy start for the S&P. The VIX continues to indicate the market’s new comfort level as it closed under 20 (18.53) for the second week in a row. There still has been no real new “resolution” in Europe, but the influx of over $500B a few weeks ago by the European Central Bank seems to have provided at least a temporary bandage to the problem. There also is that group out there that just wants unlimited creation of money (really worldwide) as an ongoing fix. In Europe a lot of Banks own stock in other Corporations, so the European stock markets’ rally since the cash infusion (DAX up roughly 27% from its lows) makes the balance sheet of Banks owning stocks look an awful lot better. Still, a lot is riding on what is being termed a “voluntary” default in Greece that has yet to be finalized. The term “voluntary” refers to a bond restructuring that all parties agree to, and somehow by being “voluntary” does not trigger the so-called Credit Default Swaps that people have purchased on Greek sovereign debt.
Let’s think about that for a second. Remember, a Credit Default Swap (CDS) is essentially an insurance policy that someone buys on, say, sovereign debt. So, say the debt of the State of Illinois is rated BB (should be D) and therefore is paying 6% on the paper it issues. If you, as a Fund manager, desire this 6% return but are nervous about the BB rating you can go to a third party and essentially buy insurance that the State of Illinois will perform on its obligations. However, to me it seems a bit irrational right out of the gate. If you desire the safety of a AA rating, say, versus the BB rating Illinois currently has, you have to find someone to sell you the insurance with at least a AA rating and who is theoretically big enough to cover Illinois should they be unable to pay. If you find such a person or place, you would think that the price you would have to pay for the “insurance” would be roughly equal to the difference between the rate on BB versus AA. In other words, you don’t really get anywhere; all you do is introduce a third party and their risk. It gets better. These people or places that sell these CDO’s sell them to people other than, and in addition to, those that actually have purchased sovereign debt. In other words, you or I can go and buy CDO’s on Greece or Portugal without owning any of their debt, which is very similar to buying life insurance on someone other than yourself. How would you feel if you found out that twenty other people had just taken out a life insurance policy on you?
By now you are probably wondering how such a business could even exist. It exists because those selling the CDO’s can declare for themselves (in essence) what the risk is and actually declare profits on what they charged in excess. So, say I sold someone a CDO on $10m in Greek debt for $1m. I now have a model that tells me the risk of default is one in a thousand, so I declare that 90% of the $1m I took in to be profit, never mind if I can actually pay out the $10m plus interest if they go bust. This is nothing short of a combination of fraud and insanity, as some have been alleged to declare bonuses based on the fictional profits that were never made. Now, however, we have “those” that have sold these CDO’s on Greek debt and we are worried that there is not enough capital among the “thoses” or the “thoses” are very politically connected so we are going to find a way where, even though Greece is essentially bust, no one has to pay out on what was essentially “insurance.” So someone has decided that if we can get everyone to agree with a voluntary settlement, even if it amounts to 30-50 cents on the buck, no real “default” occurred and the sellers of the CDO’s do not have to pay. You would think they would have to at least pay back the premiums on what, for lack of a better term, had to be a totally sham product. I would say you could not write fiction describing this system, no one would believe it.
I sometimes wonder why I spend the time trying to understand and communicate what is happening in the world around us, because often it seems like it has to be a bad dream that will end with the relentless alarm going off. It is not, however, a dream and the things we see happening around us are being orchestrated by people who are supposed to be experts; and we actually pay for their services. I can’t really say that I am sorry that someone who jumped on buying a CDO on Greece with no debt to insure (like a carrion bird) is getting stiffed, but I really do wonder why a government should choose sides on what was an allowed arms length transaction. The same sort of thing can be said about the actions of our Federal Reserve. As of last Wednesday Fed Chairman Ben Bernanke reported that the Fed had decided to keep interest rates at near zero until the end of 2014, rather than the previously announced mid-2012. That announcement essentially says that for more than an additional two years people that have accumulated savings will receive virtually no return on that savings. He also said that they are “targeting” an inflation rate of a historically traditionally “healthy” 2%. When I heard this I really did hope it was a dream, what is with these people? How can you just “choose” to essentially strip every person with accumulated wealth of any normal income for a period of many years? There is a balance, or ought to be a balance, between those that have accumulated capital and those that need capital. People who need capital for the pursuit of new ideas and products should be able (in the aggregate) to “pay” for the use of someone else’s money as they, through their new ideas, can achieve a return greater than what can be achieved by the holder of the capital. If a person has an idea for a product that will bring him or her 10, 20, or even higher percentage returns on a new factory you would think he or she could pay 2 or 3% to the person whose money is being used.
I fully understand the theory that says if interest rates go from 12% to 9% more people would be willing to take a chance on a new product or idea, and would borrow money to make that happen. I see no theory that says if you drive interest rates from 2% to zero the same effect can be expected. I do know that you cause huge problems for the savers that essentially make nothing now on their accumulated capital. When Mr. Bernanke was asked at his news conference about the effect on savers, he said basically that savers were considered and had to essentially “suck it up” for the greater good. You know what, that is insane. Suppose I think that the bright bulbs at the Fed should essentially forego all income until 2014 for the “greater good.” How popular would that be? Is there any feel at all among these people in Washington what it is like to live on fixed income and savings when you totally strip out the return on savings? It is not like there is any limit to what the Banking industry (the beneficiaries of this largess) can charge for interest, as 24 and 30% charge card rates will attest. This is flat out wrong, and these people should be shown the door.
I also have an issue with the 2% inflation target. How blind can you be, Mr. Bernanke? In his mind maybe inflation is less than 2%, but maybe in his mind he can jump and shoot like Derrick Rose. You have to question what exactly is going on in his mind if he thinks he needs to “push” the inflation to a 2 % number. I refer you to an article in yesterday’s Sun Times by Francine Knowles. In it she refers to the published inflation number for the Chicago area, up 2.7% (even that number would seem to indicate to our seriously out of touch Fed Chief that he does not have to push to get to 2%) contrasting with the published increase in private sector workers income of 1.5% (public workers of course did better). She then goes on to mention a whole list of price increases that make the 2.7% number nothing short of laughable, like gasoline up 27% in 2011 after up 20% in 2010, overall auto expenses up 10%, food up 4.3%, health insurance up 12% making it up 42% since 2007, water and sewer up 25%, tolls almost double, you get the picture without even mentioning tuition and property tax increases. So in whose mind is stiffing the guy who has saved for retirement (or anyone with cash balances) in favor of the few something for the “greater good.” I want to be a part of the getting cash for free side, tell me how I can get $2m interest free until 2014, and I will promise to hire people and remodel houses with a vengeance. The problem is the “greater good” only applies to the few that have their butt in the air since their nose in the government trough, and it is virtually impossible for anyone we know to avail themselves of the “wealth” being stolen by the day from savers. If we do not collectively find a way to make policy free from the dictates of the privileged few the “people” will not recognize this country in a few years (if you do already). This is not informed economic leadership; it is common theft and outright lies.
I think it may be bad psychologically to see things happening that look very clearly like they are going the wrong direction, and hope you are wrong. I so hope that somehow the Ben Bernanke’s and Larry Summers’s of the world pull this one off, or that the economy somehow rights itself despite the bad decisions seemingly being made, and people can say I was totally off base in my concerns. I would love to be proven wrong in where I think this is going, I can deal with sudden prosperity, I just don’t see it and would love to hear your thoughts.
As for trading, it will be interesting to see if this rally (this year) holds. The economic numbers have been a little better, but the 2.8% fourth quarter growth number last Friday was a little light. If the huge monetary and fiscal stimulus applied is going to work it needs to work now, and the up-creep needs to become self-sustaining right now. We do not need to hit another wall or slowdown; I think we need a few quarters of 3.5% growth to be able to reach a lot of the population. I also think we have to get this interest rate up to at least 2.5% to get some participation to savers. Right now the VIX has dropped to the point where we can participate in market moves from the long premium side at a better price than in a long time. We are having some luck trading the weeklies vs. monthlies although it is a little streaky. There is no reason for investors with huge market risk to not do some protection with the VIX under 20, and lock in at least some of this market advance. There still is the phenomenon where investors are less likely to protect themselves when the market is higher, even though that is when there is more to protect. I think now is surely the time to assess your risk and get it under control. The new dividend strategy continues to do well, actually better than expected, and we will be scheduling some seminars soon online to talk about the PIP and the new things we are doing.