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Who Will Guard the Guards?

January 26, 2009


Good morning. Another week, another drop in the market. This time the SPY’s were down only from $85.06 to $83.11, or 2.2%. This actually represented a decent recovery from the huge sell-off of 5.3% on Inaugural Tuesday. It does seem, from watching the market, that there still are liquidations going on and any sort of rally is met with renewed selling pressure. One only has to look at GE to see an example of that, as Friday’s earnings announcement brought an initial rally in the pre-market to $14.19, only to have it close at $12.03, a drop of 8.3% from the high. The VIX was up only slightly, from 46.11 to 47.37, even though it did have a closing spike on Tuesday of 56.65.

Obviously the big problem, other than continual and dramatic lay-offs, is the state of the financials, which is only getting worse as the economy worsens. A lot of wild ideas abound regarding how to help the situation, but no consensus appears to be forming. It makes me very nervous that the new administration has put an emphasis on speed at all costs regarding a fix; in my opinion we need to be smarter rather than faster. A lot of the damage and bad policy so far has been partially due to haste, in this man’s opinion. At these levels, the four financials left in the Dow Industrials, AXP, GE, BAC, and JPM represent a total of less than 500 total points in the average.

In the midst of this mess the new administration is defining the role of regulation in general, and financial regulation in particular, going forward. It appears that the driving forces of the “new” policies include Paul Volcher, Mary Shapiro, Arthur Levitt, and other relics from our flawed regulatory past. Of course opinions on how and how much to regulate are all over the spectrum, from the true free market guys “The market will somehow take care of everything” to the neo-somethings “You can never trust ‘people’ to behave themselves unless government is watching their every move.” Now that is quite a choice. My initial flippant response to the second group is to quote Plato, in The Republic “Who will guard the guards?”

I would submit to the readers (and our new President should he happen, by accident, on this column) that we must, once and for all, sit down and figure out the proper role of regulation (and regulators) going forward no matter how long it takes. Right now we know (or have observed) that laissez-faire capitalism has its problems; there needs to be at least a minimal set of rules governing the playing field along with fair and impartial consequences for breaking those rules. We have also seen that virtually every attempt at regulation in our society, from the early CAB (Civil Aeronautics Board), and ICC (Interstate Commerce Commission), to the current SEC and Federal Reserve, to be a virtual failure on every level. This is not new. When I was in Graduate School at the University of Chicago I took a class on Public Policies and Economics from soon to be Nobel Winner George Stigler, and we talked about the same issues 33 years ago. At that time we talked about how horrible and stifling to competition the regulators had been to the airline and trucking industries, how close the regulators get to the industries they regulate over time, and how the regulators actually form a separate sort of Justice System for those industries. It was the same conundrum we now have regarding the financial industry, as I can’t bring myself to think that in industries as big and as important as banking and securities that we should have no rules and no supervision, yet I can’t help but observe that in every instance to date the attempts at regulation (SEC, etc.) have been so co-opted and inept that they probably have only made things worse.

The regulators are so far in bed with the industry they regulate over time that anyone who says that they really work for the investing public needs some sort of sanity test. If they really do take a stand for the public, the firms they regulate are very adept at going right around them to Congress. There is also no doubt that they have created a secondary Justice Department for the firms they regulate, with a totally different, and way more lenient approach, to fraud enforcement. We have seen any number of cases in the securities industry, from front running orders, to problems with IPO’s, to issues of analysts putting out false statements, to price fixing on the exchanges, where the penalties have been a small share of the gain, with the added phrase “Without admitting or denying guilt.” When has anyone ever been able to do that in a court of law? You can certainly make the case that the absurdly small penalties in relation to the gains in some cases have made those regulated more bold in cheating the public going forward than acting as a deterrent. Let us just mention the additional subject of supposed regulators negotiating on one of these settlement deals and then showing up as an employee of the same firm shortly thereafter. “Who will guard those guards, or are they immune?”

What are recent examples of this running incompetence? Just look at the state of the banking and securities industries today. In the last several months we have seen the fruits of a regulatory framework that never saw a merger it did not like, has no concept of the risk size brings to the table, and somehow sets “safe” capital limits that are anything but “safe.” Consider the case of Citigroup (C). In the last week the bank has been fed additional billions just to keep it afloat, and the talk of nationalization is everywhere. Only weeks ago this same Bank was considered strong enough to be the regulatory choice to take over troubled Wachovia Bank, how could that be? Is there some way they could have been healthy a month ago? At times C has had total assets on its balance sheet of over $2 T, yes trillion with a T. The total take of all tax receipts by the U.S. is now $2.4T in a year; does anyone other than me think that that size of assets in one place might be a little too much? Our regulators also have declared that a bank’s equity to asset ratio is healthy when it stands at 6%. Six percent? Who is making these decisions? For a bank with $2 T dollars in assets they need only a capital base of $120 B, now that is insanity. Why isn’t the number 15%, or 17%? Ask your regulators, and you would get some long-winded bull about how our banks needed to be “competitive” and other regulatory idiots around the world were setting low levels for their banks, etc. We need to be “competitive” with Royal Bank of Scotland, whose level of assets on the balance sheet is larger then the whole economy of Great Britain, and might take Great Britain down with it. I think not. It would have been awful if banks around the world went bust and ours stayed solvent.

Enough of that, I could go on forever about how incompetent our regulators of all stripes have been. Yet I can’t bring myself to toss them all and go it without them, therein lies the issue. So how do we trade this mess? We continue to feel that the market has probably come close to discounting the obvious land mines, still leaving huge risks of state and municipal implosions and more bank failures. For those reasons we need to stay protected, although probably not more than 50% from here, and we need to be selling call premium aggressively at these levels. I still think that the surprise might be to the upside, even if it is only a bear market rally, so we are leaving some room to the upside in the calls we choose to sell. For those interested in buying stocks or indices at these levels, you should certainly consider doing covered straddle or strangle writes with one half of the originally intended stock amount, taking advantage even more of the inflated volatilities. We will also keep our clients apprised, like Dave’s investment ideas e-mail last week, in what is going on in the fixed income areas.