Failure to Communicate

So after looking at last year’s big failures, what’s next?

Informal analysis puts about 500 banks on the FDIC’s “Problem Bank List.” That number has been trending up, but it’s interesting to look at the regional differences.

It’s no surprise that the Northeast has been relatively unscathed by the financial crisis. Only 12 small New England banks are under various “agreements” with their regulators. It’s also no shocker that there are 41 banks in trouble in California. And, with 16.2% unemployment, seeing a couple of fairly large Puerto Rico banks in trouble should astonish no one.

But it is a little surprising to see that over 30 Minnesota banks are in trouble. I thought that all the home values up there were above average. And Nevada, with perpetually falling real estate values, only has 3 problem banks. Go figure.

But even with a list of problem banks, it helps to remember that bank failures and bankruptcies are lagging indicators. Now that real estate has stabilized around most of the country, these banks know pretty well how much capital they need to remain solvent. If they can raise it, either through earnings or investment, they’ll stick around. If not, the Feds will arrange a marriage, like they did last year with WaMu.

In any case, resolving problem banks is part of the recovery process. While there are always some surprises, I expect that the banking business, like the rest of the economy should be stabilizing soon.

Douglas R. Tengdin, CFA
Chief Investment Officer
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How Soon We Forget

A year ago, we were shell-shocked.

Fannie and Freddie were in receivership. Lehman had filed for bankruptcy. AIG needed an $85 billion lifeline. And Washington Mutual, the country’s biggest Savings-and-Loan, was acquired by JP Morgan for pennies, wiping out its stock and bond holders.

Is there any wonder that the market declined 20%?

It’s interesting to look at why WaMu failed. It appears that reckless lending and a couple of deposit runs doomed the bank. But the most curious aspect is the “end-game.” On September 8th, WaMu hired a new CEO to try to sell the bank. He was told by the FDIC that he had until the end of the month to find a buyer. Initially, several big banks were interested. After two frenzied weeks, though, they suddenly stopped looking. On the 25th the regulators seized the bank and announced a pre-packaged deal with JP Morgan.

The Feds must have arranged things with JP Morgan ahead of time. Did word of the impending seizure leak out and scotch any potential non-bankruptcy sale? For WaMu’s investors, the question isn’t trivial. About $15 billion in debt and equity was wiped out.

This may be a case of “loose lips sink ships.” But it’s useful to understand that when billions hang in the balance, it’s not healthy to trust your financial fate to a faceless bureaucrat. I know. I’ve been one.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Intended Consequences

In the middle of a recovery, in comes F-Troop!

The gist of the ‘60s sitcom was that nothing was too certain for those dopey Feds to mess it up. Whether it was a new peace treaty or a new railroad, Captain Parmenter and Sergeant O’Rourke were fully capable of fouling up the works.

So just as the banks are beginning to show signs of life and lending, in comes Senator Dodd with his proposal to freeze credit card rates. He says that his is proposing the freeze because banks are using the delayed implementation of new credit rules passed in May to push through rate and fee increases.

Well, this is a competitive market, isn’t it? Many people still receive so many card solicitations that they could heat their homes with them in the winter. Since new rules were enacted, banks have selectively increased rates imposed new fees. People have been free to cut up those cards if they wanted to.

We can script out what will happen if Dodd’s rate-freeze goes into effect. Banks will dramatically cut back on credit card loans. After credit is curtailed, we’ll hear story after story about how consumers lost their cars, homes, and businesses because they couldn’t get credit. Congress will mount an investigation. But will it ever point to itself? I don’t think so.

I know Dodd is facing a tough opponent in next year’s election and his reputation as the “Senator from Fannie Mae” isn’t working very well right now. But if Congress is the least bit rational, this bill will never see the light of day.

But what are the odds on that?

Douglas R. Tengdin, CFA
Chief Investment Officer
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Bubblenomics

Are we in a new bubble?

That’s the question today. As stock prices make record-setting gains after falling record-setting amounts, some wonder whether a new bubble is in the works. To answer this, it helps to understand what it takes to form a bubble.

First, you need to have a new technology that seems to “change the game” in a major way. Second, the new way needs to displace the old way and lead some to conclude that “it’s different this time” and that old analytical rules no longer apply. Finally, a broad swath of investors need to jump in, enticed by rising asset values and the prospect of easy leveraged riches. Both the internet and the housing markets went through these steps.

So, are any bubbles forming now?

Stocks certainly aren’t in a bubble. Too many people are too skeptical. Ditto for real-estate. Bonds? Please. Sure interest rates are low. But most folks expect rates to go up, not prices.

But how about Gold? Gold prices have recently spiked, and many gold investors are saying that the economic slack that might prevent inflation doesn’t apply this time. Most remain skeptical, however. For there to be a real bubble, you need a general mania.

Financial bubbles are highly destructive and hazardous to everyone’s economic health. While it pays to be vigilant, it doesn’t look like we’lll see one any time soon.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The King is a Fink

Well, he ought to know.

Larry Fink, CEO of Blackrock, says that a slew of money managers will put themselves up for sale rather than pay to meet new fiduciary standards. The head of the $2.7 trillion asset manager was speaking to a group of fellow predators—er, large money managers—and he noted that mid-sized firms will be subject to greater scrutiny from the SEC. He thinks it won’t be adequate to depend on broker-produced research.

So, he expects that they will either have to develop their own research or sell out to bigger firms. In either case, the smaller firm is crippled—either by excessive costs or by an overbearing parent. Mr. Fink is famous for his blistering attacks.

But this is a false choice. Instead of selling out, why couldn’t smaller firms pool their resources to form a joint research team. For that matter, what’s to stop an enterprising analyst from opening her own research shop and selling her reports? Using truly independent analysis would surely satisfy fiduciary duties, and might not be all that expensive.

My suspicion is that Mr. Fink is “talking his book”—discussing the possibilities of nabbing some rivals on the cheap. Mr. Fink’s share in his firm amounts to over $300 million, but he’s not beyond augmenting his empire through a little jawboning.

Hey, we’d all like to build our businesses with a little help from our friends in Washington. But given the issues large managers face—intractable conflicts, control issues, turnover—it makes sense for Mr. Fink to temper his comments.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Predicting the Past

Your mind can deceive you.

That’s one old lesson from the new emphasis on brain science and investing. For example, two-in-a-row of anything tends to make us expect a third. We may not admit this expectation to ourselves, but it is real, automatic, and uncontrollable. Our belief that the recent past will be repeated informs most of our actions—from where we plan to see a police car on the way home to what we think the stock market is going to do next month.

Which brings us to the current market. There are plenty of studies comparing the current market to 1974, or 1929, or 1492, or whatever. The problems is, the Arab Oil Embargo or Tech Crash or discovery of Peruvian Silver has little to do with the latest financial panic brought on by a housing boom-and-bust cycle. Our current problems are unique. And while human nature never changes, the winners and losers that arise from this market will be different. Or not.

Every situation is unique. That’s the risk in “risk-and-reward.” But residual claims on cash-flow see the greatest upside from growth. That’s the reward. Carefully balancing risk and reward is the job of portfolio manager. And no amount of tea-leaf reading can substitute for solid fundamental analysis and rigorous testing. That’s the way to make portfolios grow.

What’s the market going to do next month? Beats me. But I know that well-managed companies with solid business plans will pay their debts and provide returns for their shareholders. And that’s not just in your mind.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Trading Places

Is trade an unvarnished good?

Before the financial crisis, we were frequently offered humorous pictures of anti-trade militants protesting a World Trade Organization meeting. They were reportedly concerned that global trade would wreak havoc with indigenous cultures and exploit vulnerable populations.

While some could see their point, it was usually undercut by the simple fact that none of these activists were looking to move in with the indigenous peoples they were so enamored of or avail themselves of indigenous health care.

The logic of trade seems simple: when everyone does what he or she does best, and we trade our goods and services to get what we need, we’re all better off. This is as true for countries as it is for individuals.

So when global trade began to contract in early 2008, that was troubling. When it fell off a cliff last fall, its decline was consistent with the rest of the economy. But now it’s stabilized—at about the same level it was in mid-2006. That’s not a great leap backwards; that’s a minor hiccup on the road to greater prosperity.

Some think we’re headed for a world of de-globalization where Luddite loonies call the policy shots and the benefits of trade are lost. But the data seem to show that global trade is coming back. One of the striking things about this recession has been the lack of any significant protectionism. The revival of trade growth is just one more sign that the global recession is over.

Douglas R. Tengdin, CFA
Chief Investment Officer
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In Banks We Trust

This is Doug Tengdin from Charter Trust

Whither the banks?

As our historic financial panic settles out, what is the likely future of bank regulation?

Clearly, we are not going back to the status quo. A hostile Congress and trillions in bailouts guarantee that. But what is the reform going to be? A Financial Consumer Protection Agency and that’s it? A mandate to break up the big banks?

My expectation is that a complicated formula will essentially require more capital as banks get bigger. The higher capital requirements will penalize size, because the larger an institution is in the current marketplace, the more likely it is to be tied up with the global payments system and thus involved with too-big-to-fail projects.

Many people would prefer a simpler system, but I suspect that the rules-writers will justify their positions by rating assets in terms of risk level. There will also be an expanded view of assets with various risk ratings, but less emphasis on credit ratings than before.

It’s clear that regulatory failures played a big part in the financial crisis and its aftermath. Many times regulators saw that banks were overexposed to one asset type or another, but were intimidated into backing off. Well those days are over. It’s clear that combined with some sort of expanded insurance, systemically important firms will face tough examinations and significant capital requirements.

Which leaves us with a question: In the past, bigger was better. Will it now be that small is beautiful?

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Wedge

What are taxes, anyway?

Governments have to collect taxes to pay for their services. They also collect taxes to encourage or discourage various activities. For example, the mortgage interest deduction and homestead property tax exemption are designed to encourage people to own their own homes. Our governments have tax policies that affect our actions.

But taxes also act as a wedge between economic actors, distorting prices and changing behavior in unforeseen ways. For example, a tax on luxury goods has the effect of increasing the price to the consumer (depressing demand) while decreasing the price received by the producer (depressing supply). With lower demand and lower supply, the price stays the same, but less is sold. So governments never get as much in tax revenue as they expect.

When you look for them, there are tax wedges everywhere. Social security taxes are a wedge between workers and their employers. Income taxes create a wedge between the value of someone’s labor and what she receives. Capital gain and dividend taxes are a wedge between what investors earn and how much an investment returns.

The larger the rate, the bigger the wedge. That’s why many see that having a broad tax base and low tax rates as the most effective way to raise money for the government. A lower rate distorts the economy less and provides less drag.

Which raises a question: can you think of a tax that’s not a wedge? I can. I don’t like it. But it may just be the best way to go.

Douglas R. Tengdin, CFA
Chief Investment Officer
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JP More!

Was it all just a bad dream?

With the Dow hitting 10 thousand and many stocks at one-year highs, was last year’s market panic just a piece of underdone potato?

That’s the way it feels as we watch the market climb ever higher. Credit spreads have come in and global markets go up. Yesterday’s big news was from JP Morgan. Even though they bought Wamu’s bad loans last year, they reported earnings higher than any time since before the recession. Interestingly, their investment bank earned as much as the rest of the bank put together.

So what does this tell us about the economy? Clearly, we’re not in the “winter of discontent” any more. Those folks who advocated nationalizing the four major US banks should be reexamining their premises. Some big banks—notably Citi—have ongoing troubles. But all their investment arms are capitalizing on a deal-making boom.

So while problems relating to the consumer haven’t disappeared, investors are voting with their wallets and expect a solid recovery. There are enormous opportunities out there as energy, industrials, financials, and healthcare companies restructure for new markets. While unemployment is high, the leading elements of our economy continue to surge.

What this means is that banks that focus on transactions will probably continue to do well. While the road ahead may have some bumps, it looks like we’re still in a financial economy.

Douglas R. Tengdin, CFA
Chief Investment Officer
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