Government solutions disintegrate

In a dramatic turn of events, the wheels came off the government "bailout" plan today when the House of Representatives defeated the proposed legislation by a vote of 228 (nay) to 205 (yea).

While the government is temporarily unable to address the situation, the private sector has been busy recapitalizing the banks in its own free-market way: stronger banks are looking at the assets of weaker banks and other financial institutions and buying them up -- often at very attractive prices!

Could it be that the free market will be able to accomplish what the government cannot?

The Wall Street Journal ran a timely opinion piece by Gordon Crovitz this morning (before the legislation fell apart) entitled "Calling J.P. Morgan," noting that in the Panic of 1907 the capitalist titan called the nation's top bankers into his library, opened their balance sheets, and in an all-night session, "decided which financial institutions had to go and which would live."

Something similar has been taking place over the past weeks and months.

Not mentioned in the Journal's article is the fact that many politicians were so shocked that the resolution to the crisis had been accomplished by a lone capitalist outside of the halls of government that they began working to ensure that it would never happen again. Morgan's legendary meeting was the impetus for those who argued for the creation of a Federal Reserve Bank.

We have argued that the current crisis was not caused by free enterprise (as many are asserting) but rather by government (starting with Fannie Mae, Freddie Mac, Congressional legislation such as the CRA, and the Federal Reserve itself, among other players -- including many of those Congressmen pretending the most outrage now).

The biggest concern now is that as a result of the dramatic events currently unfolding, government will become even more emboldened to interfere with the free-market system, just as they did after 1907.

For later posts dealing with the same topic, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Big news on mark-to-market accounting" 03/13/2009.

• "What Rube Goldberg could teach us about economics" 12/08/2009.

• "The end of 2009" 12/30/2009.

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An important distinction

Last week was a week of enormous consequence in the financial world. The events were so dramatic that they will be analyzed, discussed and debated literally for decades. It is no exaggeration to say that Wall Street as we knew it is no more, with the news today that Morgan Stanley and Goldman Sachs agreed last night to be converted into traditional bank holding companies.*

Across America and indeed the world, last week's turmoil is being seen as final proof that we really are in the greatest disaster since the Great Depression.

But there is a very important distinction to be made between the crisis on Wall Street and the economy at large.

This distinction is one that most observers are overlooking. They are tending to "conflate" or blend together the situation on Wall Street, where one venerable firm after another fell like dominoes last week, and the situation in the economy in general. They are not one and the same and should not be confused with one another.

It was not weakness in the broader economy that caused real estate related assets on the balance sheets of firms to plummet in value. Yes, there have been loan defaults and home foreclosures, particularly on loans that clearly were irresponsible. But the rate of foreclosure and default did not jump off the charts and drive Wall Street into bankruptcy. The latest data from the Mortgage Bankers Association shows the current foreclosure rate at 2.75% (up 1.35% from a year before) and the delinquency rate at 6.41% (up 1.29% from a year before). It should be noted that in the Great Depression the delinquency rate for homes which had a first mortgage was 43.8% (in 1934) and for homes with a second or a third mortgage the rate was 54.4%, according to statistics reported in the Federal Reserve Bank of St. Louis Review for May/June 2008.

The main catalyst for the financial meltdown, which has been brewing for over a year, was the effect mark-to-market accounting had on the balance sheets, credit ratings, and borrowing capabilities of financial firms, as we pointed out in a previous post. Economist Brian Wesbury uses a great analogy in his outlook for this week, in which he asks you to imagine that your neighbor has to sell his home under exigent circumstances at a fire-sale price, and because of that your banker declares that you must now mark your own home's value to the "new market" and that you must immediately give the bank $80,000 in new capital in order to keep yourself at the loan-to-value percentage set by the bank.

But that is a Wall Street problem, and although it is true that the financial sector impacts every other business that uses financial instruments (such as currency and credit cards and money market funds and bank accounts), it does not mean that the economy is in the same state of affairs. Most businesses not in the financial industry are not impacted by these specific mark-to-market rules, because businesses outside of the financial sector do not generally need to "borrow short and lend long" as part of their business model.

It may be hard to believe, but the true situation is that the underlying economy is actually solid. We have been saying that for months, and the numbers continue to bear it out. Recently, the Bureau of Labor Statistics released revised productivity data for the second quarter of 2008 which determined that non-farm productivity increased at an annual rate of 4.3% sequentially and 3.4% year-over-year.

Productivity is one of the most important economic measurements there is, although this healthy productivity number did not get much media attention this month. In a 2003 speech, Federal Reserve official Cathy Minehan noted that "rising standards of living are almost solely a function of productivity growth."

The fact that productivity is currently increasing at 3.4% is significant. From 1947 through 1986, for example, productivity grew at an average annual rate of 2.3%.

You won't hear too many commentators in the media explaining to you that, based on numbers such as corporate earnings, GDP, and productivity, it is reasonable to believe that the economy is fundamentally sound, despite the financial sector turmoil. But that is because very few of them are aware of the important distinction between the situation on Wall Street and the economy at large.

* The principals of Taylor Frigon Capital Management do not own securities issued by Morgan Stanley (MS), Goldman Sachs (GS), AIG (AIG) or Lehman Brothers (LEH).


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This week is not an indictment of free markets

Around the world, proponents of greater government control of economic activity are arguing that the emergency measures taken by the Treasury and the Fed this week, and the financial-sector turmoil which led to them, repudiate the credibility of the market economy.

For example, in this article from the New York Times this week, French lawmaker Bernard Carayon is quoted as saying that for "evangelists of the free market, this is a painful lesson."

Former EU antitrust commissioner Mario Monti is quoted as saying that critics can now say "that even the standard-bearer of the market economy, the United States, negates its fundamental principals in its behavior."

The tendency to frame the financial-sector's problems as a case of free markets vs. government control is widespread in the media reporting of the events of the past two weeks.

For example, an NPR story from today is titled "Do Federal moves take us back to the New Deal?" In it, Clinton-era Treasury Secretary Larry Summers is quoted as saying that the idea that the government should "stand back and let the private sector sort these problems out" is "the kind of thinking that made the Depression 'Great'."

Elsewhere, an interview on the CNBC "Stock Blog" from early Thursday, before the huge rally that accompanied the first indications of a comprehensive Treasury plan to take over troubled mortgage assets, was posted under the sensationalistic title "Is This The Death of Capitalism?!"

The important point to keep clearly in mind during this week's dramatic culmination of a situation that has been building for years is the very clear role that interference with free market principles played in creating the problem.

This interference took several forms, and we and many others have pointed out these forms several times over the past months. One of the most important of them was the creation of an unprecedented amount of easy money by the Federal Reserve under Alan Greenspan, which we outline in detail in "The long shadow of the Y2K bug" as well as in earlier posts that are referenced in that piece.

Another critical but little-understood contribution was the change in accounting rules to a system known as Fair Value Accounting, which took place in the early 1990s. We pointed out how serious this problem was in a blog post on March 14, prior to the collapse of Bear Stearns.

In it, we noted that assets with real value, paying real interest, were being valued as though they were virtually worthless, because the market for those assets had frozen up. That isn't a drawback to the free market: if nobody wants to pay what you think something is worth, then in a free market you can simply decide not to sell until demand for your item returns to a level you agree with.

However, due to well-intentioned accounting changes enacted in 1991, financial firms can have a very serious problem in such a situation, because they are now forced to mark those assets to the market, even if the market has temporarily gone away. This phenomenon can easily turn into a vicious cycle, and it is exactly what happened to the financial titans that now lie in ruins after the events of the past seven days.

Two recent articles in the Wall Street Journal detail the role of this accounting regulation in the financial sector's crisis. The first is "Bad Accounting Rules Helped Sink AIG" and the second is "How to Save the Financial System."

We are not suggesting that the actions of the Federal Reserve or the decision to force mark-to-market valuation of financial assets were motivated by anything besides good intentions -- they were clearly well-intentioned efforts to respond to crises that were pressing at the time. But that is exactly the point a free-market economist would make: well-intentioned government intervention often seems like a good idea, but ends up leading to unintended consequences. Some of those consequences can turn out to be catastrophic.

The earth-shaking events of this week are not an indictment of free-markets -- they are an indictment of intervention. However, that is not the interpretation you are likely to hear from most observers.

For later posts on this same topic, see also:

• "Guide the market's invisible hand with a higher principle?" 02/26/2009.

• "How your view of 2008-2009 impacts your understanding of today's big events" 02/03/2010.

• "Great minds think alike!" 03/19/2010.

• "The political winds are swirling" 09/15/2010.

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Don't jump off the ship in the middle of a hurricane

Here are two revealing diagrams, one which we posted back in January showing the three successive market lows during the bear market of 2000-2002, and one which is beginning to look very similar to it from today.

In the first diagram, we marked with red arrows the three successive sharp bottoms, each lower than the one before, which look like someone took an axe and whacked the market three times, each one harder than the last.

As we pointed out back in January, long before the market downturn had become an official bear market, "this type of diving three or even more times as the market tests for the final bottom is not unique to the chart above -- you can see it in other significant corrections, for example between the dates of January 1, 1981 and December 31, 1982."

After the final bottom in October 2002, the stock market rallied strongly in the first quarter of 2003, although many investors were so shell-shocked from the effects of that bear market that they missed that significant move. We know that many investors missed it because the historical data (which we also presented in that January post) show successively larger investor inflows into bonds and out of stocks during those successive "axe blows":








The similarities to today's situation are striking. Yesterday, for example, the amount of money flowing into three-month Treasury bills was so large that some investors were bidding for the bills at almost 0%. Much of the frantic buying was a result of fear that money market funds and other cash instruments would not be safe, leading to a rush to buy a bill that would pay no interest but was sure to be paid back.

From a portfolio manager's perspective, the important thing to remember in the current storm is to remain centered and not panic. We have already recommended that investors not hold large amounts in bank CDs or savings account, which we discussed in our post entitled "The bond market rules the world." Money market accounts may temporarily see some turmoil, but they are still diversified and a better alternative for cash, and they pay dividends.

Additionally, as the comparison of the current market chart above to the market chart from 2001-2002 shows, we appear to be heading into a situation which looks similar to the market bottom of October 2002. It is a fact of history that when the upward movements finally take place, they are so rapid that it is very hard to catch them unless you are prepared in advance. It is fairly widely known that a 1994 study found that 95% of the stock market gains between 1963 and 1993 occurred on just 1.2% of the trading days.

As we have pointed out in a series of in-depth examinations of the ramifications of years of Dalbar studies, ample evidence supports the conclusion that "investors make most mistakes after downturns." It is easy to conceptualize the idea of not jumping off the ship in the middle of the hurricane, and yet that is what a large percentage of investors do time and again.

Baron Rothschild is credited with the expression "The time to buy is when there's blood in the streets." It is easy enough to say that when things are going well, but you have to be in the kind of environment we are currently experiencing to absorb the full impact of that idea. The late John Templeton was known for his philosophy of investing at "the point of maximum pessimism." And the famous money manager Peter Lynch has written that "In many ways, the key organ for investing is the stomach, not the brain."

These are important truths to remember during weeks such as this one. Our view is that the financial system is undergoing a serious challenge, but that the overall economy is nowhere near as bad as it is being portrayed, and that investors should not confuse the two. Finally, we have stated many times our philosophy that it is dangerous to try to time economic and market cycles, and that it is much wiser to follow a disciplined investment process which is based on ownership of well-run businesses in front of fertile fields of growth.


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For later posts on this same subject, see also:

• "Be centered, be still -- 2011" 03/17/2011.

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The Fed shows some backbone

Yesterday, the Federal Open Market Committee voted unanimously to hold their target funds rate unchanged at 2.00%.

Wall Street was urgently calling for yet another rate cut. Fed futures in the days leading up to yesterday's decision indicated a climbing percentage of bets that the rate would be cut by .25%, with an 88% probability indicated the day before the Fed's meeting. Many futures participants were even betting for a .50% rate cut.

Such a rate cut would have been in keeping with the volatile Fed policy that came to characterize the final years of the Greenspan Fed, as we have explained in greater detail in our August 22 posting, "The long shadow of the Y2K bug."

The howls of protest from some market pundits typifies the old Wall Street view that the Fed should jump to lower rates whenever it would serve their short-term interest.

That unhealthy pattern of giving Wall Street emergency cuts led directly to the severe turmoil wracking Wall Street this week -- events which have in fact just altered Wall Street as we have known it and probably ended the era of the big independent investment banks.

In light of that, it is a very positive sign that the Fed stood up to the demands for rate cuts and stood firm rather than cutting again.

The emergency cuts that started a year ago have not staved off the crisis that has engulfed AIG, Lehman, and others.* On the other hand, they have led to dramatically higher prices for businesses and consumers.

The CPI numbers continue to rise at an unacceptable rate. This week, the Bureau of Labor Statistics released August CPI data showing an increase of 5.4% over the index from a year ago. Many observers are acting as though the inflation threat has subsided, since the number shows a deceleration, mainly because gasoline prices came down significantly during the month of August, although the BLS report points out that gas prices are still up 35.6% from their August 2007 level.

But the "core" CPI, which excludes food and energy, is not only increasing but accelerating in its rate of increase. It's ironic that when the headline inflation number was going up more rapidly due to rising oil prices, inflation doves were pointing to the core CPI number that factors out food and energy. Now that the headline number is down but the core number is accelerating, the same voices are pointing to the headline number and ingnoring the core number!

In sum, the Fed did the right thing by refusing to lower rates again.

As for the rescue of AIG by the Federal Reserve late Tuesday, we are less enthusiastic. We can only point out that back in May we used that company in a post as a negative example in our discussion of why any doubts about the capability of the management of a company is a reason to avoid investment in the securities of that company.

* The principals of Taylor Frigon Capital Management do not own securities issued by AIG (AIG) or Lehman Brothers (LEH).


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