What I've Been Reading 9/26/08

The proposed Wall Street bailout has descended into chaos.

Lawmakers bickered over competing counterproposals and hours of meetings between key lawmakers broke down without any progress late into the evening.

Washington Mutual has been seized by federal regulators, its operations sold to JP Morgan.

Regulators, who termed WaMu’s failure as the largest U.S. bank failure ever, say there will be no effect on the bank’s depositors, but it appeared the WaMu shareholders would be wiped out as a result of the deal.

MSN's Smart Spending blog finds a silver lining in all of this.

The bus has gotten very crowded lately. This time last year, I could easily get a seat of my own on the 75. Now I'm lucky to be able to sit down at all.

Economic Bailout: A Tough Sell on Capitol Hill

The news has been dominated by the government's proposed economic bailout of Wall Street: John McCain may even bow out of Friday night's Presidential debate because of it. The video above goes into some detail about what the debate in Congress is focusing on.

Last night President Bush addressed the nation.

"I understand the frustration of responsible Americans who pay their mortgage on time, file their tax returns every April 15 and are reluctant to pay the excess costs on Wall Street," he said. But, he added, "given the situation we're facing, not passing a bill now would cost these Americans much more later."

According to CNN:

By investing taxpayer money in assets with underlying value, even if the market isn't yet sure what that value is currently, the government may make "much, if not all" of the money back when it resells the assets after the markets return to normal, Bush said.

What do you think? Will the government (and, by extension, the taxpayers) wind up making this money back? If the government does make this money back will any of that be given back to the taxpayers in the form of some sort of economic stimulus package?

Robert Scoble (aka Scobleizer) at MoneyAisle

Yesterday, MoneyAisle HQ was visited by blogger Robert Scoble, of Scobleizer and Fast Company TV. Mukesh and some of the engineers here showed Robert and his video crew our live auctions for High-Yield Savings and CD rates, and Robert filmed the visit for an upcoming segment on Fast Company TV.

That segment (recorded with fancy camera equipment) will be up soon, we're told. But, immediately following the visit, Robert posted the preceding video to his FriendFeed, which he shot with his Nokia video phone, and is also pretty cool. We thought we'd share it with all of you - a behind-the-scenes taste of things to come.

Unprecedented Financial Turmoil: How Did It Happen?

First of all, let me apologize for this long post. However, I wanted to summarize the reasons behind the unprecedented financial turmoil the U.S. is facing, resulting in a loss of faith in many financial institutions and a mad dash to safer investments by consumers.

Something extraordinary happened this past Friday - extraordinary even by the standards of last week, with the markets fumbling and the doomsday scenario probability going up from "about as likely to find a live dinosaur" to something far more feasible.

Even among all this turmoil, the governmental intervention to suspend short-selling on nearly 800 financial stocks (including commercial banks and investment banks) stood out rather dramatically. This intervention has raised very fundamental questions about the limits on trust placed in free markets under extreme conditions. I cannot recall such uncertainty in the financial markets in my lifetime.

Why did this happen?

Imagine for a moment that IBM's stock went down 90%, GE were to lose 95% of its value, and Wal-Mart, GM and Ford were about to go into bankruptcy. I don't think that even in this circumstance we would see the current level of government intervention to rescue those companies. The irony is that IBM, GE, Wal-Mart, GM, and Ford are much larger and employ far more people than the companies who did get the government bailout - the top three or four investment banking firms in the country.

My hypothetical loss of GE, IBM, Wal-Mart, GM, and Ford would have relatively benign consequences compared to the top investment banking firms going under. The key difference is that the investment banks have underwritten trillions of dollars of an exotic derivative known as Credit Default Swap (CDS) and none of them has the corresponding requisite capital reserves, nor are they required to have them according to regulations. This has been an incredibly lucrative business for years for the firms and their executives due to a minuscule default rate – until a year ago.

Then the Sub-prime mortgage crisis changed everything; rapidly rising mortgage defaults abruptly crashed the wild party. Investment banking firms are now on the hook to pay hundreds of billions of dollars against the Credit Default Swap related to mortgage-backed securities, and they have no money at hand. Their downfall does not have much to do with short-sellers; simple math shows that these firms have no option - none - but to default on their commitments to pay, providing an unprecedented opportunity for short-sellers to benefit.

On the other hand, the Fed knows that not only would these banks would go under for their inability to pay the CDS buyers for doomed mortgage-backed securities; the collateral damage would be catastrophic. Its not only the mortgage-related CDSs, but others ones, as well, which would have become worthless, resulting in massive losses at an unimagined scale to the investors, insurance companies, and so on. This certainly would have caused a complete financial meltdown in the country and very likely in the rest of the world.

So, when faced with this epic battle between the heart and the mind – a strong belief in the free market philosophy challenged by its inherent contradictions at the extreme end - the Fed sacrificed the philosophy and suspended the short-selling. It also announced formation of a government owned debt holding company; Resolution Trust Corporation (RTC). These two actions, I believe, are integrally tied, the defaulting assets forcing the CDS payments will be moved to the RTC – thus shifting the entire liability from banks to the taxpayers. I think the plan must be to accomplish this in 30 days, then with the dead weight around their neck removed, these investment banks would get a second life (It’s almost surreal that the second life is more real than a first death!) with no current liability requiring immediate payment. Then the short-sellers will have no reason to short these stocks - hence the suspension for 30 days.

So my question is what would you do if you were Hank Paulson or Ben Bernanke? I realize there is an incredible amount of outrage we share, the ideologues among us insist that the banks and their incredibly well-paid executives are responsible for their own actions and if, in the process, they go under, then so be it. That is what the free market is all about.

When faced with a monumental choice - a certain death of the free market and the consequences (closed factories and businesses at a scale never seen before, lost lifelong savings, a wiping out of 401K and resulting unemployment that would dwarf every single depression seen so far) or alternatively accept a deep yet likely curable wound, that will enable the economy to live for another day? It’s not fair to have to make these choices, yet one has to decide, so the multi-trillion dollar-question is:

Which one do you choose?

Money Market Funds Break the Buck

Today's Boston Globe has a good article, Money Market Funds Battered, which goes into some detail about how the recent economic activity in this country is affecting money market accounts.

The Reserve Primary Fund, a pioneer of money market funds, was the first this week to announce it had reduced the value of its shares to below $1. The fund cut its share value by 3 cents to 97 cents, which means a loss for investors, unthinkable for funds that were long regarded as safe havens. Only once before, in 1994, did a money market fund "break the buck," as the industry calls it.

What this means, essentially, is that for every dollar you have invested in a money market fund right now, you're only getting credit for 97 cents of that dollar. It's like earning reverse interest.
One person quoted in the article, 27-year-old Gokmen Kilincarslan, went so far as to transfer his money out of his money market account and into a bank savings account.

If this trend continues, I can see several consumers opting for safer investments (it's amazing that right now money market accounts, which once were considered "safe investments", is even a part of this conversation!) such as CDs or High-Yield Savings accounts.

What do you think? Is this a blip on the financial radar or a sign of worse things to come. Regardless, keeping some of your money in an airtight FDIC-insured account would seem to be one of the best ways to weather this current storm.

Bank of America and Merrill Lynch: A Season of Shotgun Marriages

First it was Bear Stearns and JP Morgan, then Bristol Palin and Levi. Now it's Bank of America and Merrill Lynch. I hope these mergers are just a blip on the radar, not a growing trend.

There was a time when banks were separated from investment banks, until Phil Gramm changed it all by removing that barrier, which kept us safe for decades. The allergic reaction some politicians have to regulation would be almost funny, so long as one can ignore the consequences. There is a reason why folks with a seriously infectious disease are cordoned off – so as not to spread the contagion. Thank God that these anti-regulation zealots (powered by lobbyists) did not concern themselves with that too, otherwise we would have yet another issue to worry about.
Sure, there is no question that too much regulation is bad and constrains growth. However, segmentation of markets and some separation also creates a barrier so that a contagion cannot spread rapidly. Now we have a situation in which banks, investment banks, insurance companies - the foundation of our financial system - are all shaking in their boots in sync, rather than taking the load of those in distress.

Someone told me the other day that if only lobbyists were allowed to vote in elections, then Phil Gramm would be elected by a landslide for life. The time has come to turn the clock back to more sensible policies, and bring back some of the separations between banks and investment banks. This shotgun marriage between Merrill and Bank of America may cause more damage in the long term.

I'd love to hear your thoughts on this issue.

Lehman, Merrill Lynch, AIG: A Crisis of Confidence

Until very recently, Lehman (NYSE:LEH) was insisting that they were doing fine and had sufficient reserves. Clearly, they were way off base. There were countless analysts reviewing their financial reports in excruciating detail and, unfortunately, all that collective wisdom and experience was largely unable to dispute it. Similar situations occurred with Merrill Lynch (NYSE:MER) and AIG (NYSE:AIG). I wonder why?

There is something fundamentally wrong with how the financial statements are prepared and the disclosures made to the investors at large. The same thing happened at Bear Stearns, Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), etc. First, there is a strong denial of any capital shortage issues, followed by a blessing from the Federal Reserve that they are fine, which is then followed by the Wall Street massacre, in which average investors and employees lost their life savings (not to mention cascading effects.) These are not private companies; their financials are supposed to give us a good window into what is happening. I wonder, how is it possible that they go up in smoke so quickly, despite all the analysis? Did the executives themselves not know? Why was the Fed unable to figure out the actual financial status, with all the top-notch economists at their disposal?

My fear is that the financial reporting system and the requisite disclosures in place for these firms is misdirected, and far short of what is needed. It tells us everything, except what we really need to know: how much risk exposure is there?

There has to be a process in place to allow a strong visibility into the risk exposure, in order to restore the shattered investor confidence. This has to occur sooner rather than later, or we risk another financial blood bath.

I would love to hear your thoughts on this matter.

The Credit Default Swap (CDS): Are Taxpayers Ultimately Responsible?

One of our recent blog comments asked my opinion on Credit Default Swaps (CDSs) in relation to the recent Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM) takeover. I felt this issue merited its own blog entry.

First, a definition. From Investopedia:

Credit Default Swap (CDS): A swap designed to transfer the credit exposure of fixed income products between parties.

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

My personal take is that this situation is not as benign as it appears on the surface. While the takeover does benefit the mortgage holder, the real beneficiaries are hidden. Only about a dozen investment firms sell a large majority of CDSs, totaling around $62 Trillion dollars. If Fannie and Freddie's debt obligations were allowed to default, then these investment banking firms would be severely exposed, potentially making the firms responsible for an avalanche of payments. These payments could be worth hundreds of billions (or even trillions) of dollars for investment banking firms, such as Lehman Brothers Holdings Inc. (NYSE:LEH), JP Morgan Chase & Co (NYSE:JPM), Morgan Stanley (NYSE: MS), and Merrill Lynch & Co Inc (NYSE: MER).

The problem with this is: these investment banks don't have that kind of money - combine this with the cascading effect on hedge funds, not to mention the insurance companies covering the investment banking firms and the entire system could blow apart!

The tragedy of the situation emanates from the fact that one does not have to own the bonds in order to buy CDSs, resulting in an uncontrolled level of such derivatives, with no correspondingly sufficient reserves to support them. Yet because this situation is highly lucrative for investment banking firms it's allowed to continue. There is still no visibility or transparency regarding the amount of CDSs which have been underwritten by a a particular banking firm, or what the corresponding reserves against the CDSs are. The amounts are unknown, and lack visibility, permitting unconstrained CDS growth. One could make a parallel to the black holes people are fearful the Large Hadron Collider is going to create!

The consequence of this lack of regulation is that we're all left footing the bill for the CDS payment exposure, yet all the profit goes to the investment banking firms. In the end, it's the taxpayers - it's always the taxpayers - who are left to cover all the losses in the fall of Fannie Mae, Freddie Mac, Bear Stearns, and the rest - companies which would have gone under in a free market, but are being kept alive by these government interventions.

As if this wasn't enough, the top five banking firms doled out nearly $37 Billion in bonuses earlier in the year to their executives! I wonder if these bonuses were handed out to saddle us taxpayers with hundreds of billions of dollars in liability?

Is this fair? I would love to hear your thoughts on the matter.

Freddie Mac's CEO and How to Fix Executive Compensation

Dick Syron, former CEO of Freddie Mac (NYSE: FRE), collected $38 Million for "running the ship into the ground", and in the process lost more than $50 Billion of the shareholders' value. The shareholders included not only regular investors, but also banks and other financial institutions. The resulting cascading effect from the shareholders' loss sent tremors all over the world. Here is Syron's quote on the collapse: "If I had better foresight, maybe I could have improved things a little bit. But, frankly, if I had perfect foresight, I would never have taken this job in the first place."

I wonder how many shareholders are thinking along those same lines, using their "perfect foresight" to not have hired Syron in the first place. There is a fundamental problem with executive compensation in corporate America. When the company does well (clearly, in spite of a self-admitted lack of foresight), the executives enrich themselves like there's no tomorrow. When the company tanks, it is the taxpayers and the shareholders who are left holding the bag. This pattern repeats itself time after time: Merrill Lynch (NYSE: MER), Fannie Mae (NYSE: FNM), Freddie Mac, Bear Stearns, Citi (NYSE: C), Home Depot (NYSE:HD), the list goes on….

If the IRS can go back and audit your taxes for the past three years, how about an audit of corporate compensation! Say, if the stock falls below a pre-determined value the excessive compensation beyond basic wages has to be returned (or, even better, is kept in an escrow account and not released until 3 years later!)

Another possibility is to keep a dollar-weighted average of the stock price for three years while the executive is still employed with the company and only in the 4th year will the executive collect the bonus for the first year based on the average performance of past three years, then in the 5th year he or she collects the bonus for the average performance of year 2, 3 and 4 on the job, and so on. This will allow for long-term decision-making instead of short-term personal gains and align the interests of stockholders with those of the executives.

What do you think?

Fannie Mae and Freddie Mac Takeover: The Fallout

During the political conventions of the past few weeks we heard both Barack Obama in Denver and John McCain in St. Paul lay out their solutions to some of the financial problems facing this country. While this was going on, a financial problem of seismic proportions was looming in the background.

On Sunday, the government took over Fannie Mae and Freddie Mac, leaving over 100 billion dollars in losses for common and preferred stockholders, with some banks included among their number. This bailout move can further drive down the price of those shares if the government exercises its warrants, giving it the right to a stake of 79.9% of each company for a nominal sum. Common shareholders are expected to see the value of their investment, which have already fallen, shrivel further - to around $1.

The bailout is especially problematic for some of the banks that hold Fannie and Freddie preferred and common shares. It will be interesting, as this situation develops, to learn how many banks are holding shares and how much this has impacted the banks' capital reserve requirements. Will they have to come up with rescue plans of their own to backfill their capital requirements? This may push the deposit rates (both High-Yield Savings and CD rates, for example) higher. If so, how will this impact mortgage rates?

The ripple effects could cause the bailout to end up being more expensive for taxpayers and private enterprise than most forecasters comprehend. What do you think? I look forward to hearing your thoughts.

Obama, McCain, Sarah Palin and Joe Biden's Tax Claims: What Does It All Mean?

Ah, the conventions. I'm sure a lot of you, like me, stayed up to watch Sarah Palin's big entry onto the national stage last night. Between that, Obama's stadium speech, Lieberman stumping for the other side, and more inspirational videos than you can shake Ken Burns at, these past few weeks have been a political junkie's dream. Although come November, I'm going to miss Tim Russert and his whiteboard.

Since we're a savings blog, one of the points that jumped out for me on both sides were various tax claims. Barack Obama and the Democrats say John McCain won't offer tax relief to 'more than 100 million Americans.' McCain and the Republicans say the opposite. Amid all the more sensational stuff, like the constant stream of new Sarah Palin information, this has been a bit lost.

Which is why I was so excited to see this CNN article, which at least attempts to break the tax issue down beyond campaign sound-bites.

What do you think? Is McCain's tax plan or Obama's the best for you and your family? If you are going to be bringing more money home, do you plan on investing it for the future or increasing your entertainment budget?

And why can't any of the delegates (both parties) dance?

Young and Saving

There's an article in the Boston Globe about the pros and cons of home ownership for students, factoring in different costs vs. returns for students living in an expensive city with high rents.

The gist of the article, after the students met with a financial planner, is that when you're young and still in school many of the factors associated with home ownership - lack of flexibility with regard to faraway job offers, unexpected maintenance costs - may not be the wisest financial move, even with home prices currently lower than they have been.

The financial planner suggested building up an emergency fund and savings, through bank CDs, High-Yield Savings accounts and other safe investments with a relatively high return.

You can see the entire article here - the advice contained inside can be of use to those of us who are no longer students, as well.

The Housing Crisis and Your Savings

The housing bubble had another perverse effect on our planning: It led us to save less. "Many people thought, 'I'm wealthier, I already have a big chunk of my nest egg thanks to my house, so I don't have to save as much,' " says Moody's Economy.com chief economist Mark Zandi.

The above quote is from this article on how the housing crisis is affecting people's retirements. The article makes some good points about saving and investing - most notably that if something is the "hot" new investment, like tech stocks were in the 90's, then it is a bubble likely to burst.

We all want to imagine a quick, easy way to get a huge return on our investment - but as the article says: Big bets on the investment du jour are more often a recipe for downsizing your wealth than growing it.

It's not as exciting, but the truth is people should have a portion of their savings in "safer" investments: like CDs and High-Yield Savings accounts. Accounts that are FDIC-insured and still collect interest, but are also in little to no danger of going anywhere if there is a crash.