Financial Review

Eight Year Anniversary

Sinclair Noe — September 15, 2016

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DOW + 177 =18,212
SPX + 21 = 2147
NAS + 75 = 5349
10 Y + .02 = 1.71%
OIL + .12 = 43.70
GOLD – 8.50 = 1315.10

Wholesale prices were flat in August, mostly because of sharp declines in the cost of food and gasoline; the Producer Price Index was unchanged for the month. In the past 12 months, the producer price index is unchanged. In August, the wholesale cost of food tumbled 1.6%, the biggest drop in almost three-and-a-half years. Gasoline prices slid 2.5%.

If the volatile food, energy and trade margin categories are stripped out, so-called core prices rose a faster 0.3%. Looked at that way, costs have risen 1.2% in the past year, the highest 12-month rate since the end of 2014.

Sales at U.S. retailers fell in August for the first time in five months as traffic dropped off for most stores, a sign that third-quarter growth might not be as strong as previously estimated. Retail sales declined a seasonally adjusted 0.3%. In August, hardly any retail segments did well. Receipts at auto dealers slipped 0.9%. Sales at gas stations fell 0.8% last month, reflecting a decline in prices.

Sales also declined 1.4% at home-improvement centers and 0.6% at department stores. Sales even fell for internet sellers and mail-order companies for the first time since the start of 2015. Only restaurants and apparel stores, helped by back-to-school demand, showed much strength. Restaurant sales increased 0.9% and clothing-store receipts climbed 0.7%.

The U.S. current-account deficit, a measure of the nation’s debt to other countries, sank 9.1% in the second quarter to $119.9 billion. The decline mostly stemmed from an increase in investment in U.S. assets such as stocks and bonds. The current account reveals if a country is a net lender or debtor. The current account deficit was 2.6% of GDP in the second quarter. That’s down from 2.9% in the first quarter and well below a record of 6.3% in 2005.

Industrial production fell 0.4% in August after a revised 0.6% rise in the prior month and a revised 0.5% gain in June. Industrial production fell 1.1% in the 12 months through August. Manufacturing output fell 0.4% over the year, and mining output declined 9.3%. In August, manufacturing, which analysts said accounts for 80% of total industrial output, fell 0.4%.

Reflecting the up and down nature of recent data, the New York Fed and its neighboring Philadelphia Fed reported contrasting conditions in September. The Empire State index, which covers the New York region, showed factory activity contracted in September while the Philadelphia Fed manufacturing index jumped to 12.8 in September from 2 in August, the first back-to-back positive readings in the index in a year.

Rates for home loans jumped. Freddie Mac reports the 30-year fixed-rate mortgage averaged 3.50% in the September 15 week, up from 3.44% in the prior week. The 15-year fixed-rate mortgage averaged 2.77%, up one basis point during the week. Despite the big weekly jumps, rates are much lower than they were a year ago.

The Bank of England opted to hold base interest rates at record lows this morning and to maintain the size of its newly enlarged asset-purchasing program. The bank’s Monetary Policy Committee (MPC) voted unanimously in September to hold the base rate at 0.25 percent, which was cut in August. It also voted unanimously to maintain the size of its corporate bonds purchases at up to £10 billion ($13.2 billion) and government bond purchases at £435 billion.

Switzerland’s central bank has kept its expansive monetary policy intact, holding its deposit rate at -0.75%, stating the Brexit vote has clouded its view of the global economy. “The negative interest rate and the SNB’s willingness to intervene in the foreign exchange market are intended to make Swiss franc investments less attractive, thereby easing upward pressure on the currency.”

Brazilian prosecutors charged ex-President Lula da Silva with being the “boss” of a vast corruption scheme at state oil company Petrobras, in a major blow to the leftist hero’s hopes of a political comeback. It was the first time that Lula, still Brazil’s most popular politician despite corruption accusations against him and his Workers Party, was charged by federal prosecutors for involvement in the political kickbacks scheme. Lula’s lawyers say the accusations are part of an effort to stop him running in the 2018 election.

On September 15, 2008, eight years ago today, investment banking giant Lehman Brothers filed for Chapter 11 bankruptcy, becoming the largest bankruptcy by asset value. The collapse of Lehman Brothers set off shock waves throughout global markets and economies.

The Dow dropped over 500 points, a 4.4% fall, in one day. The Dow Jones Industrial Average shed 25% over the next 30 days — a quarter of its value in just four weeks. Financial markets froze; not just stock trading, but derivatives tied to every kind of financial transaction from home loans to interest rates on bonds, to foreign currency exchange, to commodities – Lehman was a big player, an out-sized player in derivatives – and everything froze.

Some leading money market funds were unable to maintain their net asset value and began selling for less than $1 per share, a phenomenon known as “breaking the buck.” Liquidity dried up overnight. People were even questioning the future of capitalism.

Three days later, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke went to Congress with the Troubled Asset Relief Program, or TARP, a bailout for the banks. The Fed slashed rates to zero. Within days the contagion had spread around the world with governments having to use taxpayers’ money to bail out over-extended banks.

Despite all the damage, nobody went to jail. The Department of Justice refused to file criminal charges against individuals despite serious indications of violations of federal securities and other laws, uncovered by the Financial Crisis Inquiry Commission (FCIC) probe into the causes of the economic crash. The prosecutors’ cases were laid out for them, yet they refused to prosecute.

The FCIC findings found criminal liability at most of America’s largest banks — Citigroup, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Washington Mutual (now part of JPMorgan) and Merrill Lynch (now part of Bank of America) — along with foreign banking giants UBS, Credit Suisse and Société Generale, auditor PricewaterhouseCoopers, credit rating agency Moody’s, insurance company AIG, and mortgage giants Fannie Mae and Freddie Mac.

The FCIC presented DOJ with evidence that these institutions gave false representations about the loan quality inside mortgage-backed securities; misled credit ratings agencies; overstated assets and earnings in financial disclosures; failed to disclose credit downgrades, subprime exposure and the financial health of their operations to shareholders; and suffered breakdowns in internal company controls. All of these were tied to specific violations of federal law.

And the FCIC named names, specifying nine top-level executives who should be investigated on criminal charges: CEO Daniel Mudd and CFO Stephen Swad of Fannie Mae, CEO Martin Sullivan and CFO Stephen Bensinger of AIG, CEO Stan O’Neal and CFO Jeffrey Edwards of Merrill Lynch and CEO Chuck Prince, CFO Gary Crittenden and Board Chairman Robert Rubin of Citigroup.

And if you think things have changed, just consider the latest scandal: the thousands of Wells Fargo employees who opened millions of fake accounts in the names of real customers, just to meet unrealistic sales goals. It is more evidence that bad incentives are rampant in the financial industry and top executives either look the other way or that they don’t know what’s going on in the companies they run – a sign, if nothing else, that big banks are too big to manage. And that’s just an example from this week.

In the past 8 years we have seen a long, long rap sheet of illegal activity from the banksters; everything from money laundering to market rigging, to tax evasion, to sanctions violations, to robo-signing (that’s the word we invented for blatant, out of control forgery and perjury).

And while it is undoubtedly true that a working financial sector is crucial to the health and growth of an economy, economists increasingly argue that we now have a sector which impairs growth. The Bank of International Settlements published a white paper arguing that periods of rapid growth in finance bring with them slowing growth in productivity in other areas of the economy. In other words, growth is good but uncontrolled growth is a cancer.

The cost of the crisis has been severe. A paper from the Federal Reserve Bank of Dallas estimated that the financial crisis and the recession cost the U.S. economy as much as $14 trillion, or about $120,000 for every household. Since 2008, the global economy has been struggling to recover from the shock. Gross domestic product, or economic growth, is still below the levels seen before the crisis.

While there is growth, it’s been painfully lackluster in recent years. In the US, GDP is forecast to rise 2.4% in 2016, the same as in 2014 and 2015, according to the International Monetary Fund. Unemployment levels have fallen since the crash but there remains a particularly weak area of the labor market: wage growth. Earlier this week we reported that personal incomes picked up last year and millions were lifted out of poverty, but incomes are still at 1998 levels.

Reforms were effectuated, but that doesn’t mean banks are safer. Yes, they have more of a capital cushion but they are bigger and involved in even more risky behavior. In fact, the risks of a big bank failing may actually be greater than they were leading up to the financial crisis. Any attempts at reform were little more than a drop of water in the ocean. Disasters like Lehman Brothers’ collapse can occur at any time, without warning. Those who don’t learn from history are doomed to repeat it.

The Market Is Just Not Into Main Street Anymore

August Commentary: The Market is Just Not into Us, Anymore

I’m reminded of the story about the recently deceased arriving at the gates of Heaven and being told that he has freedom of choice he may visit both Heaven and Hell before making his eternal decision. After visiting Heaven for the day he journeys down to Hell.

The most incredible party witnessed in history is going on. The most beautiful people he had ever seen were there. The finest food and drink from the four corners of the planet was being served. The greatest band he had ever heard played every one of his favorite songs and sounding never better, from each stage of his life.

The next morning he returned to Heaven, rendered his decision and apologized for choosing Hell, along with conveying his thanks for the heavenly hospitality.

Upon returning below, the music was gone; so too were the beautiful people and the fabulous food and drink. All that remained in the dark cave was coal, fire, shovels, and heat. When he demanded to know where everyone and everything went; Lucifer winked and replied:

“Yesterday, you were a prospect. Today, sir, you are my client.”

Throughout 2010, and for the last decade, equity returns have produced practically nothing for all its troubles. Then, why do investors continue tolerating an insane amount volatility and risk of principal, for punk rewards - we are holding on to a once profitable relationship that no longer exists.

There; it had to be said.

This 30-year affair between the American middle class and financial markets has been counterproductive over the previous decade. Analysts and money managers are like your mate’s best friend who looks straight into your eyes and lie to your face. “The relationship is fine.” “You are imagining things.” “Every relationship has its highs and lows; you two are experiencing a temporary low period, that’s all.” “You think you could do better without her?”

These examples mirrors a few mindless talking points investors hear bantered about each day on business channels, describing investors’ net worth reduction and why any concern, on your part, is totally unnecessary. Let’s recall how this relationship started by returning to the beginning of this latest chapter.

Wall Street was a rich man’s playground - until the inflationary 1970‘s. At that point, the rich stop buying stocks. P/Es on stocks fell to hat size levels. Prior to the stagflation and inflationary 1970’s, it mattered little that commissions were fixed and burley. The last secular bill market ran from 1950 to 1965. Potential brokers were invited and groomed, by white shoe firms, to introduce themselves to and to form relationships, with the affluent.

In 1962, self-employed individuals or unincorporated businesses became eligible to self-direct retirement accounts through Congressional legislation with the establishment of (Eugene) Keogh or HR (10) plans. Twenty years later, employers asked the same question, differently: Why shouldn’t employees have the same freedom to self-direct their retirement account (thereby, removing corporate responsibility for employees’ retirement).

The private sector, as late as the early 1980’s, offered new workers employer-sponsored defined benefit (DB) retirement plans. Investment risk and portfolio management are entirely controlled by the company. Payouts are calculated on factors such as salary and duration of employment. If there is a short-fall on investment returns, companies are obligated to dip into earnings to cover the difference.

Luckily, for corporations, bottom line margins and much of today’s $1.6 trillion in cash, sitting on the balance sheets of corporations, is safe from being encumbered by DB plans and their retirees.

DB plans are still owned by many public sector workers. Currently, these plans are routinely vilified in the press as parasitic in nature. Defined Contribution (DC) retirement plans, enthusiastically launched in the 1980’s as DB plan’s chief competitive product, and were sold primarily by ridiculing DB plans as being inferior to self-directed accounts. DC plans’ major weakness, an unknown future payout to retirees, became its major marketing strength.

Men with ambition, real men, theoretically, could make untold millions playing the stock market. Accepting a DB plan’s corset over unlimited retirement income potential was the providence of the dull-witted or the lazy, lacking in motivation, vision and imagination.

The tiny requirements for raking in bushels of filthy lucre, for your golden years, as the pitch went, were reading Peter Lynch books and by faithfully watching Louis Rukeyser’s Wall Street Week; “as you know, over time, all stocks increase in value.”

Because of the internal logic of DC plans’ supposition from 1980’s Wall Street, it was antithetical for Human Resource departments and mutual fund companies to argue, at the beginning of a secular bull market, in favor of capping pedestrian, formulaic, DB plan payouts. Unrestricted, free market-based, DC plans were vastly superior on every count.

Beside, where did DB plans’ returns really come from? They came from the stock market! Eliminate the middle man; keep for yourself all the returns your hard earned dollars generate in the stock market. Mr. Hare, meet Mr. Tortoise.

The accelerants fomenting this new mindset, when stocks such as Boeing, Walt Disney, Mattel, and many others, sold for $5 dollars a share or less, were de-regulated commissions, Merrill Lynch’s new Money Market Account, and Sears acquisition of Dean, Witter, Reynolds (now Morgan Stanley). Additionally, declining inflation and interest rates, tax cuts, and deficit spending, helped deliver to Wall Street the middle class aspiration of champagne wishes and caviar dreams.

Over the next 20 years it was a world wind affair with unbridled infatuation. Mutual fund sales loads were cut from 8.5% to 4.5%. Exchange privileges inside mutual fund complexes were established. Letters of Intent, reducing sales fees further, became standard. Investors began choosing stock investment over precious metals, over real estate, over all other asset classes.

Stock market DC plans, became the preferred method of saving for retirement. Dividend Reinvestment Plans (DRIP) and stock purchase plans, compounding returns, also became more popular, adding fuel to the roaring stock market fire. Owning equities were touted by every financial services company. Consequently, more workers chose DB plans, year after year, playing at the big boys table.

Fictional character Gordon Gecko became the Pontiff of American financial idolatry and fictional prosperity. In the late 1980’s, banks begin selling mutual funds and insurance; and vice versa. Charles Schwab introduce the no load mutual funds Fund companies created A, B, C, and D shares, offering various sales load configurations.

In the 1990’s, everyone made money playing the stock market. The beginning of online trading even made it easy to do. The WSJ ran a recurring article featuring a chimp throwing darts, selecting stocks, and comparing his returns with professional money managers. That’s when you know when you are in a secular bull market.

The 14-member investment club from Beardstown, IL, the Beardstown Ladies became national celebrities for reporting earning compound annual average returns of 23.4%, over 10 years, thru 1993 - until they were audited.

Their actual return was 9.1%. By 1997, the Ladies had upped their stock picking skills and annual average returns over 10-years increased to 15.3%, yet, they still lagged the S&P 500’s 10-year return, during this period, of 17.2%.

Yes, we were so in love with each other. Then, dark clouds appeared and forever changed the future – Glass-Steagall was repealed.

Early in the next decade, Wall Street’s wandering eyes caught a glimpse of augmented proprietary trading and underwriting fees. Enhanced leverage, donning smaller and more provocative capital reserves, heretofore, disapproved of among prudent men, became desirable and lusted after by all. Scandalous risk was in vogue.

Investors’ trading commissions and management fees were a competent and faithful, if somewhat, plain way for firms to earn revenue. It was like home cooking five nights a week and backyard grilling on the weekends – safe, predictable, fulfilling, and bland.

Conversely, trading the firm’s capital and collecting securitization fees was the long-legged, redheaded, man-eating, gorgeous knockout, swinging from your arm each night, walking into your favorite hangouts.

Are you still dollar-cost averaging into your funds? Maximizing 401k and IRA contributions? Sporadically purchasing round lots of a few hundred or a few thousand shares of stocks, at discounted prices? This was no longer enough for descendants of the Buttonwood Agreement.

Once Wall Street felt the rush from mainlining mortgage-backed securities, the relationship with John and Jane Q. Public was doomed.

Any hope of salvaging this fraying union ended in 2008. We were unsuccessful in getting American finance off the narcotic of toxic assets; kicking this addiction to fast money, infinite fees and profits, and nympholeptic bonuses. A clean and sober banking system, facing tough new regulations, would function properly, yet again.

Regrettably, the wrong crowd appeared to offer help – Buffett, Paulson, Geithner, Blankfein, Bernanke, and Geithner – peddling TARP, Quantitative Easing, credit facilities, and government guarantees.

Immediately, overnight loan orgies were being held at the Feds’ discount window. The decency of mark-to-market accounting was scoffed at and ignored. Banking hedonism ran amuck on the streets of Manhattan and through the halls of Congress. Someone had shot the sheriff and the deputy, too.

It’s over. In a world of globalization, high frequency trading, melt-ups, flash-crashes, and algorithms, Wall Street doesn’t need the American middle class anymore; Need proof? Here is a snapshot from the internet of an Investment Company Institute chart displaying flows into LT Mutual Funds thru 07/21/2010:

The stock market was up 7% in July despite the fact that equity mutual funds experienced outflows in each of the last 12 weeks.

Wall Street borrows pure, uncut, scratch – at 0% - directly from Mr. Big; Washington DC. Treasury auctions are co-dependent enablers of this bankrupt practice. There is no turning back. Investors will make the wrong choice during a flash crash or flash bounce and will lose.

Somehow, that someone is always John and Jane Q. Public.

Goldman Sachs: The $64,000 Question

My favorite hotel in Las Vegas is Steven Wynn’s Wynn Las Vegas and Encore. His Encore Macau opened on April 22. As revenue from Asia becomes a larger portion of Wynn Resorts Holdings, moving the headquarters from Las Vegas is being considered. If every American CEO demanded the responsibility for his or her company as does Mr. Wynn, American business would, instead of fearing the future of global completion, instead be relishing the sweet smell of opportunity. Lee Iacocca was that type of CEO at Chrysler. However, high stakes poker games, in high-roller card rooms on the strip, pales in comparison to the ultimate poker hand being played out between New York and Washington DC.

I have refrained from writing about the unexpected battle between Goldman Sachs (GS) and the United States of America. The outcome will determine the direction of the financial industry for the next generation. If I were a wagering man, I would not bet the fans’ favorite; the over-educated and overpaid Ṻbermensch investment bankers at 85 Broad St. versus the career civil servants. On the surface, Goldman has more money than God and a better rolodex. But I‘ve seen this movie before. If GS can contain this SEC civil complaint to its existing size and allow it to disappear, they can come back from this embarrassment. All will be forgotten about fraud charges.

It is a puzzlement why they chose instead to fight this civil complaint. Goldman Sachs has the financial and political wherewithal to make this disappear.

Lloyd C. Blankfein could potentially be reprising the role portrayed by Michael Milken 25 years ago. Then, Drexel Burnham Lambert occupied the role of Goldman Sachs. No one dared to even whisper a negative thing about Milken or Drexel in 1985, 1986 or 1987. That is, no one except Ivan bosky, an arbitrageur who plead guilty to securities fraud and implicated Michael Milken in several illegal securities transactions. Is there an Ivan Bosky orbiting John Paulson’s shop, or Abacus- 2007 AC1, that can be squeezed, either by Neil Barofsky, the special Inspector General for the TARP program, the SEC lead litigation counsel Richard E. Simpson, or Andrew Cuomo, New York State Attorney General?

Drexel invented the contemporary meme of masters of the universe. As the SEC civil complaint moved forward, a separate criminal probe was being developed by a little known United States Attorney from the Southern District of New York by the name of Rudy Giuliani. Long story short, after Bosky was convicted and implicated Milken in 1988, the SEC sued Drexel. The following year, Michael Milken was indicted on 98 counts of racketeering and fraud by a federal grand jury. To appreciate how important Milken and Drexel were at the time, their high yield “junk bond” financing deals accelerated the development of cable television, satellite communications, cellular telephony, resort casino gaming in Las Vegas and financed the beginning of the private equity firms. On April 24, 1990, Michael Milken pleaded guilty to charges of securities and tax violations.

Corporations can and do survive civil court convictions. Ask Bank of America (BAC) and Merrill. The kiss of death for a firm, however, is felony convictions. The US Government also has as much money as God; they also have subpoena power, a Justice Department, the FBI, the IRS, wiretaps, and the Racketeer Influenced and Corrupt Organizations Act (RICO). This current special poker game moreover features angry European countries, such as the UK and Germany, plus large angry pensions like CalPers.

Still, Goldman has to look over its shoulder for pissed-off former billionaires, the likes of Maurice “Hank” Greenberg from AIG (AIG) and Richard “Dick” Fuld, of Lehman Brothers – that may be amenable to some cosmic payback, or even singing recitals. The House of Sachs drew Judge Barbara S. Jones, whose career is steeped in racketeering and organized crime. If Goldman cannot get this case dismissed, and they are subsequently charged, prosecuted, and found guilty of felonies, the government will systematically put Goldman out of business, with the cold-blooded dispatch of Javier Bardem’s sociopathic killer, Anton Chigurh, in “No Country for Old Men.” Washington will view it as a necessary honor killing. It was Goldman’s decision to call and raise this pot when the possibility of extinction could have been removed from the equation.

So for me, the $64,000.00 question is this: It is both John Paulson and Goldman’s contention that ACA was aware, Paulson may be involved in selecting some of the mortgages for the CDO and ACA was never told that Paulson would be long. If Paulson had no greater assurance than 50% that Abacus – AC1 would fail, why would he take a position? Paulson admitted that wanted to make a killing. Why waste your time attempting to make a killing with a neutrally-structured vehicle? If he really believed the real estate market was about to crash he would want maximum exposure. Goldman would know this as well. Did Goldman not give equal advice to both clients in the same transaction? This is where their story falls apart.

An Alternative to the Trillion Dollar Deficit

Am I the only one who thinks that a trillion dollar deficit, proposed by the President-elect, is financially insane?

True, as we head into the deepest recession since the Great Depression of the 1930's, we may succeed in becoming the Great Depression II. However, before we touch a lit match to a fuse on a trillion dollar budget deficit (not to mention funding for the wars in Iraq and Afghanistan occuring outside the annual budget, which will surely detonate our country in the future), let us try to address the original problem.

We all agree residential real estate began this current economic slide and that residential real estate's recovery is necessary to end this slump. So, let us rethink the solution.

Since a trillion dollars is on the table, why not try the following; The US government enacts a new program to refinance the following mortgages: 1) all sub-prime mortgages that have reset and will reset. 2) Any mortgage that is underwater by more than five percent; 3) mortgages of homes repossessed in the 4th quarter of 2008 and currently unoccupied, if the previous owners are interested in returning.

Once the government has identified these mortgages, borrowers may apply for a new, 30-year, fixed-rate mortgage, issued at one percent over the current 30 year T-bond.

Do not stop reading. Here is how we save residential real estate and America.

All refinanced mortgages are backed by the full faith and credit of the US government. All refinanced mortgages are assumable.

Yes, I said ASSUMABLE.

Catalog the benefits. Currently, a raging debate about mortgage cram-downs by banks is taking place. Both sides have valid points. By refinancing existing mortgages and paying off lenders immediately, investors holding MBSs are "made whole", per the terms of the mortgage, and contract law is preserved.

Is a home more valuable or less valuable with an assumable loan? The current inventory of vacant and unsold homes would quickly reduce while prices stabilized. Ask a real estate agent if a home with a 30-year, fixed rate mortgage, at 4.25%, completely assumable, is marketable.

Banks' capital requirements and their need to raise cash for 2009 is lessened. Banks will also have fewer assets on their books. Retirees living on fixed income investments are starving for yield. T-bills and CDs today only reduce investors' disposable income and subtract purchasing power from the economy.

On a $200,000 mortgage, refinancing a 6%, or 8%, 10% mortgage, down to 4.25% mortgage is like getting a stimulus check, for several hundred dollars, every 30 days. Would a small business owner rather receive a lower tax rate and fewer customers or 10 or 20 homeowners in his neighborhood with additional money in their pockets?

Vacant homes lower property values. Vandalism occurs to individual properties, squatters break in and stay illegally, and crime can increase in the neighborhood.

The government could begin taking applications 30 days after Congress approves such a bill and begin issuing checks within 90 days, for immediate repayment of mortgages to lenders and injecting more disposable income, through lower mortgage payments, throughout the economy. The psychological benefits to the country alone, with such a program, are incalculable.

Mortgages are public records. This program is completely transparent. As the money is spent, its final destination is available for all to see.

Lastly, if the government is going to destroy the dollar by issuing two trillion dollars in obligations this year, why not try this approach first.

It is just as insane as a trillion dollar deficit for years to come.