i can post the full editorial TSR a few times a year:)
But must include home page
spearreport.com
The Spear Report Executive Summary
The Kids and the Cookie Jar
Executive Summary
The credit crisis is not going away anytime soon. In fact, it is starting a new phase, one that includes class action lawsuits, perp walks and an FBI sting known as Operation Malicious Mortgage. It may eventually lead to the demise of most independent brokerages and greater regulation of the investment arms of money center banks.
Treasury Secretary Paulson is paving the way for this regulatory transformation, but his loyalties are divided. The frankest talk on the problem comes from folks at places like PIMCO, who call a Shadow Banking System a Shadow Banking System. It is the same size as the conventional banking system, around $10 trillion, but it is as unstable as nitroglycerine. No wonder Paulson is tiptoeing around the issue.
Financial stocks will continue to be a minefield at least until sometime in 2009. Meanwhile, commodities and consumables are the opposites of the paper pyramid that is the banking system at this time. In that respect, we like nitty gritty shoe manufacturer Deckers (DECK). There is a revolution in men and women's shoe fashion underway and DECK is a key player.
The Best 4 Quants Model drops: GRMN, LNCR, XOM and adds: ARO, FUL, SYK. The full list for this week is: AAP, ARG, ARO, FUL, MCHX, NTY, PETS, QSFT, SYK, WDC.
We've been hearing that this model is being underutilized by our readers.(edit: like me, i haven't utilized at all--max) It has great performance and because it is a quantified system, it isn't dependent upon anyone's emotional reactions to the news or changes in style used by newsletter editors or Wall Street Analysts. This model shows us the stocks that are recommended by at least four of the 60+ computer models we follow that mimic famous or very successful investing methodologies. Further, each of the four models recommending the stocks we hold must have beaten the market over a specified recent period. This means that only recommendations from sources that are doing well in the current market are considered and at least four of them have to agree on a given stock before we share it with you!
For the last two months (from issue date 4/18), the S&P is down 4.6% and the Model is UP 5.5%. Year-to-date (from issue date 12/28/07), the S&P is down 10.3% and the Model is up 1.5%. Since its backtested inception on 3/14/03 (the limit of our data for the computer models used in the system) the Model has a compound annual growth rate of over 30% per year. For more information on the Model, see:
spearreport.com
Detail
Graft has always been a part of the US financial system. More than some countries and less than others, but always there. In 1795 every member of the Georgia legislature accepted a bribe to endorse a land deal. During the great westward expansion in the 1860's the directors of Union Pacific Railroad formed a dummy corporation to overcharge the Federal railroad subsidy program. When Congress decided to assist the S&L industry in the 1970's by deregulating it, swindlers stepped in, bought the troubled banks and approved billions in insider loans on worthless projects.
Scandals on Wall Street were rampant both before and after the 1929 crash but it wasn't until Roosevelt was elected that Congressional hearings were held on the issue. In zealously objecting to government regulation of any sort, Richard Whitney, the head of the NYSE for most of the 1930's, testified that "the Exchange is a perfect institution." The question is, perfect for what purpose? Whitney vigorously opposed regulations that would eliminate a number of common practices of the day, such as insider trading by Exchange specialists that today would get one thrown in jail in a NY minute.
Lawmakers eventually stepped in and passed the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1934 law created the SEC, but the government mostly relied on the self-regulation system at the exchange level that is still in effect today.
How did that work out? About as well as turning over care of the cookie jar to the kids.
Whitney, while still head of the NYSE, was eventually charged with looting a fund he managed that aided widows and orphans and with embezzlement of the NYSE's death benefit fund. His personal trading firm finally went bankrupt in 1938, he was indicted on a number of counts and served three years of a 5-10 year sentence in Sing-Sing. The judge wrote, "To cover up your thefts and your insolvency, you resorted to larcenies, frauds, misrepresentations and falsifications of books and financial statements..." If the President of the NYSE was engaging in this type of behavior for eight years, one can only imagine what else was going on around him. Note that he served just three years.
The More Things Change...
It never stopped, of course. From 2005 - 2007 there was scandal after scandal involving the NYSE and major banks and brokerages. Many in the U.S. take great pride in living in a country that is dedicated to the rule of law, but the fact is that there are two sets of laws. A teenager robbing a gas station of $100 can get shot on the spot or do several years in prison, but when the NYSE and seven major banks defraud investors out of billions of dollars, it is unlikely that more than one or two individuals will ever see the inside of a jail, and if they do, it won't be the same one to which they sent that 16 year-old who stole $100.
But it is different when the crooks pick on the wrong victims. Defrauding tens of thousands of investors is one thing, but bring down the economy that the super-rich depend upon to get super-richer, and you're going to do some time.
Yesterday (6/19), two former Bear Stearns fund managers took the early morning perp walk from their quiet upscale residences into the black FBI car with no inside door handles-- the first players to be charged with criminal misconduct in the credit crisis, but most certainly not the last. The SEC slapped them both with civil charges, as well. If convicted of conspiracy to commit securities fraud, wire fraud or mail fraud, the two middle-aged defendants could theoretically face 30-year prison terms, which would be tantamount to life sentences. What do you think are the odds?
Federal prosecutors are concerned about possible discrepancies between the managers' public and private discussions about the state of their funds. The issue is whether Cioffi and Tannin deliberately misled investors about the condition and prospects of the two sub-prime bond portfolios they managed. Barclay's, the third largest bank in the U.K. and a client of the fund, thinks so, and is suing for restitution. State pension funds are already starting to join in the fray. The ethical and legal accountability process has just begun.
Meanwhile, the FBI has arrested about 300 real estate industry players since March, and perhaps as many as 50 in the last two days, in Operation Malicious Mortgage, a crackdown on industry borrowers, loan originators and real estate agents. In 2007, banks reported nearly 53,000 cases of suspected mortgage fraud, which is approximately 10 times the level from pre-boom days. The FBI is looking into collusion regarding statements of income or assets, forged documents, inflated appraisals and misrepresentations about intended occupancy. Some of these cases are likely to implicate major financial institutions.
Can Paulson Save The Day?
Given the crackdown, Treasury Secretary Paulson's extended speech yesterday on the complexity of the current financial crisis could not have been better timed, even though it skirted the ethical issues. Paulson noted that "In the last few decades, we have seen an evolution in mortgage finance that reflects a broader evolution in financial services. Commercial banks used to be the primary channel for U.S. financial intermediation. That is less true now, as non-bank financial institutions play a significantly more important role."
What he means here are brokerages, mortgage companies and hedge funds: what Bill Gross at Pimco calls the Shadow Banking System. The size of this market is estimated at $10.5 trillion according to the Federal Reserve, or about the same size as the conventional banking system.
Paulson goes on to say, "Shortly after I came to Washington, I pointed out that our financial regulatory structure has not kept pace with this market evolution." He may have "pointed it out," but he didn't sound any alarm, because coming from Wall Street, Paulson had divided loyalties.(edit: to say the LEAST!! i do not think his loyalties are divided, i say he loyalty is to the WS period. Hell he is part of the scandal,imo!Max) The folks at PIMCO put it much more bluntly. "The shadow banking system model as practiced in recent years has been discredited," says Ramin Toloui, PIMCO executive vice president. The shadow banking system has a major structural flaw because it 1) relies completely on borrowed money, not on cash deposits like regular banks, 2) it relies on excessive leverage, 3) it has no backup source of funding in times of stress, and 4) it is unregulated so it can ignore standard capital reserve requirements and other risk management provisions. This makes the enterprise inherently unstable, like nitroglycerine.
Paulson then addressed the delicate issue of government regulation and the backup of the financial sector vs. real-world requirements for self-discipline on the part of the institutions themselves. On the one hand, Paulson said, "...the Bear Stearns episode and market turmoil more generally have placed in stark relief the outdated nature of our financial regulatory system."
On the other hand, he then pointed out the paradoxical nature of the conundrum for regulators and the Fed, in that "the greater the belief in a safety net, the more risk market participants are willing to take and the greater the risk to the taxpayer." Thus, Paulson concluded, in order to "reduce the perception and the likelihood that a complex financial institution is too interconnected to fail, steps are needed to strengthen our practices and financial infrastructure...and to provide greater certainty around the mechanics of winding down a failed institution that is not a federally insured depository institution."
Paulson then backed down from this hardline stance and in a statement seemingly appropriate to a scene from Alice in Wonderland, he said, "In other words, we must limit the perception that some institutions are either too big or too interconnected to fail. If we are to do that credibly, [however] we must address the reality that some are." This may mean that the government (the Treasury and the Fed) is drawing a line in the sand and will bail out FDIC banks, but not brokerages, mortgage companies or hedge funds. It also implies that if these non-bank entities want the backup protection of the Fed, then they will need to operate with the transparency of banks and play by bank rules.
The Past is Prologue
Fear of the possibility of the failure of companies "too large to fail" was precisely the sentiment driving the market panic on Thursday, October 24, 1929 when counterparty confidence began to unravel on Wall Street. On the day after Black Thursday the N.Y. Times wrote,
"In a society built largely on confidence, with real wealth expressed more or less inaccurately by pieces of paper, the entire fabric of economic stability threatened to come toppling down."
That day the Dow dropped 10.8% on record volume in the morning session. The Federal Reserve Board held an emergency meeting in Washington during which members decided to do nothing. Leading bankers on the Street, however, decided to take matters into their own hands. They met and raised a pool of capital ($130 million) to liquefy the market. Their strategy was to refloat the boat that afternoon by buying key blue chips with a great deal of fanfare and bravado.
It worked, for the time being. The Dow closed down just 6 points. Over the next two days (yes, they traded on Saturday) the market moved sideways, but on Monday October 28th the Dow plummeted 12.7% and on "Black Tuesday" it shed another 11.5%. The Dow did not trade over 300 again and eventually drifted down to its July 8, 1932 low of 40.80, a 90% drop from its 9/11/28 high at 386.10.
Counting on Accountability
Clearly, the 1929 "crash" was not the real problem. By the end of that year, the Dow had only fallen 37% from the 1928 high, a normal amount for a correction. The majority of the damage was done in a long, slow bear market that lasted another two and a half years. Perhaps the level of corruption in the market at that time required an excessive amount of cleansing. It sure looks that way from what we know of the 1930's.
Historically, whenever Attorney's General or other legal beagles have cracked down and attempted to hold the Exchanges or the brokerages accountable, Wall Street has resisted, while expressing outrage and indignation. When the crackdown comes, Wall Street begrudgingly accepts some regulation, but follow-through and accountability are generally lacking and the cycle has repeated in another form. Could this time be different? It's doubtful.
Some argue that the magnitude of the financial crisis is sufficiently large to put at risk the credibility and perhaps solvency of the entire U.S. financial system, so perhaps the long-standing cycle of fiduciary autonomy and opacity leading to misbehavior and eventual government wrist slapping will finally come to an end. Perhaps this crisis will initiate a new moral accountability in the sector whose expertise is the application of that same "accounting" skill in a more concrete manner. Yeah, right. Isn't that what they said after Enron and Worldcom?
The legal system is likely to be the main arena in which this plays out over the next few years. It is already starting with Cioffi and Tannin, but a few high profile scapegoats won't be sufficient to settle the matter. The systemic nature of the 'problem,' which affected well regarded money center banks, brokerages, mortgage companies, credit rating agencies and insurers will cause more regulation of the brokerages and most will not survive in present form, but don't get your hopes up that the culprits will really pay, or that crises like this one are behind us. In the end, most of those who cheated will come away with massive profits and no jail time, so the lesson to those who follow will be clear.
Until the dust settles, we recommend buying consumables, like energy, food, dirt and... shoes. Gregory Spear |
