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September 23, 2008

September '08 Market Outlook


What a wild ride the last few weeks have been - and in particular, this week (September 15th-19th). News is changing by the minute with one unprecedented step taken after another. So, we've been editing and changing Marketscope but we've decided to finalize it and send it out. We'll continue writing in Ken Kam's Best Ideas blog so you can follow along with our thinking.

Market Outlook

As we said last month, the big risk facing the market and the economy is the reduced credit capacity of the banking system. Massive losses from bad loans, particularly sub-prime mortgages, and the risky securities that were backed by these bad loans have reduced bank capital significantly. Until the banking system turns around - reestablishing their capital base - and credit becomes more available, the economy will continue to throttle back and be at risk of continued weakness.

We believed that strengthening Fannie Mae and Freddie Mac's ability to buy and securitize mortgages was the best, most leveraged way that the government could shore up the balance sheets of the banking industry and free up the industry's capacity to begin lending money again. That's why we applauded when Congress gave U.S. Treasury Secretary, Hank Paulson the authorization to inject funds into Fannie and Freddie. That move restored some confidence for Fannie/Freddie bond holders and the thought was that it might give enough confidence that shareholders would invest new money into Fannie/Freddie, increase the firms' lending capacity, and begin the process of relieving the credit crunch. Unfortunately, that didn't happen.

The market could turn around on signs of stability and new capital coming into the banking system. Until there are visible signs of such progress, we believe that investing in individual companies that are executing well in this difficult environment makes a lot more sense than investing in the overall market.

Paulson's Bazooka

In July, U.S. Treasury Secretary, Hank Paulson, asked Congress for the authority to lend and inject capital into Fannie Mae and Freddie Mac. At the time, Mr. Paulson said that he did not plan to use the authority because as he put it, "if you have a bazooka in your pocket and people know it, you probably won't have to use it."

Well, Mr. Paulson used his bazooka. Over the weekend he announced that the government was taking over both firms and injecting fresh capital. In hindsight, it was inevitable because the threat of Mr. Paulson using his bazooka and wiping out the equity holders prevented both firms from raising capital from anyone else. But it was the discovery by Morgan Stanley's team, brought in to investigate Fannie/Freddie's books, that aggressive accounting approaches made the firms look stronger than they really were, triggered the need to move now. Already leveraged at 40 to 1, far beyond normal banks, restatement of their balance sheets would have made it worse, possibly moving them towards bankruptcy. That would have not only wiped out the equity holders, but would have hurt the bond holders too.

Mr. Paulson's decision led to a huge windfall for the banks, institutions, and even central banks that own the debt securities of both Fannie and Freddie. The yield on those instruments were higher than U.S. Treasuries because they were riskier and those bonds clearly stated that they were NOT guaranteed by the U.S. Government. Now they are and since the yield on Treasuries are lower, the VALUE of those securities just jumped higher. That's good news for the institutions holding them and the banks trying to improve their capital position.

The Credit Crunch

The billions of dollars of losses that the banking industry has been hit by come at the expense of reductions in bank capital. Banks must maintain a minimum level of capital for every dollar they lend out.

The problem is that the losses have been so severe that many banks don't have enough capital remaining to lend more money. In fact, they don't have enough capital to support the amount of loans they have already made. So they have to either raise new capital or sell and reduce their loan portfolios. That's what Merrill Lynch, Lehman Brothers, Washington Mutual, Citibank, and many, many others are trying to do right now. In today's market, raising capital is difficult, especially when nobody knows how extensive the losses will be.

Until a few months ago, investment banks would buy mortgages to create structured securities that were then sold all over the world to bond buyers looking for higher yields. The major rating agencies played along, issuing their highest ratings to these complex securities and giving bond holders a false sense of security.

But as the bond holders suffered significant losses the industry that securitized these loans collapsed. Bond holders no longer could trust the rating agencies that said the bonds were safe, the insurance companies that guaranteed the loans, the investment banks that packaged the loans, the banks that originated the loans, and the home owner that borrowed the money. As a result, banks have been unable to sell loans to free up their capital to make new loans.

To break the logjam, a way must be found to create securities out of these loans that bond buyers will trust and purchase. That's where Fannie and Freddie come in. I think it's going to take nothing less than a government guarantee to bring them back to the market.

Before Treasury's takeover, both Fannie and Freddie had little capacity to purchase mortgages from banks because of their own lack of capital. Paulson's "bazooka" made it possible for both firms to borrow money at favorable rates, but it also made it impossible to raise the capital needed to buy enough mortgages for banks to start lending again.

When it took over the firms, Paulson committed the U.S. Treasury to injecting up to $200 billion in capital as needed. Since both firms have been leveraged as much as 40 to 1, an additional $200 billion in capital could potentially support the purchase of up to trillions of dollars worth of mortgages. That's enough to free up credit capacity in the banking system and break the lending logjam.

If its done well, banks will be able to make new loans that conform to Fannie Mae and Freddie Mac standards secure in the knowledge that they will be able to sell them. If this is the case, the ultimate cost to the taxpayers may be smaller than many expect.

However, it could be done poorly, if banks are able to sell all the bad loans they made when investment banks were setting such very low lending standards. Let's hope that is not the case, otherwise, the cost to the taxpayer will be much higher.

In short, the plan should accomplish its intended effect: first, of stabilizing and increasing the value of $Trillions of Fannie/Freddie bonds because the U.S. Government has taken responsibility to guarantee payment. That should shore up the balance sheet of lots of financial institutions around the world. Next, the injection of capital by the U.S Government should enable Fannie/Freddie to start buying loans from banks again. Finally, it will give breathing room for banks to write-off their bad loans and clean up their balance sheets so that new capital can be raised.

The hope is that that will get the banking system to start lending again so that the credit worthy parts of the economy are not starved. It could take awhile to work its way through the banking system, but I think real progress has been made.

Investment Banks

The move to takeover Fannie/Freddie does not help the investment banks. Their capital is even thinner - leveraged 2 or 4 times more than the banks: from 24 or 33 to 1. So, the write-downs and losses have quickly eroded their thin capital base. Their ability to survive, let alone their capacity to conduct business, is dependent upon their ability to attract new capital.

The investment banks convinced the world that housing prices would continue to rise and couldn't or wouldn't fall. They created mortgaged-backed securities to capitalize on this belief and co-opted the credit rating agencies and default risk insurance companies to believe this too. Then they convinced their customers there was very little risk. They believed their own sales pitch so much that they decided to go in even deeper by loaning to hedge funds (and sometimes even creating the hedge funds themselves) 30 to 1 so that the hedge funds could buy their mortgaged-backed securities.

They took big risks on the bet that housing prices would not fall. While prices rose, they made huge bonuses. When they were wrong, they bankrupted their firms.

This segment of the industry will be recapitalized to the level of activity that makes sense; but at a reduced leverage rate. 30 to 1 leverage is excessive, perhaps even reckless. More due diligence will be required. Ratings and insurance will cost more and mean less.

The net result? Less credit capacity, less money available, especially to dumb projects that don't create real value, and higher cost of capital. The last point is significant. It means that future earnings will be discounted at a higher rate and maket values will be lower.

Are Falling Oil Prices Bad?

Oil prices have recently come down over 25% so you would think Wall Street would be celebrating. They are not. So, the question is whether falling oil prices are good or bad?

Throughout oil's long climb, numerous experts told us that record high oil prices would stop economic growth and cause inflation. Five years ago, when oil hit the then all-time high of $40, we were warned of dire consequences. As the economy kept chugging along and oil hit $50 it was doom and gloom. And at $60 the sky was falling.

But, oil eventually reached $147 a barrel, a level far beyond almost anyone's expectations, and yet the economy kept humming along. That showed how inelastic the demand for oil is and how much capacity the economy had for absorbing higher oil prices.

With oil now having fallen back below $100, you would think the experts would be cheering the good news. But instead, the experts are warning that falling oil prices may lead to deflation - which could be worse than inflation. If you listen to the experts, it would be easy to be confused about whether rising or falling oil prices are worse for the economy.

Here's what I think.

America uses about 21 million barrels of oil a day. If the price of oil falls by $40 a barrel, we save $840 million a day or about $76 billion per quarter. To put this in perspective, the stimulus checks that the President and Congress approved earlier this year put about $90 billion into consumers hands in the 2nd quarter.

The drop in the price of oil is going to have almost the same impact on the economyas the stimulus checks did last quarter. But, this kind of stimulus is better because it is paid for by the oil producers such as OPEC and not America's taxpayers who will eventually be called upon to repay the $90 billion of additional debt that was incurred to fund the government's program.

I agree that deflation would be bad for the economy. But, as explained, I think falling oil prices will actually be stimulative to the economy. So falling oil prices is not a cause but really an effect of a weakening economy, which we believe is due to the credit crisis.

Additionally, if falling oil prices leads to a slowing down of the inflation rate, it would be very positive, giving the Federal Reserve room to further reduce interest rates if needed to combat deflation, or to further stimulate the economy.

In my view the falling price of oil is more a result of a weak European economy, which actually shrunk last quarter, than the result of the American economy, which grew a surprising strong 3.3% last quarter. In large part this is because the European Central Bank (ECB) and the Bank of England (BOE) have held interest rates steady in order to fight inflation whereas the U.S. Federal Reserve has cut rates quite aggressively.

But, if lower oil prices reduces inflationary pressures, then look for the ECB to declare victory on the inflation front and start cutting their interest rates. The expectation that lower European interest rates are coming is the most likely explanation for the dollar's recent strength against the euro.

In a best case scenario, look for the Federal Reserve the ECB, and the BOE to coordinate a round of interest rate cuts later this year. If the cuts were coordinated, they would provide economic stimulus without weakening the dollar or the euro relative to each other.

The Election

It is clear that next President is going to inherit an economy in some distress. Since the success of any investments we make now will in large measure depend on the policies of the next President, we need to consider how government policy may change in an Obama or McCain Administration and start to make plans.

Because I don't usually comment on politics, I'd like to tell you a little about my background so you can understand my perspective.

When I lived in Hawaii, I went to high school with Barack Obama and worked for a firm whose principle work was conducting public opinion polls for politicians. After I graduated from college, I worked as a legislative aide to Senator Spark Matsunaga of Hawaii, who at the time was the ranking Democrat on the Senate Finance Committee when Senator Bob Dole was the Committee's Chair and Ronald Reagan was the President.

One of the big lessons I learned in those jobs is that you don't get to run in the general election unless you first win your party's nomination. In order to do this, candidates frequently take positions to appeal to their base, that they know they have to back away from to win the general election.

Now that the nominations are settled, both candidates must appeal to voters who do not identify with either major party in order to win the general election. This is when we'll start to hear the candidates take positions that they believe are more centrist. In addition, the prospect of winning and then having to govern has a way of pouring cold water on positions that are ideologically appealing but impractical.

Consequently, I believe that the positions the candidates take now more accurately reflect the positions they would act on if elected, and I am not particularly alarmed by some of the bad ideas that been put forward by both candidates in the primaries.

In my view, government can create the conditions under which value can be created, but the government does not by itself create any value. Value is created by people who produce products and services other people want to buy. If you have to compel people to do things they do not want to do, as is to often the case with the government, the presumption must be that value is destroyed.

I think it is safe to say that the election of Barack Obama or John McCain will change the landscape of investment opportunities in different ways. As we get closer to the election, it will become clearer where the opportunities and threats to our portfolios will be under either candidate.

No matter who wins, there will be good investment opportunities. We may need a different mix of expertise and skill to take advantage of them, but we are well prepared for this. We have a big bench of talent, and a lot of data from which to construct a team that can take advantage of the opportunities the future holds.

A Win-Win for Banks and Homeowners

As we've been researching and debating the causes, impact of, and possible solutions for the credit crisis, an idea has been percolating that I'd like to share with you. I welcome your feedback.

Here's the idea. Banks should be required to tell homeowners the value at which the bank is carrying their mortgage on their books and homeowners should have the right to buy their mortgage from the bank at that value. In today's market, could you imagine being able to buy back the mortgage on your house for half the amount you borrowed?

Why is this important? I think the current crisis on Wall Street is being exascerbated by well meaning accounting rules that are forcing banks to write down the value of their mortgage portfolios much lower than I think is reasonable. That in turn reduces their capital base.

Accounting standards require banks to value their portfolios at "the lower of cost or market." But when there is no market for a security, the only prices you can get are lowball prices from brokers who have no intention of really buying. But that fake price forces the bank to write down the value of their portfolio and take a hit to their capital.

Additionally, if a bank is forced to liquidate their assets, they are generally sold at fire sale prices. Recently Merrill Lynch sold a $30 Billion portfolio of mortgage-backed securities for 22 cents on the dollar. Those fire sale prices put pressure on all the other banks to write down their portfolios to the same price - priced to market - even if they believe they are worth a lot more.

So, the capital base of the entire financial system is highly sensitive to the estimated market value of mortgage securities. If we use prices that are too low to value mortgage securities, bank capital is reduced and the credit crisis look worse. If we use prices that are too high, bank capital is increased and the credit crisis looks better than it really is.

Since the "market price" has a significant impact on the bank's balance sheet and their ability to conduct business, doesn't it make sense to go beyond the fake price or the fire sale price to arrive at a more accurate price? So, shouldn't we ask someone that really understands the underlying value of the mortgage and the home that the mortgage is secured against - like the homeowner?

The key problem is that there is no market for these mortgages and securities backed by them. If homeowners are given the opportunity to buy back their mortgage at below face value, I think banks would find a lot of willing buyers - far above the market prices they are getting right now from brokers and vulture investors. If Merrill Lynch had offered the home owners that owed those $30 billion of mortgages the opportunity to buy them back at say 50 cents on the dollar, much higher than the 22 cents on the dollar they sold it for, don't you think most if not all of those homeowners would have jumped at the chance?

By creating more or a market and including the investors that have the most at stake and can value the home and the mortgage most intimately, I think prices will stabilize, and the credit crisis would ease.

It may help to work through an example.

Consider the situation of a homeowner who paid $500,000 for a home and borrowed 100% of the purchase price. After several years, the home is only worth $400,000 and the homeowner is underwater by $100,000. If the homeowner had the opportunity to pay off the $500,000 mortgage for $250,000 - a 50% discount - would they do it?

Since the house is worth $400,000 today, by taking advantage of the offer, the homeowner would go from being $100,000 underwater to being $150,000 ahead. I think that is a tremendous incentive for the homeowner to move heaven and earth to marshall the funds needed to accept the offer. In fact, the homeowner may even be able to get a bank to finance a new $250,000 mortgage because the new mortgage would represent a loan to value of just 62.5% of the $400,000 home.
Are these kinds of deals possible? Many banks have not marked down the value of their mortgage securities as aggressively as Merrill. Lehman Brothers, for example, said that they had marked down their Alt-A mortgages to 39% of face value. But, all banks have already taken some mark-downs. The big question is whether they have been marked-down enough?

The best way to answer that question is to see whether anyone would be willing to buy these mortgages at the discounts the banks have already taken. The bigger the mark-downs that are already on the books, the more room there is to work out deals that make both the homeowner and the bank better off than they are now.

No matter where prices settle out, they will be a more accurate reflection of the "market value" of the mortgages than what the accountants use now. It may turn out that mortgages have already been written down far more than is warranted.

If homeowners in general would be willing to buy back their mortgages at a 50% discount, and banks in general have already written off more than 50%, it seems to me that the mark-downs have been carried too far and the worst of credit crisis is behind us.

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