What a Mess!

Author: David Kotok, Post Date: October 1, 2008
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What a mess!   And it is about to get worse.

Americans have repudiated both their 2-term Republican Administration’s leaders (Bush & Co.) and the Democrat Congressional leaders (Pelosi, Frank, and Dodd).  We have done so for good reason.  These politicians are neither trusted nor respected.  This is the result of their behaviors over the last few years.  The Congress has an approval rating so low that it is in competition with cockroaches and palmetto bugs.

Terrified House members voted “no” and broke with their party leaders.  Democrat Pelosi faced an out right leadership defeat so she gave “permission” to her party members to vote against her.  They were going to anyway.  Republican Boehner allowed his members to ”vote their conscious” and oppose him.  They were going to do it anyway. 

Query: shouldn’t Congressmen and woman always vote their conscience?  Should they have to ask for “permission?”

Because the voter, independent business man, retiree, and bank depositor is afraid, the rank and file American citizen has finally emerged from a cocoon and besieged Congress with an avalanche of “no”.   Members who face election only weeks away responded. And a lousy piece of legislation failed in the House.  Yes, it was a bad bill.  Yes, it had been improved from an even worse initial draft offered as the Dodd-Frank proposal.   Yes, it took away some of the blank check handed to the Secretary of the Treasury.  No, it did not go far enough.

Today the Senate will take the same lousy bill and add an increase in FDIC limits and some other Alternative Minimum Tax fixes and pass it with a wide majority.  Senators believe they are “safer” than Members of the House.  Only one-third of them stand for re-election at a time.   This Senate version is still a lousy bill.

Here’s why.  It takes cash and buys bad assets from the institutions who decide to participate.  Any institution that can avoid the constraints in this bill will try to do so.  Thus only the weakest will opt in as an act of desperation.  The others will languish and deteriorate until they, too, become so weak as to leave them without any choice.  This bill’s structure only prolongs and exacerbates the problems.   

The transfer of assets does not get banks additional capital.   It gets a liquidity substitution and that will help but it is capital that the banking system lacks and this plan doesn’t provide it.  Alternate plans offered in the House are addressing this serious deficiency. 

Meanwhile the banking industry is consolidating rapidly on its own.  The Federal Reserve is now aggressively adding liquidity at unprecedented levels in ways that were never previously contemplated.   Bernanke and Co. realize they must avoid a Depression.  They will succeed on the liquidity side. 

The solvency issue is different.  It takes new additions of capital.  And it takes recognition of loss.  The current plan that will be passed by the Senate gives some consideration of the later but it doesn’t solve the former.   That is the flaw. 

Raising the FDIC limits will help slow the “runs” that are occurring on banks.   But the limit of $250,000 is not a sufficient increase to protect an independent businessman who operates with a bank account balance that is in the uninsured zone.   That business is afraid of losing its money in a bank failure.   Hence the businessman is spending his efforts managing his bank deposits for safety rather than running his business.  He is just as human as the retired CD buyer who is now using a dozen different banks to stay federally insured.  Think about all the wasted effort being consumed to protect one’s cash instead of growing the economy.

The FDIC is now acting relatively quickly and competently in ways that lessen the losses to depositors.  FDIC folks know that every uninsured depositor loss now will have a heavy multiplier and create more havoc in a weakened banking system.  There is now visible and responsible action by this federal agency and they are to be supported.

The problem is that banking is consolidating very rapidly.  The big three banks now have one-third of all the deposits in the country.   There will be a lot more consolidation before this turmoil period is over.  That means the smaller regional and local banks must fill a local service provision needed by their local customers.  This is a business opportunity for those banks but they must seize it with adequate capital.   

Congress is already way behind.  They’re acting reactively and not proactively.  They have shirked responsibility for years and the voters are truly angry.  

Alternate proposals are circulating in the House.   They need daylight and it must be done quickly.   The House leaders need to see that they must pass a “people’s version” of a proposal.  It needs to reflect the interests of the nation’s depositors and independent businesses.  It needs to protect 140 million Americans who are still employed and who earn their daily bread in a gainful enterprise.  And it needs to be clearly understood.  It must not hand a government official a blank $700 billion check. 

If we get that form of a bill we can meet the three tests needed to blunt the systemic risk that has developed following the failure of Lehman and the onset of accelerating contagion.  The three tests are: (1) a lot of money (2) transparency about valuation of assets (3) clarity of the process of resolution.  The House voted “No” on a bill that had only the first of these three elements and not the second and third.  The Senate is about to pass a bill that still only has the first element.  It is now going to be up to the House to add numbers 2 and 3. 

On September 12, we discussed the possibility of a Dow 1000 point drop if Lehman failed.  That interview is still up on cnbc.com.  Insert my last name into the search and it will be on the list.  In it we referred to the issue of systemic risk.  Now we have it.  In fact we are more than half way through the result already.  While our Washington emperors have fiddled, Rome has already burned.  The House has a way to put out this fire.  To do so, it must offer an alternative to the Senate version.  Otherwise we are only prolonging and intensifying the agony.

All that said, we expect stock markets are nearing levels of a bottom.  There are many signs that a bottoming process is now underway.   And credit spreads have already widened.  They are at levels where markets are seized.  Witness the LIBOR-OIS or the General Electric credit default swap pricing this morning.  We have reached the point of reversal because it is the only remaining option. 

Reversal in the credit markets will come with certainty of outcome.  I believe spreads narrow whether or not Congress acts.  Either failure or passage will remove the political uncertainty.  An election will lift the other uncertainty.  Markets will respond positively regardless of the political outcome.  Markets greatest fear is uncertainty.  Credit spreads hold the key and they are now so wide as to suggest they can only narrow.  The country cannot function unless they do. 

In sum, we are witnessing extraordinary American financial history.  The amount of fear in the land is immense.  That is usually symptomatic of a buying opportunity and that is how we are seeing it.   We are actually leaning toward becoming strategically bullish.  In the 800 point drop we did a little buying.  We expect that we will be doing some more.  In the bond market the tax-free municipal bond is now priced as a true gift and not just a bargain. 

We offer a final thought in the spirit of the calendar.  The Old Testament has many commandments and instructions.  The most frequently mentioned is not “do charity” or “respect thy neighbor”.  122 times the deity instructs us not to be afraid.   Fear is the worst enemy.  Panic is the outcome of intense fear.  Biblical scholars have examined this question for a long time.  There are reasons why fear is the number one issue addressed in the bible.  Those reasons are valid in the financial world today. 

A banker friend told me about the elderly woman who took her $250,000 out of his bank and put the cash in a shoe box.  He stopped her long enough to get her to sit down so he could ask her what she would do if she slipped in the parking lot and the wind blew the lid off the box and her life’s savings blew away.  In the end he was able to calm her and to convince her to put $100,000 in each of 2 banks and the other $50,000 in a third bank.  He helped her do it. 

That banker did a “good deed.”   He addressed her fear. 

The leaders of both Houses of Congress and our very unpopular president and our Treasury Secretary have not lessened American’s fear.  They have made it worse.  They now own it and voters will be able to express themselves in only a few weeks when memories are still fresh. 

It is now time for our national leaders to confront this fear and not fan its flames.  Riots must be quelled not fueled.  And we, the voters, have a duty to throw out any elected politician who chooses partisan scapegoating over national interest. 

We voters, too, must set aside our partisan differences and make selection only based on the candidate’s character.  That goes for Democrats and Republicans.  Partisan bickering is now painted with the same brush regardless of political party.  Partisan bickering is the enemy and those who engage in it must be thrown out. 

The Senate votes today.  Then all eyes turn to the People’s House.  There is where we will find the true test of leadership.  So far, its leaders have failed. 

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