Subprimes and The Efficient Market Theory

Many active investors who don't believe that markets are fully efficient (if they did, of course, they wouldn't be active investors) nevertheless believe that markets are mostly or frequently efficient (see, for example, Warren Buffett making this point in his 1988 Berkshire Hathaway Chairman's Letter). How then to explain the yawning gap between the market prices of certain mortgage-backed securities and their supposed hold-to-maturity or intrinsic values?

Brian Wesbury, chief economist of First Trust, reiterated on CNBC today a point he made in a recent Forbes column: if 100% of the mortgages in a subprime mortgage CDO defaulted, owners of the security would recover something -- perhaps 40 cents on the dollar -- from the sale of the houses. And yet, two months ago, Merrill Lynch unloaded some CDOs for about 22 cents on the dollar (Barry Ritholtz argued at the time that, since Merrill was financing about 75% of the sale itself, the actual sale price for the assets was about 5.47 cents on the dollar).

If what Wesbury says is right (and it seems reasonable), why aren't institutional investors lining up to bid on subprime-backed paper for 22 cents on the dollar?

"You Can't Rescue the Financial System If You Can't Read a Balance Sheet "

In his weekly market commentary published this morning ("You Can't Rescue the Financial System If You Can't Read a Balance Sheet"), John Hussman, Ph.D., of Hussman Funds opposed the Paulson rescue plan that was voted down by the House of Representatives earlier today. It's worth clicking on the link to read Hussman's lucid explanation of his position, but in summary, his objection to the Paulson plan is that if the government buys distressed assets at their market value, that won't do anything to boost financial institutions' assets, since the distressed assets should have been already written down to their market value. Hence,

The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them.

Of course, if the Treasury overpays for distressed assets, there's less chance it will eventually recoup its investment in them. Hussman's preferred solution would be for the government to infuse capital directly into firms as needed, in the form of a "super-bond" senior to all of a company's existing debt but subordinate to customer liabilities:

The “super-bond” would [...] be seen by customers as a legitimate cushion of protection. However, in the event of bankruptcy, it would have a senior claim in front of both stockholders and even senior bondholders. Do that, and you've actually got a mechanism to protect the financial system while at the same time protecting customers and taxpayers. Ideally, the super-bond accrues a relatively high rate of interest so that financials have an incentive to shift to private financing as soon as possible, but you would also defer the interest until the bank meets a minimal level of profitability to make sure that the financing doesn't strain the institution's liquidity.

But then, Congress didn't do this because nobody thinks in terms of balance sheets.

Hussman isn't the first to suggest direct government investment in financial firms as a way of recapitalizing them; John Paulson, of Paulson & Co. -- the man who made billions of dollars last year shorting sub-primes -- recommended something similar in a Wall Street Journal op/ed last week ("The Public Deserves a Better Deal"); both Hussman and Paulson point to Buffett's investment in Goldman Sachs last week and suggest the government should follow a similar tack in any rescue. Others (including the editors of the Financial Times, if memory serves) have advocated both approaches: buying distressed assets and direct, preferred investments to recapitalize key financial firms.

A proposal along the lines of the one I or University of San Diego Professor Frank Partnoy) suggested ("Why Not This?") might have been an easier sale. Since we proposed buying only mortgages, and not the securities derived from them, this sort of proposal would have been more difficult for populists to characterize as a bail out of Wall Street at the expense of Main Street. There might have also been less concern about the government overpaying for distressed assets, since houses and first mortgages are easier to value than complex securities such as CDOs. Now that the the House has rejected the plan for the government to buy distressed assets though, perhaps it will consider a plan along the lines of what John Hussman and John Paulson have suggested.

"In Praise of Free Markets"

If you missed it, this editorial from The Financial Times last week is worth reading, "In Praise of Free Markets". Here are a few excerpts:

The financial system has reached the point of maximum peril. After years of profligacy, banks have all but stopped lending to each other as the US Congress decides whether to extend support. If the unravelling of the banking system continues, the economic consequences will be dire. Yet there is an even greater risk: that the politicians now contemplating Wall Street’s follies draw the wrong conclusions and take the wrong decisions, losing their confidence in markets altogether.

It would not be the first time. After the Wall Street Crash, markets were deemed to have failed and US lawmakers attempted to regulate short-cuts through the crisis. The widely-copied Smoot-Hawley Tariff Act quadrupled the effective tax rate on thousands of imports and deepened the “Great Contraction” of 1929 to 1933. The price of popular anti-market sentiment was much higher in some of Europe’s fledgling democracies: fascism.

Despite the severity of the current crisis, such extreme reactions remain very unlikely. Yet there is plenty of room for policymakers to compound the damage already inflicted by the irresponsible conduct of the financial sector. It is time, then, to remember what open markets have achieved, and what lies in wait for societies that suppress them.

It is no help that some of the loudest critics have little interest in what went wrong, less in how to fix it, and none at all in safeguarding against problems in future.

[...]

The current crisis is routinely described as a symptom of deregulation, but it is equally the child of earlier, ill-fated interventions. Subprime mortgages grew because the prime mortgage sector was dominated by Fannie Mae and Freddie Mac, two institutions founded, regulated and effectively underwritten by the government.

[...]

Capital markets clearly need better regulation but policymakers should guard against unintended consequences. Markets are places of trial and, very frequently, error. Their genius is not perfect efficiency, but the rewarding of success and the weeding out of failure. No better alternative has ever presented itself.

This is a difficult time to defend free markets. Nevertheless they must be defended, not only on their matchless record when it comes to raising living standards, but on the maxim that it is wise to let adults exercise their own judgment.

Market freedom is not a “fundamentalist religion”. It is a mechanism, not an ideology, and one that has proved its value again and again over the past 200 years. The Financial Times is proud to defend it – even today.

John Mauldin's Open Letter to his Congressman Regarding the Bailout

Last month ("The Credit Crisis a Year Later") I mentioned John Mauldin's excellent, early column on the credit crisis ("The Panic of 2007"). Mauldin was one of the first to grasp the scale of the credit crisis and offered the most lucid explanation of it that I've seen. Mauldin's Friday column ("Who's Afraid of a Big, Bad Bailout") was written as an open letter to his Congressman, Joe Barton of Texas, explaining why he should vote for a bailout despite its current unpopularity among his constituents. It's worth clicking the link above to read the whole thing and see the helpful charts, but below are some excerpts.

Dear Joe,

I understand your reluctance to vote for a bill that 90% of the people who voted for you are against. That is generally not good politics. They don't understand why taxpayers should spend $700 billion to bail out rich guys on Wall Street who are now in trouble. And if I only got my information from local papers and news sources, I would probably agree. But the media (apart from CNBC) has simply not gotten this story right. It is not just a crisis on Wall Street. Left unchecked, this will morph within a few weeks to a crisis on Main Street. What I want to do is describe the nature of the crisis, how this problem will come home to your district, and what has to be done to avert a true, full-blown depression, where the ultimate cost will be far higher to the taxpayers than $700 billion. And let me say that my mail is not running at 10 to 1 against, but it is really high. I am probably going to make a lot of my regular readers mad, but they need to hear what is really happening on the front lines of the financial world.

First, let's stop calling this a bailout plan. It is not. It is an economic stabilization plan. Run properly, it might even make the taxpayers some money. If it is not enacted very soon (Monday would be fine), the losses to businesses and investors and homeowners all over the US (and the world) will be enormous.

[...]

If we act now, we will start to see securitization of mortgages, credit cards, auto loans, and business loans so that the economy can begin to function properly.

What happens if we walk away? Within a few weeks at most, financial markets will freeze even more. We will see electronic runs on major banks, and the FDIC will have more problems than you can possibly imagine. The TED spread and LIBOR will get much worse. Businesses which use the short-term commercial paper markets will start having problems rolling over their paper, forcing them to make difficult cuts in spending and employment. Larger businesses will find it more difficult to get loans and credit. That will have effects on down the economic food chain.

[...]

This deal needs to be done by Monday. Every day we wait will see more and more money fly out the doors of the banks, putting the FDIC at ever greater risk. Panic will start to set in, moving to ever smaller banks. Frankly, we are at the point where we need to consider raising the FDIC limits for all deposits for a period of time, until the Stabilization Plan quells the panic.

I understand that this is a really, really bad idea according classical free-market economic theory. You know me; I am as free market as it comes. But I also know that without immediate action a lot of people are really going to be hurt. Unemployment is not a good thing. Losses on your home and investments hurt. It is all nice and well to talk about theories and contend the market should be allowed to sort itself out; and if we have a deep recession, then that is what is needed. But the risk we take is not a deep recession but a soft depression. The consequences of inaction are simply unthinkable.

Joe, I am telling you that the markets are screaming panic. Yes, Senator Richard Shelby has his 200 economists saying this is a bad deal. But they are ivory tower kibitzers who have never sat at a trading desk. They have never tried to put a loan deal together or had to worry about commercial paper markets collapsing. I am talking daily with the people on the desks who are seeing what is really happening. Shelby's economists are armchair generals far from the front lines. I am talking to the foot soldiers who are on the front lines.

Every sign of potential disaster is there. You and the rest of the House have to act. It has to be bipartisan. This should not be about politics (even though Barney Frank keeps talking bipartisan and then taking partisan shots, but I guess he just can't help himself). It should be about doing the right thing for our country and the world. I know it will not be fun coming back to the district. Talking about TED spreads and LIBOR will not do much to assuage voters who are angry. But it is the right thing to do. And I will be glad to come to the town hall meeting with you and help if you like.

"15 Minutes Away from the End of the World"

The Wall Street Journal ("Lawmakers Reach Tentative Bailout Deal"), The New York Times ("Breakthrough Reached in Negotiations on Bailout"), and The Financial Times ("US Congress close to approving bail-out") all report that Congress has reached a tentative deal on the bailout. Hopefully, the proposals to earmark 20% of any potential proceeds from the government's eventual sale of distressed assets to advocacy organizations, and to allow bankruptcy judges to re-write the terms of mortgage loans won't make it into the final legislation. My sense is that they won't.

The Financial Times report included this paragraph, which gives a sense of the urgency of the situation:

Global markets have been holding their breath at the outcome of the talks, and bankers warned of a catastrophic response if the talks did collapse. “It feels as if we are 15 minutes away from the end of the world,” the head of equities at a big UK bank told the Financial Times.

Drug Prices and the Cost of Research and Development

This Wall Street Journal interview conducted last year with Genentech CEO Arthur D. Levinson, Ph.D. is worth reading, "How Genentech Wins at Blockbuster Drugs". Here's an excerpt:

WSJ: How do you balance the high cost of innovation with the pressure to cut cancer-drug prices?

Dr. Levinson: Since 1976, when our company was founded, the biotech industry has lost $90 billion in aggregate. I think it's the biggest money-losing industry of all time. It is hemorrhaging. There are some exceptions: We are doing well, and Amgen is doing well. But for most of the 1,300 to 1,400 companies -- 300 or 400 of them public -- this is a money-losing enterprise.

You don't just crank these drugs out. My lab cloned a portion of the breast-cancer gene in 1982. And we started making antibodies to it in the mid-'80s. Then we got cell-culture results in the late '80s and by the early '90s we were getting animal results. And then approval was in December '98. So this goes back a long, long time. Unless these companies can get a return, we are not going to get the new medicines that are making such a difference to patients' lives right now.

WaMu: "Whoo Hoo!"

The Wall Street Journal: "WaMu Fails, Is Sold Off to J.P. Morgan".

An oddity here is that, at least in this market, up until the end, Washington Mutual kept advertising aggressively -- I heard a radio add for the company just a few hours ago. Here's a link to the press release by WaMu announcing the company's "Whoo Hoo!" campaign, "Whoo hoo! WaMu Unveils New Ad Campaign Celebrating and Inspired by Their Customers". Just in case the link is dead by the time you read this, here's an excerpt:

SEATTLE--(BUSINESS WIRE)--Feb. 12, 2008--WaMu (NYSE:WM) today announced a new marketing and advertising campaign that taps into customers' emotional reactions to capture the essence of what it feels like to bank at WaMu.

"We want to become an iconic brand that people love," said Genevieve Smith, chief marketing officer for WaMu. "Through ongoing brand tracking, we know we always outperform our peers when it comes to being emotionally relevant to people. It gives us a unique opportunity to talk about who we are."

The new campaign brings WaMu's brand values to life: A company that lives to simplify banking and do it with a smile.

"Whether it's been in focus groups or surveys, we hear that WaMu is a bank that truly cares about the customer, doesn't nickel and dime them, and gives something back. We created a campaign that reflects this," said Smith.

A few weeks ago, Cheryl and I were watching TV when a WaMu commercial came on, and when the announcer said, "we won't nickel and dime you", Cheryl noted the company's dire straits and said, "Maybe they should start nickel and diming people again".

A Difference Between the Dot-Com Bust and the Real Estate Bust

During the dot-com bust, the bag holders were, for the most part, individual retail investors -- average Americans, who bid up the price of Internet stock IPOs. Investment banks collected huge fees on those IPOs, regardless of how the companies they brought public performed. In the wake of the real estate bust and the related credit crunch, the biggest bag holders have been on Wall Street: Lehman and Bear Stearns -- two firms that survived the Great Depression intact -- gone, nearly all of their respective CEOs equity stakes wiped out; the country's largest broker/dealer, Merrill Lynch, forced into a sale to Bank of America; etc.

That's something I've thought about as I watched Congressman after Congressman rail against Wall Street in yesterday's hearings while lamenting the plight of his average American constituents.

Why Not This?

A question a number of pundits have raised with the government's proposed solution bailout plan is this: How will the government determine the value of complex mortgage-backed securities it buys so it doesn't overpay for them¹? I reiterated my suggested approach in a comment thread on Megan McCardle's Atlantic blog:

The government could offer to buy first mortgages for 50% of the face amount or 50% of the current appraised value of the underlying property, whichever is lower. The loans sold to the government would mostly be non-performing loans. The government could then write down those loans by 20% or 30% and try to get the delinquent borrowers to start making payments again. Whether they did or didn't, as long as real estate prices didn't fall another 50%, the government would eventual break even or better on the deal.

By putting a floor under the price of mortgages, this deal would, presumably, stabilize the market for mortgage backed securities and CDOs derived from MBS. If not, the same financial engineers who put the complex securities together could figure out how to unwind them and sell the underlying mortgages to the government. Since mortgages would be easier to value than the securities derived from them, the government would be less likely to overpay and more likely to turn a profit on the whole deal.

Entrepreneurs are already taking this sort of approach on a small scale, as I mentioned in a post last month ("Profiting from the Credit Crunch/Real Estate Bust"). I don't see why the Treasury Department couldn't scale up a similar approach.

Update: University of San Diego Law Professor Frank Partnoy proposed something similar in this New York Times op/ed published Saturday, "Buy the Loans".

¹Some have speculated that the government intends to deliberately overpay for these assets, in order to infuse more capital into firms participating in the reverse auctions. If this is true, it's a bad idea. A better way to infuse capital directly in key firms, if it is needed, would be to take preferred equity stakes in them (along these lines, some pundits have asked why the government can't get a deal similar to what Buffett got with Goldman Sachs).

The 64th Fastest Growing Company in British Columbia

Is Destiny Media Technologies (OTCBB: DSNY.OB), apparently. Destiny Media just touted this designation by Business in Vancouver in a press release. I wouldn't have, if I were Destiny's management. Perhaps I would have mentioned this and put a link to the list on Destiny's website, but I suspect frequent press releases conveying relatively minor information may have the opposite of their intended effects. When Destiny closes another major deal with a client -- or, better yet, starts turning a profit -- that would be more worthy of a press release.

Some investors get frustrated by companies that they feel publish press releases too infrequently, so companies need to strike a balance. In general though, I think most small companies would be better off with fewer, more substantive press releases.

Bill Gross Estimates the Yield-to-Government on an RTC-like Rescue Plan

In an op/ed in today's Washington Post ("How Main Street Will Profit"), PIMCO's Bill Gross estimates that the government could make 7%-8% by investing in distressed mortgage assets:

I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.

This doesn't take into account the proposals for the government to take equity stakes in the institutions that participate in these auctions, but as Wharton Prof. Jeremy Siegel noted earlier today on CNBC, if the government takes equity stakes in participating companies, it may be willing to offer higher prices that it would offer otherwise for the troubled assets.

Another Perspective on, and Proposed Solution to the Financial Crisis

In the Financial Times, Martin Wolf objects to Paulson's proposed solution to the current crisis and offers his own ("Paulson’s plan was not a true solution to the crisis"). The charts above were published along with his column in the FT, and the first two of them illustrate the dramatic growth of leverage in the last few decades among households and in the financial sector.

One of Wolf's objections to the Paulson plan is that a lot of mortgage-backed securities are so difficult to value that the government will invariably overpay for them, thus "guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors"¹. He prefers an approach centered on recapitalizing the financial institutions:

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system.

The advantage of these schemes is that they would require not a penny of public money. Their drawback is that they would be disruptive and highly unpopular: banking institutions would have to be valued, whereupon undercapitalised entities would have to adopt one of the ways to improve their capital positions.

If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper.

¹A simple way to avoid this, in my opinion, would be for the government to only buy mortgages themselves (at a significant discount to the value of the underlying properties), and not to buy the mortgage backed securities derived from them or the more complex CDOs derived from the mortgage backed securities. Once the prices of the underlying mortgages and real estate were stabilized, one would think the market for the more complex securities would stabilize as well. If not, then the same financial engineers who put those securities together could be tasked by their respective firms with unwinding them. Unfortunately, the bailout as currently proposed wouldn't limit itself to just buying mortgages.

USEG Expands Share Buyback; More of Mark Cuban on Buybacks

U.S. Energy Corp (Nasdaq: USEG) expands its share buyback. It had already bought back about $3.1 million worth of its shares under its previous $5 million authorization, and now USEG's board has expanded that authorization to $8 million.

Separately, on his blog last week, Mark Cuban reiterated his opposition to buybacks ("The AIG-Lehman-Merrill Link"),

3 Companies facing cash crunch oblivion. A bankruptcy, an desperation sale and pure desperation. What do all 3 companies have in common ? Share buybacks. Billions and Billions and Billions in share buybacks over the last 18 months.

[...]

Can anyone say “financial engineering” ? think all 3 companies could have used that cash they spent trying to pump up their stock prices ? All that cash going to people who sold the stocks, huge losses going to those who held the stock. Thats why dividends are far better than share buybacks. At least in this case all shareholders could have gotten something back other than “the bag” remaining shareholders continue to hold.

In the cases of AIG, Merrill, and Lehman, I doubt the shareholders would have been much better off if they had received dividends in lieu of buybacks over the last 18 months, and I doubt the money used in the buybacks would have been enough to materially affect the outcomes there. It certainly didn't help though.

I wonder what Cuban would think of USEG's share buybacks. USEG has plenty of cash, so it's not facing a cash crunch; it doesn't have current earnings, so it's not engaging in 'financial engineering' to boost earnings per share; and it's buying back its shares at well below book value.

Cognitive Dissonance in Congress on the Proposed Bailout

Some in Congress are demanding that any Treasury plan to buy up hundreds of billions in distressed mortgages at a discount include provisions to protect homeowners against foreclosure. One question raised by these demands is to what extent these provisions will interfere with the government's ability to recoup its investment in the mortgages. As the owner of the loans, it will be in the government's interest to modify non-performing loans by writing them down so home owners will be more inclined to start paying them again¹. Obviously, this is preferable from the government's perspective to the costly foreclosure process, but if the delinquent mortgage borrower doesn't have to fear foreclosure, what will be his incentive to start making payments on even a modified loan? I haven't heard anyone address this potential conflict yet. Congress can make a show of advocating for the tax payer here or advocating for the delinquent borrowers, but it's hard to see how it can effectively advocate for both at the same time.

¹Presumably, the government will buy the mortgages at a significant enough discount to still make a profit on the modified loans, e.g., if it buys a pool of mortgages at, say, 40 cents on the dollar, and writes them down to an average of 70-80 cents on the dollar.

McCain Should Bring Back the Straight Talk Express

Can a Republican married to a beer distributorship heiress win the presidency by railing against Wall Street and otherwise engaging in populist demagoguery? That doesn't seem to me to be a promising strategy. Why not engage in a little of his famed straight talk and point out that one of the causes of the current crisis was that millions of Americans borrowed recklessly and then walked away from their obligations?

Obama has followed a similarly dishonest populist tack, as even his ardent supporter Andrew Sullivan acknowledges,

Instead of telling Americans in no uncertain terms that their recklessness has consequences, he too is peddling populist blather. He too will spend money the government doesn’t have to protect small-time borrowers from the consequences of their folly. He too blames companies that operated within the rules as dictated by Congress for maximising their profits by irresponsible lending.

All the more reason for McCain to try to differentiate himself by not pandering, but that would require smarter positioning than his campaign has demonstrated over the last week. The smart thing to do now is to be statesmanlike and express support for the bipartisan rescue being negotiated this week. No more stream-of-consciousness musings about firing administration officials -- if anything, express confidence that we're in good hands with Paulson and Bernanke. The next step is to start looking ahead, for the next bounce of the ball. That means acknowledging, as Mark Cuban mentioned in his blog, that this rescue will be a fiscal game changer¹. The economic proposals made by McCain and Obama that were unrealistic before won't become any more feasible after Congress allocates ~$700 billion to buy up distressed mortgage debt.

McCain can benefit from recognizing this reality first. That may require him to walk back some of his tax cut proposals, but that will probably cost him less politically than it will cost Obama to walk back his promises, simply because Obama has made more generous promises to a broader cross-section of the electorate. A Republican candidate who maintains even the faintest claim to fiscal conservatism, as McCain once did, can't beat a Democrat in a Santa Claus contest anyway, so why try? Why not propose policies that will lead to a stronger, stabler economy in the long run, and trust the American people to vote for them instead of trying to promise them a bigger free lunch than the other fellow?

¹It's also important to distinguish between the fiscal response to the current crisis, which needs to be hammered out within days, and the regulatory response, which doesn't and which would benefit from a thoughtful deliberation by the next administration and the next Congress.

Goldman Sachs and Morgan Stanley Approved to Create Commercial Banks

According to the AP ("Last major investment banks change status"), today the Federal Reserve approved requests by Goldman Sachs and Morgan Stanley to change their statuses to bank holding companies and create their own commercial banks. This makes sense, since the large combined commercial bank/investment bank conglomerates (e.g., JP Morgan Chase) have proved to be more stable than the stand-alone investment banks (e.g., Bear Stearns, Lehman Brothers) during the current credit crisis. Something to keep in mind next time you hear a pundit blame the current financial crisis on the 1999 Gramm-Leach-Bliley Act, which repealed the provisions of the depression-era Glass-Steagall Act that separated commercial banks from investment banks.

Destiny Media Update

Destiny Media Technologies (OTCBB: DSNY.OB) released its fiscal year-end update this morning. Excerpts:

Fred Vandenberg, Destiny CFO, says, "Our largest area of growth continues to be revenue from our Play MPE® system, which is up at least 25% from Q3 and which grew for the 12th consecutive quarter.

"Every major customer group showed an increase in usage. Universal Music Group announced an expansion of their agreement with Destiny in June and an encouraging trend is the high revenue growth with labels that have recently gone to commercial usage. Revenue from EMI, Warner Music Group and Sony BMG grew more than 300%. Contracts signed with Major Label clients in Northern Europe and expanded use by existing major independent labels also contributed significantly to the over-all growth."

"What's encouraging about this increased revenue, is that operating costs continue to decrease as labels incorporate Play MPE® into their work flow," said company CEO, Steve Vestergaard. "Loss from operations has dropped by more than 40% from the prior quarter. The company is not seeking external financing and is looking forward to imminent profitability."

[...]

The company completely phased out all unpaid trials in the United States as of August 31. Three major labels have gone to paid agreement in northern Europe and this usage is continuing to expand. Trials continued in the rest of Europe and Latin America. 636 singles, 49 bundles and 1 album generated 95,000 transactions during the quarter in Australia and New Zealand.

Late to This

Finally got around to reading Sunday's NY Times Business section after clearing off my coffee table, and this opinion piece by George Mason economist Tyler Cowen was worth reading, Economic View - "Too Few Regulations? No, Just Ineffective Ones". Excerpt:

... [L}egislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.

It would be unfair, however, to blame the Republicans alone for these regulatory failures. The Democrats have a long history of uncritically favoring expansion of homeownership, which contributed to the excesses at Fannie Mae and Freddie Mac, the humbled mortgage giants.

The privatization of Fannie Mae dates back to the Johnson administration, which wanted to get the agency’s debt off its books. But now, of course, the government is on the hook for the agency’s debt. As late as this spring, Congressional Democrats were pushing for weaker capital requirements for the mortgage agencies. The regulatory reality was that few politicians were willing to exchange short-term economic gains — namely, higher rates of homeownership — for protection against longer-term financial risks.

Trouble in Russia

With all the excitement in the U.S. markets this week, the crash in the Russian stock markets, and the subsequent suspension of trading Tuesday (The Financial Times: "Russia halts trading after 17% share price fall") didn't get as much attention as they might have otherwise. Now Forbes reports that the Russian stock markets are set to reopen tomorrow ("Inside Russians Stock Market Panic").

A couple of months ago, I mentioned an e-mail I received from friend who worked for a Moscow-based brokerage. I've sent him an e-mail to see what his thoughts are on the current situation there.

USEG Update

Shares of U.S. Energy Corp (Nasdaq: USEG) have dropped by about a third this month, in the wake of the commodity correction and the broader market chaos. Today USEG announced positive initial results from its first of three exploratory wells it is participating in with PetroQuest Energy (NYSE: PQ).

On Seeking Alpha this week ("Cash is King?"), David Zurbuchen noted,

Due to the simultaneous reduction in market liquidity and commodity prices, metal exploration and mining companies that need to raise funds to finance their activities are facing the prospect of substantial share dilution or the possibility of losing their property interests if they cannot meet contractual spending commitments. We believe there has to be a very compelling reason to own cash-strapped companies in this market.

Conversely, companies that are not in need of financing have an important margin of safety in the current environment.

[...]

One example of a company that deserves closer examination is U.S. Energy Corp. (USEG). The company has a market capitalization of about $54 million while holding $70 million in cash, short-term investments, and marketable securities. With debt of $14 million, this means the company itself is being valued by the market at negative $20 million despite the fact that it holds an interest in several prospective projects and other potential royalty streams. Specifically, the market is giving less than zero value for

1. the company’s Lucky Jack molybdenum project where Thompson Creek Metals Company Inc. (TC) will have the ability to earn up to a 75% interest by spending up to $400 million,

2. various oil and gas interests,

3. a 4% Net Profits Royalty on the Green Mountain uranium property in Wyoming owned and operated by Rio Tinto (RTP),

4. up to $40 million in payments from Uranium One starting in 2010, and

5. a real-estate project which could conservatively net $15 million to the company during 2008.

Short of being a very profitable producer (which the market doesn’t seem to like either), what else can a mining equity offer?

Zurbuchen is probably understating the cash USEG has on hand now (e.g., he doesn't take into account the funds from the recent sale of most of its stake in Sutter Gold Mining), but what he writes is otherwise consistent with what I've written in previous posts on the company.

Update: Commenter Albert notes that Zurbuchen's arithmetic was a little off above; using Zurbuchen's data, the enterprise value should have been negative $2 million and not negative $20 million.

AP: Stocks Surge on Report of Entity for Bad Debt

AP: "Stocks surge on report of entity for bad debt". Excerpt:

A report that Treasury Secretary Henry Paulson is considering the formation of an entity like the Resolution Trust Corp. that was set up during the savings and loan crisis of the late 1980s and early 1990s left investors ebullient.

Excellent news, if it turns out to be true. I floated a somewhat similar idea in a recent post

Insurance against Catastrophic Failure

An interesting suggestion by Yale School of Management professor Jonathan Koppell in today's NY Times (Op-Ed Contributor - "A Failure Tax"): companies that are "too big to fail" ought to pay premiums for catastrophic risk insurance that would fund their rescue in the event they are at risk of failure. There would be all sorts of challenges in implementing this in practice (e.g., Which firms would be covered? How much should the premiums be?, etc.), and Koppell briefly touches on them, but in principle, it's an idea worthy of consideration.

The Atlantic's Megan McCardle on the Politics of the Financial Crisis

Excerpted from Megan McCardle's Atlantic column, "The Blame Game":

Naturally, the two presidential candidates are moving quickly to deal with this crisis -- that is, to blame it on everyone except themselves. John McCain and his surrogates are pushing the dubious notion that the primary problem is a lack of transparency and accountability. He might send someone down to Lehman's trading floor to ask the people packing up their desks whether they feel they've gotten away with something.

Meanwhile, Barack Obama is pointing the finger at John McCain, or at least Senator McCain's ideas:

The challenges facing our financial system today are more evidence that too many folks in Washington and on Wall Street weren't minding the store. Eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs while ignoring middle-class Americans have brought us to the most serious financial crisis since the Great Depression.

I certainly don't fault Senator McCain for these problems, but I do fault the economic philosophy he subscribes to.

This may play well on television, but it is rather disappointing coming from the man who promised us a new kind of politics. There have been no significant changes to the financial regulations in the last eight years that might credibly have created this crisis (the one major alteration, Sarbanes-Oxley, moved things in the other direction). And it's hard to blame loosened oversight when the entire market systematically overvalued the now-toxic securities. Lehman Brothers was not, after all, trying to put itself into receivership for the sheer joy of molesting taxpayers.

Worth reading the rest of it.

It's a little disconcerting to have both major party candidates running as populists. Of the primary candidates in both parties this year, I think the one who might have been best-qualified to deal with the financial crisis was Mitt Romney. He didn't have the sorts of qualifications the American public seems to prefer this year though: he wasn't raised by a single mother, didn't spend any time in a POW camp, didn't live until age ten in Scranton, PA, didn't seem like he actually liked hunting, etc.

Edeleheit Updates Again on PhotoChannel

As Albert noted in the previous post's comment thread, Edelheit offered an update on PhotoChannel (OTCBB: PNWIF.OB). PhotoChannel's stock has gotten hammered recently (along with most other stocks, of course), but Edelheit is still bullish on the company's fundamentals. From the Value Investors Club:

They actually just presented at the Merriman conference and had a lot of positive things to say including:

1)They have launched Kodak China and Kmart Australia

2)They are working on a Facebook photo application

3)They haven`t seen any slowdown in orders

4)There is an opportunity to get Kodak India, which has 14,000 locations

Clearly there is a large seller out there and it is pressuring the stock, but in my opinion this has nothing to do with fundamentals.

[...]

there are many small caps and many Canadian small caps that are getting decimated. Photochannel is not alone.

Consider this. I estimate that on an EBITDA basis, PNWIF will earn $0.10 per share in the December quarter alone.

AIG, Merrill Lynch, and the DJIA: Questions

Someone on CNBC asked an interesting question of NY State Insurance Dept. Superintendent Eric Dinallo this morning: might AIG have avoided this crisis had Elliot Spitzer not forced out long-time AIG chief Hank Greenberg? Dinallo, who was nominated to his position by Spitzer during his scandal-truncated governorship, declined to speculate.

Two questions I haven't heard anyone speculate on yet (though I'm sure I'm not the first person to think of this): Is there any chance AIG will stay in the Dow Jones Industrial Average after this? If not, what companies will replace AIG and Merrill Lynch in the DJIA? It will be interesting to see if the editors of the Wall Street Journal use this opportunity to replace one or both of these companies with non-financial companies, to reflect the contraction of the financial sector as a percentage of the economy.

Privately-held versus Publicly-traded Investment Banks

In the course of work for a client, I've had some discussions with senior executives at a decent-sized, privately-held investment bank. Since the company is privately-held, of course I don't know exactly how well it is doing, but judging by how it has expanded and made a lot of new hires over the last couple of years, I'm inclined to believe the company's executives when they say their investment bank has been doing well and has avoided the problems that have plagued larger, publicly-traded firms such as Lehman Brothers. I wonder whether this is true more broadly of privately-held investment banks, and whether there has been any research conducted comparing privately-held investment banks to their publicly-traded counterparts with respect to their stability, ability to manage risk, etc. Perhaps it's simply the case that firms with less capital available are forced to be more prudent in how they employ that capital. Perhaps there are relevant differences in culture between publicly-traded and closely-held investment banks. I do remember reading that this was a concern of some Goldman partners before the firm went public in the 1990s.

More Sunday Night Excitement

A lot of news for a Sunday Night:

- Lehman Brothers is filing Chapter 11.
- Bank of America is buying Merrill Lynch.
- The Fed is expanding the types of collateral it will lend against to include equities.
- AIG is planning asset sales to raise capital as part of a massive restructuring.

I wonder if at some point it might make sense for the Federal government to create its own vulture fund with one or two hundred billion dollars and start buying up distressed mortgages and mortgage-backed securities at steep discounts. Maybe that would put a floor under the prices of some of the complex assets derived from mortgage-backed securities, and if the Feds buy these securities at steep enough discounts, they might turn a profit on them when the credit markets revive. Just a layman's thought. Perhaps professional pundits will offer better suggestions.

Sunday Night Excitement

We went to see the pre-hipster rock band The Cult play at Irving Plaza Sunday night with another couple, and, since this was a fairly older crowd¹, I figured it would be a mellow one as well. Not so. Maybe it was the unseasonably hot and humid weather for a mid-September evening in New York, or maybe it was because the place was packed to the gills (the show was originally scheduled for the larger Roseland Ballroom), but from the upper level we saw a couple of fights on the floor, and, separately, a couple of juiced-up fellows close to the stage get bodily ejected. When the lead singer of a rock band stops what he's doing to single you ought and tell you to tone it down, that's a good indication you've gone too far. That was the case with one of the fellows who was shown the door. In any case, a good show, even if Ian Astbury chopped off some of his lyrics. Worth catching if you are into pre-hipster rock.

¹To give a sense of how long this band has been around (and to date myself in the process), the first time I heard The Cult's music was on a barracks-mate's smuggled Sony Walkman during infantry training at Fort Benning, GA in 1989. The album I heard (on a cassette tape, no less) was The Cult's third album in their then-current incarnation. So it's likely that many of the folks at the show tonight first started listening to the band in the early 80s and were older than me.

New York Times Book Reviewer: A Vote for McCain is a Vote for Apocalypse

Author Robert Stone, hired by The New York Times to review the book Forever War by NY Times war correspondent Dexter Filkins, offers his calm assessment of the consequences of a McCain victory in November's election:

As for the 2008 presidential election, Stone had this to say: “If, in this campaign, illusion triumphs over what we must believe is reality, we will fail as a nation. There is, after all, a point of no return. If McCain wins, history is here big time, scythe, sackcloth and all four horsemen.”

More of Mark Cuban on Stocks

Another excerpt from Mark Cuban's compilation of posts, "Talking Stocks",

On presenting his company Broadcast.com to institutional investors during the roadshow he and his partner Todd Wagner went on before its IPO:

Prior to the road show, we put together an amazing presentation. We hired consultants to help us. We practiced and practiced. We argued about what we should and shouldn't say. We had Morgan Stanley and others ask us every possible question they could think of so we wouldn't look stupid when we sat in front of these savvy investors.

Savvy investors? I was shocked. Of the 63 companies and 400-plus participants we visited, I would be exaggerating if I said we got 10 good questions about our business and how it worked. The vast majority of people in the meetings had no clue who we were or what we did. They just knew that there were a lot of people talking about the company and they should be there.

The lack of knowledge at the meetings got to be such a joke between Todd and I that we used to purposely mess up to see if anyone noticed. Or we would have pet lines that we would make up to crack each other up. Did we ruin our chance for the IPO? Was our product so complicated that no one got it and as a result no one bought the stock? Hell no. They might not have had a clue, but that didn't stop them from buying the stock. We batted 1.000. Every single investor we talked to placed the maximum order allowable for the stock.

On July 18, 1998, Broadcast.com went public as BCST, priced at 18 dollars a share. It closed at $62.75, a gain of almost 250 percent, which at the time was the largest one day rise of a new offering in the history of the stock market. The same mutual fund managers who were completely clueless about our company placed multimillion orders for our stock.

Mark Cuban on Stocks

On Megan McCardle's Atlantic blog, a commenter named Devin Finbarr posted a link to a compilation of posts on stocks by the billionaire entrepreneur/investor Mark Cuban, entitled "Talking Stocks". Cuban, famously, was one of the few investors savvy enough to lock in his profits near the peak of the dot-com bubble. After selling his company Broadcast.com to Yahoo! in a stock deal, he used options to lock in his profits on Yahoo! stock. Below is an excerpt from this compilation of posts.

On Buybacks versus Dividends (prompted by the occasion of Microsoft's huge special dividend):

To stock traders, the buyback makes perfect sense. If you buy stock in the open market, you help maintain the stock price. If you buy back shares of stock, you reduce the number of shares outstanding, which in turn increases the earnings per share.

This of course is completely contrary to every message that every company CEO, particularly Microsoft tries to send, that they are not trying to manage earnings or the stock price.

More importantly, it rewards the exact thing that should not be rewarded. It rewards people getting out of their investment, while not rewarding keeping the investment.

Sell the stock, you get paid. Keep the stock, you get nothing. Yes, I know that the stock price is supposed to go up for those who keep it, but there are no assurances that it will. The only certainty is that the seller has cash in the bank. The holder has the same amount of risk.

Shouldn't continuing shareholders be rewarded rather than the sellers?

That's why I am such a big fan of dividends. Dividends are the investors' best friend for several reasons:

1. The obvious, it's cash in the bank

2. It reduces your cost basis and rewards you for being a continuing shareholder

3. It can put a cap on how much the company can dilute your holdings. When a company pays a dividend, it's much more expensive just to issue stock and options to insiders. They have to consider the cash implications of each additional share or option issued. That's a good thing. It keeps companies with legitimate dividends from going nuts.

4. It creates a precedent of rewarding shareholders, hopefully with increasing dividends.

On the flipside, share buybacks are horrid for several reasons

1. It allows companies to manipulate earnings per share. Buy back enough stock, and you will hit your Wall Street expectations.

2. Companies will undertake risky cash management strategies to pay for the share buybacks. Since its one time, they can take greater risks

3. Companies will undertake buybacks with CEO and management incentives and bonuses in mind. Hit those numbers, earn lots of stock and options.

4. Companies will buyback stock so that they can re-issue it to themselves and employees. In essence they use the market as their personal and corporate piggybanks. They Buyback stock to push up earnings in hopes the stock goes up. Then they issue the stock to themselves. Then if the stock goes up, they sell the stock they awarded themselves to unsuspecting shareholders who have no idea the money they are paying for shares is going to insiders.

Stock buybacks are a very bad idea for investors and a very profitable idea for insiders and traders.

Edelheit's Updates on PhotoChannel

Again, from the Value Investors Club:

There is absolutely no change to fundamentals. This is simply forced selling by funds blowing up. I`m personally trying to take advantage.

* * * *

My estimates are that the company earns $0.25 per share in cash eps (excluding amortization) in 2009. The company is cash flow positive now and is poised to have have revenue of $6 million in revenue in the September quarter and $8 million in the December quarter.

* * * *

[...] All of the losses came from getting Costco up and running, building data centers, hiring extra software consultants and from lingering losses from Pixology. That is mostly in the past.

Also note that of their income expenses, that over $1 million are non-cash amortization expense.

Edelheit Offers Update on Destiny Media

From the Value Investors Club:

1)I expect a real acceleration in revenue, while expenses stay relatively flat.

2)New customers are transitioned to pay, and their use of DSNY`s service continues to grow.

3)launching of the new Clipstream product.

The stock is down on general microcap weakness. As they announced in June, the company expects to be profitable in the November quarter and I expect the stock will react quite positively to that. Plus new customer wins as well.

Bergen County's 9/11 Memorial

Two towers inscribed with the names of the 147 Bergen County residents who were killed in the attacks, set in a heart-shaped base. This memorial is in the center of a county park surrounded by a 1.25 mile track, so on a sunny day like today was it's usually full of folks running, biking, rollerblading, walking dogs, pushing baby carriages, etc. I was going to head there for a run today and take a closer shot of the memorial myself, but I got tied up on a conference call, so I pulled this photo from the Internet.

After the first attack in 1993, the World Trade Center instituted some elaborate security measures. For example, all visitors were given laminated photo IDs after checking in, that they were required to show to the guards at the relevant elevator banks. Security tightened at all office buildings in New York after 9/11, but before 9/11, the WTC had uniquely tight security. The last time I was in one of the towers was in June of 2001 and I think I still have that laminated ID card in my desk somewhere.

David Einhorn on Lehman Last Year

Via Seeking Alpha again, Amit Chokshi's notes on David Einhorn's presentation on his Lehman (NYSE: LEH) short idea at last November's Value Investing Congress in New York:

Value at Risk (“VaR”) is not appropriate for measuring risk:

• Einhorn compared investment bank VaRs to actual results for recent quarters, which showed that actual results were off by multiples of VaR estimates in some cases.
• Risk managers should focus on the tails of bell curves and also be prepared for fat tail risk - 5-10 sigma events are not uncommon¹.

FAS 159: Profit from One’s Demise

• Fair value accounting standard that allows asset and liabilities to both be marked at fair value.
• This accounting mechanism allows for income to be recognized as liabilities are marked down to fair value.
• FAS 159 is acceptable for market risk but not for idiosyncratic risk.
• The Street is comfortable with FAS 159 but does not seem to grasp all aspects of the ruling.

Lehman Brothers (LEH) – short idea

• Looks vulnerable due to lack of transparency regarding writedowns
• Could be following its “playbook” from 1998 liquidity crisis

LEH had mortgage exposure but took no writedowns

The market recovered and LEH pulled through

Could that happen now?

• LEH stock has held up because of “good” quarters

2008 EPS estimates remain unchanged at $7.75 which would follow a record year in 2007

Sellside believes the chance of a writedown at LEH is minimal

LEH 10-Q reveals no significant loss on Level III investments which Einhorn is skeptical of

• In 2006, fixed income accounted for 48% of LEH income while securitizations accounted for 15% of income.
• LEH should be much more exposed to losses than what has currently been reported.

LEH either recognizes larger losses (which will be a negative surprise) or LEH will likely under-earn competitors that have taken larger losses and cleaned up their balance sheets relative to LEH.

Lehman was trading at about $60 per share last November when Einhorn gave this presentation. Today it closed at $7.25 per share.



¹Not to be picayune about it, but if I remember my statistics correctly, by definition, 5- and 10-sigma events are of course uncommon, and also by definition, bell curves (normal distributions) don't have fat tails. I think Einhorn's point (simplified, apparently, for his audience) was that in finance returns usually do not follow normal distributions; their distribution curves have fat tails, indicating that extreme events are far more likely to occur than they would under a normal distribution. This is true, and has been, as far as I know, widely accepted for some time.

"Freddie Mac is the Cheapest Stock I've Ever Seen"

So said value investor Richard Pzena¹, of Pzena Investment Management, at the 3rd annual Value Investing Congress in New York last November, according to the notes of attendee Amit Chokshi. Chokshi posted the following notes from Pzena's presentation on Seeking Alpha last November 30th (hat tip to commenter "cm1750" on GuruFocus):

* Pzena's talk was entitled 'Evaluating Financials in a State of Panic'
* The only time good businesses sell for cheap prices is during times of distress
* Financial stocks are cheap on a P/B basis against historical multiples
* Freddie Mac (FRE) is the cheapest stock Pzena has 'ever seen':
* Losses are absorbable and GAAP is not useful in evaluating FRE
* Pzena believes the mortgage payment resets that result in higher monthly payments will be handled by borrowers because they will be reluctant to forfeit the equity in their homes
* Fears in the market don’t necessarily impact FRE’s business but are impacting its stock
* FRE Loan to Value = 60% and are mostly in fixed high credit
* Believes FRE will follow similar action to P&C insurance companies

1. Hurricane/natural disaster occurs, P&C insurance companies experience losses, P&C companies raise prices/premiums, P&C stock goes up
2. Housing crisis has occurred, FRE and other industry players will raise fees, tighten credit standards, experience lower losses resulting in strong capital returns and thus improving stock price.

At the time, Freddie Mac (NYSE: FRE) was trading at about $30 per share. Today it closed at 95 cents per share. Off the top of my head, I can't think of a value investor who has made money going long on a financial stock over the last year and a half, but another investor at last November's Value Investing Congress, David Einhorn, has done well shorting Lehman Brothers (NYSE: LEH).



¹Richard Pzena went to Wharton with Joel Greenblatt, author of The Little Book That Beats the Market. In that book, Greenblatt appeared to be alluding to Pzena as "the smartest money manager I know" on p.72.

John Paulson Gets Ready to Go Long

John Paulson of Paulson & Co., whose hedge funds posted huge returns last year by betting against sub prime mortgages, is starting a new fund on October 1st to invest in mortgage backed securities and selected financial institutions, according to today's Financial Times ("Paulson moves into Recovery Mode").

An Astute Comment

On his Atlantic blog, Marc Ambinder posted an open thread for Obama supporters, inviting them to answer the question of how the Obama campaign should respond to the Palin selection. Ambinder has received 437 comments in this thread so far. One, by a commenter calling himself "Gamechanger", was astute. Unlike some professional pundits who have written that McCain was foolish to pick Palin because it weakened his advantage in experience, "Gamechanger" analogizes the selection to an exchange of pieces in chess:

The themes of the campaign this year are change and experience. The democrats had only to run against Bush to win, and Obama proved to be the most effective anti-Bush democrat. McCain, on the other hand, has to run against Obama AND Bush, and also has to radically remake his party (to expand the Republican voter base by adding independents and others).

This situation favored Obama and he entered his convention slightly ahead of McCain. And here is where strategy comes in.

In chess a player sacrifices a pawn or other lesser piece to execute a winning strategy. In this case McCain sacrificed his strongest issue, experience, in order to steal the change theme from obama.

Why did he do this? Two facts are clear:
1. everyone who was going to vote for Mccain on the issue of experience was already on his side

2. He was losing to Obama

Hillary Clinton tried the experience theme (the 3AM ad) and although it slowed Obama, she lost. Similarly, although McCain was running a decent race, the terrain was so unfavorable that given the high level of enthusiasm of Democrats, the huge number of new voters, the desire for change was going to overwhelm concerns about experience.

So, he tore up the game plan (which was to run as a moderate and try to get independent/moderate voters who worried about experience, while hoping not too much of the conservative base sits it out) and wrote a new one -- the all-Western reform ticket.

Paul Kedrosky on Fannie & Freddie

On his Infectious Greed blog, Paul Kedrosky summarizes the Fannie and Freddie intervention:

Details on the just-announced Fannie/Freddie bailout plans were initially scant, but the OFHEO and Treasury websites now have most of what you're looking for. Here is the gist:

1. The two mortgage giants will open Monday under Treasury control
2. New CEOs and boards are inbound
3. Common shareholders are being massively diluted as preferred of a preferred/warrant deal that is being held out as offering taxpayers upside
4. The U.S. is now buying MBS securities direct from GSEs in the open market, and there is no explicit limit specified
5. The U.S. just [added] a planet-sized new (red) line item on its national balance sheet [one would think it also added some offsetting assets too]

For those of you who like more words, here is OFHEO's description of the bailout's key elements:

There are several key components of this conservatorship:

First, Monday morning the businesses will open as normal, only with stronger backing for the holders of MBS, senior debt and subordinated debt.

Second, the Enterprises will be allowed to grow their guarantee MBS books without limits and continue to purchase replacement securities for their portfolios, about $20 billion per month without capital constraints.

Third, as the conservator, FHFA will assume the power of the Board and management.

Fourth, the present CEOs will be leaving, but we have asked them to stay on to help with the transition.

Fifth, I am announcing today I have selected Herb Allison to be the new CEO of Fannie Mae and David Moffett the CEO of Freddie Mac. Herb has been the Vice Chairman of Merrill Lynch and for the last eight years chairman of TIAA-CREF. David was the Vice Chairman and CFO of US Bancorp. I appreciate the willingness of these two men to take on these tough jobs during these challenging times. Their compensation will be significantly lower than the outgoing CEOs. They will be joined by equally strong non-executive chairmen.

Sixth, at this time any other management action will be very limited. In fact, the new CEOs have agreed with me that it is very important to work with the current management teams and employees to encourage them to stay and to continue to make important improvements to the Enterprises.

Seventh, in order to conserve over $2 billion in capital every year, the common stock and preferred stock dividends will be eliminated, but the common and all preferred stocks will continue to remain outstanding. Subordinated debt interest and principal payments will continue to be made.

Eighth, all political activities -- including all lobbying -- will be halted immediately. We will review the charitable activities.

Lastly and very importantly, there will be the financing and investing relationship with the U.S. Treasury, which Secretary Paulson will be discussing. We believe that these facilities will provide the critically needed support to Freddie Mac and Fannie Mae and importantly the liquidity of the mortgage market.

One of the three facilities he will be mentioning is a secured liquidity facility which will be not only for Fannie Mae and Freddie Mac, but also for the 12 Federal Home Loan Banks that FHFA also regulates. The Federal Home Loan Banks have performed remarkably well over the last year as they have a different business model than Fannie Mae and Freddie Mac and a different capital structure that grows as their lending activity grows. They are joint and severally liable for the Bank System’s debt obligations and all but one of the 12 are profitable. Therefore, it is very unlikely that they will use the facility.

Still Stranded

Same shot, a couple of hours later.

Stranded at Starbucks

Pouring rain in North Jersey today, courtesy of Tropical Storm Hanna, apparently. Could be a lot worse, of course, but by the time these storms get here, their destructive winds have usually died down. Above is a photo, taken a couple of hours ago, of the parking lot at the local Starbucks from where I'm posting this.

M&Ms for Investing

Morbidity and Mortality conferences ("M&Ms") are regular meetings where hospital physicians discuss, without fear of punishment, their cases that had bad outcomes. The point of the exercise is to catch and correct errors and improve the way physicians diagnose and treat their patients. What prompted me to think of this was a recent discussion on the GuruFocus website, particularly this comment by prolific poster, former dentist, and stockbroker Dr. Paul Price (aka "Stockdoxc99") to Daniel Wahl,

Defending your methods regarding your highly touted pick of SRA Corp. after its 96% drop is akin to saying...

"The patient died... but the operation was a success".

Daniel Wahl had already reexamined his investment process on the zinc miner SRA Corp (TSX: SRZ.TO) on a post on his blog, and after noting that in the comment thread and making the M&M analogy, I wrote,

As in investing, there is the process and there is the outcome; sometimes a poor outcome is due to a poor process, in which case the process can and should be improved, and sometimes regardless of the process the outcome would still have been poor.

I went on to suggest that it might be useful for GuruFocus to create its own version of an M&M forum for bad investment outcomes. There's no shortage of commenters eager to point out others' losses, but usually this is done in a spirit of schadenfreude, and not in an attempt to learn from any mistakes that might have been made. I thought an M&M approach might make more sense, where investors could discuss what went wrong without insult.

A quick Google search of M&Ms brought me to an essay by Vincent A. Gaudiani, MD on the Cardiothoracic Surgery Network (CTSNet) that suggests that physicians' M&Ms have their own issues. Dr. Gaudiani writes of the M&Ms he participated in during his residency,

The huge disparity in experience level and the residency hierarchy often led to one-upmanship and a focus on affixing blame for failure as if adverse outcomes implied inadequate performance or lax intent. In other words, it was misused to create winners and losers. As we will see in a moment this is an entirely foolish and juvenile misuse of M&M.

Dr. Gaudiani also notes that problems with M&Ms continue post-residency,

Second and equally foolish is the deafening silence and acceptance of adverse outcomes that often accompanies M&M in the private setting. Experienced practitioners know that they too will have adverse outcomes and therefore choose to judge not.

[...]

To the extent that these misapplications of M&M conference prevail, they subvert the value of meeting in the first place.

It's a little disheartening, though not entirely surprising, to see the same sort of bad faith at work among physicians that you find among commenters on investing websites. Dr. Gaudiani offers some ideas to improve M&Ms. Some of this could apply to investing M&Ms as well:

For its part the community must value learning and desire to improve above all else and abandon invidious judgment. Practitioners must have the honesty and humility to recognize their contribution to an adverse outcome [...]. A few ideas may facilitate this process:

- Ask at which point critical decisions were taken that increased the likelihood of the adverse outcome.
- Ask what information or analyses might have led to a better outcome.
- Avoid defending or attacking a bad outcome. Neither helps.

Food for thought. Worth reading the rest of Dr. Gaudini's short essay.

USEG Update

As I mentioned in my last post on U.S. Energy Corp. (Nasdaq: USEG), adding in the proceeds from the sale of most of its stake in Sutter Goldmining Inc., USEG currently has about $79 million in net cash and Treasuries. Intraday, its market cap is currently under $66 million. I just put in a limit order to add to my position.

Missing from McCain's Speech

Another area where there seems to be little daylight between the major party candidates is in the conceit that government-sponsored training or education is an all-purpose solution for economic advancement. McCain had a better real-life example of economic advancement in the audience, in his running mate's husband Todd Palin. Todd learned one of his trades from the company he worked for, BP -- not from a government-sponsored training program (I doubt he learned his other trade, commercial fishing, from a government program either). McCain could have used the opportunity to point out that allowing more domestic energy production will create more high-paying jobs like the one Todd Palin had, but I guess that would have conflicted with the line elsewhere in his speech where he made bogeymen of big oil companies.

Although increasing domestic energy exploration and production will create more high-paying jobs, of course it won't be a panacea either for those whose jobs are lost to outsourcing. That said, the idea that the government is going to retrain laid off workers for jobs that "won't go away" isn't serious. How would the government know what skills will be needed five or ten years down the road? A better approach from the government would be to enact policies that will encourage more companies to set up shop and hire people in this country.

Trying to Trade Alloy Steel

Alloy Steel (OTCBB: AYSI.OB) seemed to have been trading in a range from the low 1.70s to the 1.90s recently, in the absence of any new news¹, so I bought a few more shares today at $1.72, with the intent of selling these shares in the $1.90s. I figure if I am looking at this stock every day anyway, then maybe I can make a few dollars if I recognize a pattern. We'll see how this works out.


¹There hasn't been any company-specific news, but the strengthening of the U.S. dollar versus the Australian dollar recently is something of a headwind, since most of the company's business comes from Australia now and is denominated in Australian dollars, which are now worth less in U.S. dollar terms.

Unskilled Immigration and Economic Statistics

Robert Samuelson ("The Real Economic Report Card") brings up a point that ought to be obvious but isn't made more often: unskilled immigration makes economic statistics such as poverty levels and the number of those without health insurance worse. It seems like common sense that if you import more poor people whose likely jobs (landscaper, busboy, non-union construction worker) usually don't include health insurance, you will end up with more poor, uninsured people in the country than you would otherwise. Perhaps the reason this point isn't made more often is that immigration is one area where there currently is no significant policy difference between the major party presidential candidates.

It makes some sense, from a political perspective (if not from an economic perspective), for Democrats to be in favor of increasing unskilled immigration. If unskilled immigrants become citizens, they are more likely to be net recipients of government benefits, and thus more likely to vote for the party that favors more progressive taxation and more generous spending on social services. Unskilled immigration makes less sense politically for Republicans, but it makes economic sense for certain Republican constituencies, e.g., the small business owners who hire the busboys, landscapers, etc. From the perspective of these small employers, the GOP offers the best of both worlds: support for cheap labor and support for pro-business policies such as lower taxes. Of course, over the longer term, it's hard to see how an embrace of unskilled immigration won't consign the GOP to permanent minority status, unless somehow these immigrants are never given a chance at citizenship, which seems unlikely.

The real estate bust, by drying up the demand for residential construction laborers, seems to have put this issue on the back burner for now, which helps John McCain, since his stance on immigration is one of the areas where he is against his base.

No Shares Available to Short?

That was one of two error messages I got from Scottrade today when I tried to short Federal Trust Corp. (Amex: FDT), one of the stocks I mentioned in this recent post, "The Strongest and Weakest Banks in America". FDT had risen from about 65 cents per share when I posted that to 85 cents per share, and after following its candlestick charting on Americanbulls.com, I intended to short it at 80 cents today. Plan foiled.

Another Side of the State

Yesterday we headed out to a rural part of NJ to help out at my mother's small horse farm there. My mother went to a show with a couple of her students, so Cheryl and I had make sure the horses left behind had water and hay. Here are some photos we took while we were out in Sussex County, NJ. The photo of the horse was taken from my mother's farm; a couple were taken in downtown Newton, the county seat; and the other two were taken at points in between.