John Hussman's Latest: "Money Doesn't Grow on Trees"

From Dr. Hussman's latest market commentary, "Money Doesn't Grow on Trees":

On the BofA/Merrill Lynch deal:

[I]nstead of Merrill Lynch's bondholders taking a loss on their bonds, or swapping their debt for BofA equity, those bondholders will now be made whole for all of the losses that Merrill incurred, with 100% principal and interest, right alongside of the bondholders of BofA that are being protected. That's what these bureaucrats want during their stint in government service, that's how they advise our elected officials, and then their revolving door takes them right back to Wall Street.

On what it would take for the banks to earn their way out of their losses:

[T]he earnings to recover the losses have to come from somewhere, which implies a redistribution away from where they were going before. Really, money doesn't grow on trees. We've got an economy running with outstanding debt of about 350% of GDP. Even a moderate percentage of that as loan losses will represent a significant share of GDP. To reallocate enough funds to fill that hole, we would have to keep deposit rates near zero, and corporate lending rates high, so that financial institutions would earn a persistently wide spread, or “net interest margin.” Over the short-term, that's what's been happening, so ironically, banks are more “profitable” today than they probably will ever be. Unfortunately, that “profitability” is an artifact of a) unsustainably wide net interest margins, and b) a failure to adequately book losses, at the encouragement of government bureaucrats.

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In order for U.S. financial institutions to earn their way out of the losses, they will have to accrue and retain an amount on the order of 25% to 35% of GDP. From where will they reallocate that amount?

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If banks were able to sustainably charge high interest rates on loans and pay low interest rates on deposits, the earnings of the banks would come at a cost to what would otherwise have been retained: corporate earnings and private savings. Essentially, savers will earn less, and corporate borrowers will pay more. To accrue 25-35% of GDP to cover the debt losses (which is a mainstream estimate, not a worst-case by any means), you would have to persistently depress non-financial corporate profits and personal savings by about 25% for well over a decade.

As Dr. Hussman goes on to reemphasize, this is a high price to pay to provide 100% protection to the bondholders of poorly-run financial institutions.

"Unable to Read the Air"

In yesterday's Financial Times, letter writer Takashi Ito introduces a Japanese idiom to describe ousted Merrill Lynch CEO John Thain's recent behavior:

Sir, The hot new word in Japan is “KY”. An abbreviation for “kuuki-yomenai”, it literally means unable to read the air. For an ex-Goldman Sachs partner, John Thain was astoundingly KY. He decorated his office as he laid off Merrill Lynch employees, and then he asked for a $10m bonus when the whole country had turned against excessive executive compensation. There was also the little detail that his company was not doing that well.

The height of his KY was the fact that he was buying company stock the day before he was ousted!

Now a true believer (in Goldman superiority) may say that he was buying stock because he knew his departure would ignite the share price, but I am not willing to give Mr Thain that much credit. Anyway, the stock dived on the news.

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.

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.

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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.

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.

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.