Friday, September 26, 2008


Yesterday, a game of "Deal or No Deal" was played. With John McCain on a plane headed for DC, democrats declared a deal had been reached. They did not have the votes, they knew they did not have the votes but they announced the deal was done. Of course, McCain repeated his standard line that he is in DC to serve his country and not his political future. (Yeah, right!) If he misses the first debate, to save his country then it will be a worthwhile sacrifice. McCain is the better choice for president but he needs to give it a break!

By declaring a deal when there was no deal, democrats made McCain out to be the bad guy. Paulson went along with the charade because he is eager to make "his deal". The alternative plan, floated by house republicans, would require banks to pay a premium to the government in exchange for insurance that would allow mortgage backed paper to be revalued. In other words, the people would not buy 700 Billion Dollars of Paper from the banks but would insure some portion of it and collect insurance premiums for that insurance. It sounds like a good idea, but Paulson's initial response was that it will not work. Rightly or wrongly, he is clearly invested in his own plan.

I missed the name of a knowledgeable and rational participant on CNBC last night but the gentleman made an excellent point. He noted that it would be rather easy to devise a formula for evaluating the damaged paper using the discounted cash flow model. I must admit that this sounds much better than the amortization of loss proposal that I endorsed only yesterday.

The clamor to get this done yesterday has come close to panic; time is certainly short, but we should not be stampeded into a panic. There is great value in allowing the best ideas to float to the surface while taking the time to get the deal done right. Yesterday, a regular reader endorsed the Paulson plan on the basis that Paulson is a highly respected, highly successful financier. Paulson as the former Chairman of Goldman, having already announced that he will return to the private sector in January, has a "special interest". I have always been a little skeptical about giving anyone a $700 Billion blank check. The fact that we have no details about how the Treasury would value the paper, under the Paulson plan, asks us to write this proverbial blank check.

The congressional leadership has declared time and again that they will not write the blank check. The solution crafted is to have an over-site board. The trouble is that an over-site board can verify that things are being done according to the plan and have no effect on how the paper is being evaluated. Do we want to give any one person $700 Billion Dollars that can be used to choose winners and losers? I do not. If I were a representative, I would vote NO! Tell me details on how the $700 Billion is going to be allocated fairly and I might change my vote. I thank the reader who suggested I should be more involved in the decision, but the reality is that many people much smarter than I are already working very hard behind the scenes to craft the best solution. A ground swell of voters can influence the final decision, but only a select few can actually alter the plan.


The market in London and the futures markets in the USA are taking a hit this morning. However, once again, financial stocks are showing relative strength! As regular readers know, the financial stocks are expected to turn up well before the bottom of the markets. This morning, once again, basic materials, capital goods and materials are getting hammered. The prices of gold and crude oil are down again.

Low and behold, over in China, interest rates have been cut. As regular readers know, interest rates and commodities "take long hikes with one another". In the past, I have written about trading correlations and R Squares. I have recently come up with the idea of describing correlations as "community walks or hikes". I started this analogy by saying that gold and the dollar are like the two legs of a tall man, they don't move in perfect harmony, but they arrive at their destination at about the same time.

The benefit of the concept is to understand how silly the constant declaration of pundits; when they say that gold is going up because the dollar is going down; when they say the dollar is going down because gold is going up. When the tall man heads in a certain direction, his legs, gold and dollar, will move in a certain direction, but looking at the direction of one leg or the other does not tell us why the man is going in a certain direction. I am reminded of the admonishment of Dr. Efird who routinely says that if you ask the wrong biblical question, you will get the wrong answer.

Commodities are falling because we have reached clearing prices. Clearing prices occur when prices reach levels that cause significant shifts in supply and demand. In the current business cycle, the price of oil went higher than anyone expected before the clearing price was reached (if anyone says he knew how high the price would go he is a gazillionaire). Of course, there are still perma-bulls around who say that oil is still on the way up but it is actually pretty clear that clearing prices have been reached.

In the EIA report yesterday, we saw that US consumption fell by the largest amount in history. In percentage terms, US oil product consumption was down 5.3% below last year! From the same source, we know that in 1999, there were 102 million feet of oil and gas wells drilled in the USA, and that we are on course to drill 321 million feet of oil and gas wells in 2008. US drilling is up 307% in 9 years! and, next week the congressional ban on drilling will expire. It took a very significant change in demand to cause the congress to let go of this politically powerful drilling ban.

The price of crude is down $3 this morning. China lowered its interest rates a couple of days ago. The price of crude did not fall because China lowered its interest rates; the two things are simply taking a long hike together. China tightened its money 19 times from 2003 until a couple of days ago. Oil and gold have been at "the point" on this long hike since way back in 1999. While oil and gold turned around some time back, it took a few months before China's interest rates turned to follow the leader; a long trail of hikers are one by one reaching the turning point.

The lesson continues to be that the decline in the cost of commodities, which includes the cost of money, is going to give a different kind of stock a boost. For a long time, it has been the producers of everything from steel to bridges to oil that have done well. Now it is going to be the consumers of goods that will do well. Most businesses are "hybrids" of one type or another. Gold miners, for example, consume CAT machines and produce gold. Now that the price of gold is in a down trend, the demand for the gold and the CAT machines is falling. When banks borrow to lend, they are acting much like the gold mine that buys CAT equipment. In the current credit crunch, banks are caught by the normally profitable strategy of borrowing short to lend long. Banks own mortgages that have a certain value because they represent a stream of payments that goes out many years. Banks collect money to lend, primarily through short term instruments. The problem is that banks are not being allowed to value the mortgages based on the expectation of many years of payments.

The bottom line is that financial stocks are due for a major turn. Goldman Sachs just paid Warren Buffet a handsome premium for his help in raising $10 Billion. Goldman is raising money to buy deeply discounted mortgages, primarily by buying entire banks. It was only a few weeks ago that a Goldman analyst declared that oil is on the way to $200 per barrel. Investors should always be very careful to avoid bidding as high as the auctioneer suggests. Investors should do as Goldman does, not as Goldman says to do. Put another way, Warren Buffet is adding at least $5 Billion and probably at least $10 Billion to his investments in bank stocks. The situation at Goldman is now very much like the situation that recently existed between the Gold Mining Stocks and CAT. For about 5 years, it paid to buy gold miners even though they were paying out the nose to buy CAT equipment. One could have made money by buying gold, by buying CAT or by buying the gold miners. Now one can make money by buying deeply discounted, high yield junk paper, shares in banks, shares in Buffet (Berkshire), or in Goldman.

Last night, Washington Mutual bit the dust. JPMorgan, another strong player, "accepted ownership". The sharks are feeding. The little guys are in a scramble to avoid being consumed by the sharks before they have the power to negotiate a sale to the sharks. The difference in making it to the life boat is extreme. Depending on the final "tilt" to the final bail-out plan, the little guys will get help to defend the sharks or the sharks will have an even greater advantage. Obviously, the safer plays are to buy companies such as GS, JPM, Wells Fargo or BAC, the sharks. Obviously, the most money will be made by those who buy surviving "little guys". It seems strange but big firms such as Wachovia (WB) are among the "little guys" that are threatened by the sharks. I believe WB will survive, at least long enough to negotiate a good deal with a shark.

There are many other "little guys" that are not being chased by the sharks. These are primarily the banks that wisely avoided leveraged purchases of sub-prime paper. These banks should survive and prosper, BBT is perhaps a good example of this class.

We are back at square one. The whole key to the problem at hand is how to value the sup-prime paper. It is currently marked to fire sale prices. If the USA is going to avoid a great depression, then this paper is currently seriously undervalued.

The odds of a great depression are less than 1 in 10,000. Never-the-less, it is reasonable to mention the great depression at a time when the congress has been inching toward a $700 Billion bail-out plan without knowing how the values are going to be set. By holding back this information, the public is not allowed to value the merits of the plan.

The most probable scenario is that a deal will get done, a deal that will allow the sharks to feed on a number of owners of leveraged paper. The movement of the paper from the current holders to the government and then onto the books of stronger players will "solve the crisis". The plan will work but it should be fully fleshed out before it is approved. I believe a "new deal" will be struck by Monday morning. This time it will be a "real deal", one in which there are enough votes for passage.