WEEKLY ECONOMIC ANALYSIS: May 1st, 2009

Provided by TEAM Financial Services

"Confronted with the choice, the American people would choose the policeman's truncheon over the anarchist's bomb."
- Spiro Agnew

Items for Discussion

Delving into the political spectrum is always a dicey endeavor, as one is nearly certain to upset close to 50% of people. We’ve tried to limit political commentary to how markets are impacted by policy decisions made by the federal government. This level of involvement has exploded in the past year, so we have had to dedicate more time analyzing what government involvement may mean for investors. This week’s announcement about the bankruptcy of Chrysler opened up a political Pandora’s Box for us, as we believe the handling of the situation is smothered with political influence.

The confluence of political power with money is a long standing and bipartisan tradition. The relative ways in which the banking crisis has been handled compared to the Chrysler situation provides an excellent example of how political interests are trying to replace the basic rule of law and market forces. 

One of our biggest criticisms regarding the various bank bailouts has been the amount of taxpayer money that has been committed and/or squandered without bank bond holders incurring any losses. For example, the Bear Stearns collapse and subsequent bailout resulted in stockholders receiving $10 and bondholders being paid back 100% of their investment. In return, the Federal Reserve absorbed billions of dollars of toxic assets that have since incurred tens of billions of dollars of losses which are absorbed by the taxpayer. So why were stock and bondholders spared losses while the taxpayer has been thrown to the lions?

Federal officials site the collapse of Lehman Brothers as an example of why the Bear Stearns bailout was necessary – taxpayer be damned. However, we believe this view is misguided. This country has a long history of the bankruptcy process taking failed and undercapitalized entities and reorganizing them. While not always quick, this process has worked pretty well over time. Just because a bankruptcy occurs does not mean chaos must ensue or that the entity disappears or is liquidated – though liquidation does sometimes occur. 

The bankruptcy process provides for various stakeholders in a company to receive compensation for their stakes. These stakeholders are ranked based on their relative level of attachment to a company’s assets. For example, the IRS is at the top of the list if a company has outstanding tax liabilities. Debt holders who hold debt that is attached to specific property/plant/equipment that was pledged as collateral for the loan often come next. Unsecured debt follows, with it being broken down into senior and junior levels. Various other unsecured stakeholders fall near this area of the claims list, such as pension and healthcare trusts for employees/unions. Preferred stocks follow with common stocks being at the bottom of the totem pole. This is why common stock holders often walk away with nothing when a company enters bankruptcy – all other stakeholders must be compensated prior common stock holders receiving anything. 

In the case of the various troubled banks, bankruptcy would likely have resulted in stockholders losing everything and bond holders losing a good chunk of their investments – but we believe it is very clear there was ample capital to absorb losses and protect depositors and counterparties. Yet for some reason the government decided to make the taxpayer absorb these losses rather than the direct stakeholders – whom we would argue should absorb the losses. 

The handling of Chrysler lies in direct contrast to the banks. The government is now pushing a bankruptcy that would result in the bondholders getting crammed down to about $.10 on the dollar and hand over a 55% stake in the restructured Chrysler to the United Auto Workers union. The proposed plan and President Obama’s verbal assault on the hold out investors/hedge funds was not well received by us. We can speak first hand that our fiduciary duty to our clients compels us to act in THEIR interests – not those of a politician or 3rd party. The administration’s plan asks these bondholders to forfeit their legal right to be a higher claimant in the bankruptcy process – as we explain above. Why would they do this? Some large firms have consented, but may of them are recipients of government money through the various mortgage bailout plans. They certainly don’t want to bite the government hand that feeds them easy profits. 

In addition, some politicians continue to argue that the recent financial problems and economic downturn were somehow caused by a “failure of markets or capitalism”. Along these lines, they slander hedge funds and their “greed”. We find this argument to be empty. In fact, TEAM would argue that the hedge fund industry is an exact model for how markets WORK. While largely unregulated, not a single hedge fund has received or requested a single dime of taxpayer money. This is in comparison to the very epicenter of the financial crisis – “regulated” banks, insurers and broker/dealers. Many hedge funds collapsed last year and lost their clients vast portions of their investments. Those funds have largely closed, while funds that were successful have survived and even thrived. Most hedge funds have high water mark and claw back provisions which means that the managers only make and retain their incentive fees if their clients earn AND KEEP their gains. This is in direct contrast to government "regulated" banks who pay $100's of millions to executives who helped decimate the companies they run/ran.

Why the different handling of the banks versus Chrysler? While it is our opinion, we suggest the answer lies in following the money – surprise! Banks, insurance companies and broker/dealers have contributed MASSIVE amounts to politicians on a bipartisan basis. This could explain why the Bush and Obama administrations have had similar policies in bailing out banks and preventing their stock and bondholders form absorbing the losses that are rightfully theirs instead of the taxpayer. In the case of Chrysler, the UAW donates over 95% of its political contributions to democrats – perhaps they should learn to dole out the money more equally like the banks to get bipartisan preferential treatment?

This relatively long editorial does have an underlying point. This kind of politically driven interference in markets and the rule of law are very dangerous. If the bondholders in the Chrysler case stand firm (as we would for our clients if we were involved), we expect a very messy and extended bankruptcy. However, judges can be politically pressured, as well as hedge fund managers. This kind of picking of “winners and losers” prevents markets from efficiently allocating capital – as it has done in the hedge fund world ironically. This is likely to cause economic growth over at least the next 5-10 years to be lower than it could be and much more uneven. Rather than vilify the hedge funds involved in the Chrysler bankruptcy, we'd prefer it if our political leaders of both parties learn a lesson or two from them regarding the rule of law and fiduciary duty. 

Market/Economic Climate 

Our extended diatribe above relates to long term concerns we have about the course of US economic policy and growth. Ironically, we believe the intermediate term outlook for the economy continues to emerge from the darkness to see the light. Our favored economic forecasting firm, ECRI, formally announced that they believe it is likely that the recession will be over by the end of this summer. Their track record is superb, so we place significant weight on their forecasts. They rightly state that forecasting economic recoveries is a distrusting business – i.e. most people cannot see the forest for the trees and greet optimistic news very skeptically when the pain of the recession remains acute.

TEAM would like to stress once again that markets are not the same as the economy. Perhaps the best example of this in the recent past is the 2001 recession, as the economy emerged from recession in late 2001. Despite the economic recovery, stocks suffered a dreadful 2002. We would characterize our economic views as follows – short term neutral, intermediate term positive and long term negative.

The markets continued to oscillate this week between the 880 and 840 levels on the S&P 500 index. TEAM believes the market is currently forming a more complicated topping process prior to retracing a chunk of the rapid 7 week move higher off the early March low. We expect recent winning sectors like technology and financials to suffer the brunt of any retracement, while the sectors which have largely sat out the rally like healthcare are poised to be resilient and possibly even rally.

The investment theme we remain most bullish on is commodities. Recent developments with commodity prices, the US dollar and long term interest rates makes us even more bullish and our clients remain positioned accordingly.

Humor for the Weekend 

This graphic comes via the Big Picture Blog authored by Barry Ritholtz.

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.