Dismal consumer sentiment readings. The worst economy since the Great Depression. Vice-President Elect Joe Biden says the economy is in danger of "falling into an abyss." President Elect Obama says it could take years for the economy to recover.
Does anyone get the feeling that the new President and his supporters in the media are sandbagging the American economy? I mean, it would make sense wouldn't it? If they are successful, that would seem to give them free reign to pass a new stimulus package virtually unlimited in size, far beyond what the American public would willingly allow if we were in merely a recession.
I fear that is where we are headed. I expect that come late January we will see a truly gargantuan economic stimulus package with every liberal democrat project you can image. I also expect that shortly after its automatic approval by the new leftist congress we will begin to see stories in the media and from the new White House administration of recovery in the economy. And low and behold, the "reason" given for the recovery will be the Liberal's economic agenda. I can see it now: the fulfillment the new Messiah's "hope and change."
So, what am I going to do about it? I am investing. I think buying the stock of great companies when they are depressed and holding them for the long term is always a great idea. I also believe there are some very good selective opportunities in real estate. For the first time in quite a while it is possible to buy a property a such depressed levels that significant positive cash flow can be achieved with a reasonable down-payment and a conservative assessment of income generation. I continue to believe that if you are prepared to hold you investments for the long term, this could be the buying opportunity of a lifetime in a number of asset classes.
Tuesday, December 30, 2008
Friday, December 19, 2008
Horrible Southwest Experience
Any of you who know me or have read my blog can quickly determine that I am a passionate advocate for free-market capitalism and business. I am an honest believer in the ingenuity and ambition of uninhibited entrepreneurship and the enormous benefit it brings to each and every one of us. There are times, however, and this is one of them, that I become frustrated, exasperated, and truly disappointed, when I see a company deliver an awful product or provide extremely poor customer service, to the point of contempt for their customers.
Yesterday, I started early in the morning, departing the airport in Los Angeles at 7 a.m. bound for home in Spokane, Washington, on a full-fare ticket. Flying through Oakland, my flight to Spokane was cancelled after an hour delay due to heavy snow in Spokane and I was eventually re-booked through Seattle. Five hours after my original scheduled departure from Oakland we were airborne once again only to be informed by a flight attendant minutes before landing in Seattle that Spokane International Airport had closed for the remainder of the evening. I could see this was going to be a mess. And to make matters worse, the snow fall had been so heavy that the pass between Seattle and Spokane had been closed to all traffic.
Walking out of the jetway I immediately knew I had walking into a customer service disaster. The lines were already hundreds of people long and far too few gate agents to assist customers. I immediately headed for Alaska Airlines where a helpful gate agent diligently juggled multiple customers' reservations. Despite my best efforts, no flight was available into area cities but I appreciated the efforts the agent provided.
Back to Southwest Airlines. Standing in one of the ridiculously long lines, I called the Southwest Reservations number to expedite getting re-booked. I was told at that time, to my astonishment, that the first flight available for them to rebook me was on December 22, a full 4 days away!
"Okay," I said, "book me on another airline."
"I can't do that. We don't have any agreements with other airlines to do that," the customer service agent on the phone informed me.
"Okay, then get me a hotel for next four days." That seemed reasonable to me.
"We can't do that. We can't be held responsible for the weather," was her reply.
"Hold on a second," I retorted, "No, the airport in Spokane was closed because of the weather. You aren't re-booking me for four days because Southwest cancelled all the flights and made no provision to get your passengers to their destination when the airport opens." After speaking to two successively higher supervisors on the phone I could see I was never going to get anywhere with them on the phone.
After another hour of standing in line I eventually came to a Southwest Airlines customer service agent. To add insult to injury, the agent informed me that she would happily rebook me for the next available flight...on December 23, five days away! Here we go again. Okay, book me on another airline. "We can't," was the immediate reply. Do you know what "we can't" means to Southwest Airlines? It means "we won't because you don't mean enough to us as a customer to make it worth our while to do so." Okay, then pay for my hotel and meals for the next five days. No? Okay, then pay for my hotel and and a rental car until the pass opens. And to each and every request, the response from Southwest Airlines was "No, we can't. It's not our fault. It's because of the weather."
Do you know what? No, wrong answer! Again, the airport in Spokane was closed because of the weather. I am stranded in Seattle for five days because Southwest Airlines cancelled all the flights and deemed it was an acceptable response to not add any flights to get their passengers to their destination! I am stranded for five days in Seattle because Southwest won't take the steps necessary to rebook me on another airline because they don't care that much about their customers! I am stranded in Seattle for five days with no compensation for a hotel, meals, or a car, because Southwest has absolute contempt for their customers! Tell me: What good is an airline that has no commitment to providing that service they are supposedly in business to provide - flying their passengers safely, in a timely manner, to and from their destination and not just somewhere, anywhere, in between? What good is an airline that thinks it is an acceptable answer to strand their passengers and with no regard for their well-being? How can a company with service like this still be in business? How can such poor business people maintain gainful employment? Unreal!
"We can't" is not a solution to a customer's problem. Look, I am a pilot for a well regarded major foreign airline. My company doesn't do that. Though they are by no means infallible, they respect and value their customers and it shows. If passengers are stranded due to weather, they take whatever steps are necessary to get them to their destination in a reasonable period of time, whether it be booking them on another airline or scheduling additional flights. For example, just a couple of weeks ago, protesters in Thailand took control of the airport in Bangkok and shut it down for days. Immediately my company began working on contingency plans. As a result, when the airport was eventually opened some six day later, an unscheduled aircraft arrived to pick up our passengers as well as passengers from other airlines, and fly them Hong Kong so they could continue their travels. It is because of a commitment to service like that that my company is considered one of the best airlines in the world. It should be no coincidence then that they are also one of the most profitable airlines in the world.
Yesterday, I started early in the morning, departing the airport in Los Angeles at 7 a.m. bound for home in Spokane, Washington, on a full-fare ticket. Flying through Oakland, my flight to Spokane was cancelled after an hour delay due to heavy snow in Spokane and I was eventually re-booked through Seattle. Five hours after my original scheduled departure from Oakland we were airborne once again only to be informed by a flight attendant minutes before landing in Seattle that Spokane International Airport had closed for the remainder of the evening. I could see this was going to be a mess. And to make matters worse, the snow fall had been so heavy that the pass between Seattle and Spokane had been closed to all traffic.
Walking out of the jetway I immediately knew I had walking into a customer service disaster. The lines were already hundreds of people long and far too few gate agents to assist customers. I immediately headed for Alaska Airlines where a helpful gate agent diligently juggled multiple customers' reservations. Despite my best efforts, no flight was available into area cities but I appreciated the efforts the agent provided.
Back to Southwest Airlines. Standing in one of the ridiculously long lines, I called the Southwest Reservations number to expedite getting re-booked. I was told at that time, to my astonishment, that the first flight available for them to rebook me was on December 22, a full 4 days away!
"Okay," I said, "book me on another airline."
"I can't do that. We don't have any agreements with other airlines to do that," the customer service agent on the phone informed me.
"Okay, then get me a hotel for next four days." That seemed reasonable to me.
"We can't do that. We can't be held responsible for the weather," was her reply.
"Hold on a second," I retorted, "No, the airport in Spokane was closed because of the weather. You aren't re-booking me for four days because Southwest cancelled all the flights and made no provision to get your passengers to their destination when the airport opens." After speaking to two successively higher supervisors on the phone I could see I was never going to get anywhere with them on the phone.
After another hour of standing in line I eventually came to a Southwest Airlines customer service agent. To add insult to injury, the agent informed me that she would happily rebook me for the next available flight...on December 23, five days away! Here we go again. Okay, book me on another airline. "We can't," was the immediate reply. Do you know what "we can't" means to Southwest Airlines? It means "we won't because you don't mean enough to us as a customer to make it worth our while to do so." Okay, then pay for my hotel and meals for the next five days. No? Okay, then pay for my hotel and and a rental car until the pass opens. And to each and every request, the response from Southwest Airlines was "No, we can't. It's not our fault. It's because of the weather."
Do you know what? No, wrong answer! Again, the airport in Spokane was closed because of the weather. I am stranded in Seattle for five days because Southwest Airlines cancelled all the flights and deemed it was an acceptable response to not add any flights to get their passengers to their destination! I am stranded for five days in Seattle because Southwest won't take the steps necessary to rebook me on another airline because they don't care that much about their customers! I am stranded in Seattle for five days with no compensation for a hotel, meals, or a car, because Southwest has absolute contempt for their customers! Tell me: What good is an airline that has no commitment to providing that service they are supposedly in business to provide - flying their passengers safely, in a timely manner, to and from their destination and not just somewhere, anywhere, in between? What good is an airline that thinks it is an acceptable answer to strand their passengers and with no regard for their well-being? How can a company with service like this still be in business? How can such poor business people maintain gainful employment? Unreal!
"We can't" is not a solution to a customer's problem. Look, I am a pilot for a well regarded major foreign airline. My company doesn't do that. Though they are by no means infallible, they respect and value their customers and it shows. If passengers are stranded due to weather, they take whatever steps are necessary to get them to their destination in a reasonable period of time, whether it be booking them on another airline or scheduling additional flights. For example, just a couple of weeks ago, protesters in Thailand took control of the airport in Bangkok and shut it down for days. Immediately my company began working on contingency plans. As a result, when the airport was eventually opened some six day later, an unscheduled aircraft arrived to pick up our passengers as well as passengers from other airlines, and fly them Hong Kong so they could continue their travels. It is because of a commitment to service like that that my company is considered one of the best airlines in the world. It should be no coincidence then that they are also one of the most profitable airlines in the world.
Wednesday, December 17, 2008
Free Market Destoyed by Loss of Faith
We are witnessing yet another "forest for the trees" moment. So often in life the most obvious answer to a problem is the wrong answer. In fact, the most often asked question is usually the wrong question to ask. That is the case right now with the financial crisis we are going through in the United States. The financial crisis is actually a crisis of confidence, and that crisis of confidence has been caused by a loss of faith in the free market system by those who regulate it. The federal government created the problem because they lost faith, or never had it, in the free market system's ability to create wealth and benefit our society.
How did the government create this problem? We only have to go back to the end of the technology bubble in 2000 and the failure of Enron. Many people, including myself, lost money in the subsequent market sell-off. I had faith that the excesses of the system would be wrung out, that capital would be redeployed to those industries and markets most worthy. Shareholders would begin to assert control and implement needed corporate governance actions. Inefficient companies or those with poor management unworthy of investment would be forced to change or face extinction. Sure there would be layoffs and lost jobs and people get hurt, but recovery in a dynamic economy is swift. After a relatively short period of dislocation, the United States would again be on the path toward healthy, sustainable, economic growth, increased wealth, and employment growth.
But our politicians had no faith. Many of their noisiest constituents (and ignorant news media talking heads) were clamoring for action. Feeling a need to be seen doing something, they instituted a number of regulatory "reforms" culminating in the ill-conceived Sarbanes-Oxley bill. One of these ill-conceived reforms was the fore mentioned mark-to-market accounting standard (see Mark-T0-Market Disaster, December 9 2008, post below). There were other stupid moves made by our federal government, particularly the enforcement of the Community Reinvestment Act which forced banks to make mortgage loans to less credit-worthy borrowers in under served communities. Those borrowers made up a large percentage of sub-prime loans that were subsequently guaranteed by Fannie Mae and Freddie Mac under pressure from congress. Those sub-prime loans began to fail in 2007 in increasing numbers which led to the rapid decline in the overheated housing market. Buyers for those sub-prime collateralized mortgage obligations disappeared quickly. Exacerbated by mark-to-market accounting of illiquid securities, financial institutions were forced to post mounting losses driving many into failure and destroying the market capitalization of the survivors. The result: a massive loss of stock market value, a massive contraction of credit, and a rapid decline into recession. The long and short of it all: THE GOVERNMENT CAUSED THE FINANCIAL CRISIS!
Contrary to conventional wisdom and the pronouncements of offending politicians, unfettered capitalism did not cause this financial crisis. It was the regulators that caused the problem. And now we are expected to believe that regulation will save us? Not a chance. How do I know? Because instead of fixing the "reforms" that got us into this mess, the federal government keeps coming up with giant new programs and regulations that do nothing to reverse their previous actions, deal only with resulting credit seizure, and require yet more government control and eventually higher taxes. The use of government intervention to save the free market? Socialism can not save capitalism. Government caused the problems with the "free market." Socialism can't save the free market.
"Okay, smartypants. What should we do then," you say? The first answer is simple: Undo the actions that got us into the problem in the first place. Immediately repeal the mark-to-market accounting standard for assets not held for sale and replace it with mark-to-model accounting. That would immediately make the vast majority of financial institutions liquid and solvent. In fact, they would have too much capital on their balance sheets so lending to credit worthy borrowers would increase very rapidly. The regulator's job would then be to validate the models of financial institutions for asset write downs based upon actual and historical loss rates and cash flow expectations.
The second is more difficult but can be answered by asking the right question: Absent the credit crisis, what are the most immediate problems with the financial markets? The answer: market liquidity, market volatility, and housing values.
1. Market liquidity. How can we help market liquidity? We have to encourage participation in the market. How do we do that? Lower taxes. Immediately reduce capital gains taxes to zero for at least the next two years. Lower capital gains taxes encourage investors to take risk. Money will pour out of money-market funds into stocks, bonds, and mutual funds re-liquefying the market. And a rising market will encourage investment and recovery. How else? Double IRA and 401k contribution limits for at least the next two years. As it is, contribution limits are not high enough for individuals to save enough for a secure retirement. Raising the contribution limits would help. And it would allow individuals who have been so hurt in the last year's decline to participate in the market's recovery.
2. Market volatility. Reinstate the uptick rule for short sellers. As it stands now, short sellers using massive leverage can destroy the market value of virtually any company in a spiralling down market in a "bear raid," limiting a company's ability to raise capital, and endangering its entire existence as a going concern regardless of a company's intrinsic value or true economic prospects. The uptick rule prohibits a stock from being sold short when the last sale was priced down. It has worked well in the past at ensuring market stability and reducing volatility while enabling the practise of short selling to provide efficiency in market pricing.
3. Housing values. Rich Karlgaard of Forbes Magazine had a great idea (http://www.forbes.com/business/forbes/2008/1208/029a.html). In Hong Kong, when a mortgage borrower's financial situation changes in the historically volatile Hong Kong housing market, lending institutions simply rework the mortgage terms extending mortgage loan lengths to match the payment to the cash flow generated on the property. When cash flow increases, the mortgage term contracts. As a result, mortgage foreclosure is relatively infrequent in a market that is much more volatile than ours even considering the large declines over the last two years. Rather than renegotiating principle reductions or payments on mortgages that have a high propensity to fail yet again, financial institutions should negotiate increased loan lengths to keep people in their homes so long as they have the ability to pay. I spend a lot of time in Hong Kong. I've see it. It works.
What is the common thread here? No massive government intervention in the credit markets and equity ownership. We do not need socialism to save capitalism. We need government to get out of the way and have faith that the free market will continue to provide the most freedom, highest incomes, and greatest sustainable growth possible to this great country.
How did the government create this problem? We only have to go back to the end of the technology bubble in 2000 and the failure of Enron. Many people, including myself, lost money in the subsequent market sell-off. I had faith that the excesses of the system would be wrung out, that capital would be redeployed to those industries and markets most worthy. Shareholders would begin to assert control and implement needed corporate governance actions. Inefficient companies or those with poor management unworthy of investment would be forced to change or face extinction. Sure there would be layoffs and lost jobs and people get hurt, but recovery in a dynamic economy is swift. After a relatively short period of dislocation, the United States would again be on the path toward healthy, sustainable, economic growth, increased wealth, and employment growth.
But our politicians had no faith. Many of their noisiest constituents (and ignorant news media talking heads) were clamoring for action. Feeling a need to be seen doing something, they instituted a number of regulatory "reforms" culminating in the ill-conceived Sarbanes-Oxley bill. One of these ill-conceived reforms was the fore mentioned mark-to-market accounting standard (see Mark-T0-Market Disaster, December 9 2008, post below). There were other stupid moves made by our federal government, particularly the enforcement of the Community Reinvestment Act which forced banks to make mortgage loans to less credit-worthy borrowers in under served communities. Those borrowers made up a large percentage of sub-prime loans that were subsequently guaranteed by Fannie Mae and Freddie Mac under pressure from congress. Those sub-prime loans began to fail in 2007 in increasing numbers which led to the rapid decline in the overheated housing market. Buyers for those sub-prime collateralized mortgage obligations disappeared quickly. Exacerbated by mark-to-market accounting of illiquid securities, financial institutions were forced to post mounting losses driving many into failure and destroying the market capitalization of the survivors. The result: a massive loss of stock market value, a massive contraction of credit, and a rapid decline into recession. The long and short of it all: THE GOVERNMENT CAUSED THE FINANCIAL CRISIS!
Contrary to conventional wisdom and the pronouncements of offending politicians, unfettered capitalism did not cause this financial crisis. It was the regulators that caused the problem. And now we are expected to believe that regulation will save us? Not a chance. How do I know? Because instead of fixing the "reforms" that got us into this mess, the federal government keeps coming up with giant new programs and regulations that do nothing to reverse their previous actions, deal only with resulting credit seizure, and require yet more government control and eventually higher taxes. The use of government intervention to save the free market? Socialism can not save capitalism. Government caused the problems with the "free market." Socialism can't save the free market.
"Okay, smartypants. What should we do then," you say? The first answer is simple: Undo the actions that got us into the problem in the first place. Immediately repeal the mark-to-market accounting standard for assets not held for sale and replace it with mark-to-model accounting. That would immediately make the vast majority of financial institutions liquid and solvent. In fact, they would have too much capital on their balance sheets so lending to credit worthy borrowers would increase very rapidly. The regulator's job would then be to validate the models of financial institutions for asset write downs based upon actual and historical loss rates and cash flow expectations.
The second is more difficult but can be answered by asking the right question: Absent the credit crisis, what are the most immediate problems with the financial markets? The answer: market liquidity, market volatility, and housing values.
1. Market liquidity. How can we help market liquidity? We have to encourage participation in the market. How do we do that? Lower taxes. Immediately reduce capital gains taxes to zero for at least the next two years. Lower capital gains taxes encourage investors to take risk. Money will pour out of money-market funds into stocks, bonds, and mutual funds re-liquefying the market. And a rising market will encourage investment and recovery. How else? Double IRA and 401k contribution limits for at least the next two years. As it is, contribution limits are not high enough for individuals to save enough for a secure retirement. Raising the contribution limits would help. And it would allow individuals who have been so hurt in the last year's decline to participate in the market's recovery.
2. Market volatility. Reinstate the uptick rule for short sellers. As it stands now, short sellers using massive leverage can destroy the market value of virtually any company in a spiralling down market in a "bear raid," limiting a company's ability to raise capital, and endangering its entire existence as a going concern regardless of a company's intrinsic value or true economic prospects. The uptick rule prohibits a stock from being sold short when the last sale was priced down. It has worked well in the past at ensuring market stability and reducing volatility while enabling the practise of short selling to provide efficiency in market pricing.
3. Housing values. Rich Karlgaard of Forbes Magazine had a great idea (http://www.forbes.com/business/forbes/2008/1208/029a.html). In Hong Kong, when a mortgage borrower's financial situation changes in the historically volatile Hong Kong housing market, lending institutions simply rework the mortgage terms extending mortgage loan lengths to match the payment to the cash flow generated on the property. When cash flow increases, the mortgage term contracts. As a result, mortgage foreclosure is relatively infrequent in a market that is much more volatile than ours even considering the large declines over the last two years. Rather than renegotiating principle reductions or payments on mortgages that have a high propensity to fail yet again, financial institutions should negotiate increased loan lengths to keep people in their homes so long as they have the ability to pay. I spend a lot of time in Hong Kong. I've see it. It works.
What is the common thread here? No massive government intervention in the credit markets and equity ownership. We do not need socialism to save capitalism. We need government to get out of the way and have faith that the free market will continue to provide the most freedom, highest incomes, and greatest sustainable growth possible to this great country.
Saturday, December 13, 2008
Market Inefficiency Equals Market Opportunity For Investors
Even in the best of times it is difficult for the average investor to earn market beating returns in the stock market. There are many reasons, among them which are two that explain to a great degree the difficulty: market efficiency and investment expenses. You see, in a "normal" market, individual stocks reflect a consensus value by money managers, traders, analytical computer models, and individual investors, at any particular moment in time based upon all information that is publicly available. This is the essence of market efficiency. In order to outperform the market, therefore, one must know something that others don't or see something that others can't. And contrary to popular perception, professional money managers are not clairvoyant or investing wizards. In fact, money managers that actively select stocks are subject to the same market efficiency and the net performance of their funds are hampered by management fees.
Of course, these are not "normal" times for the stock market. Hedge funds subject to margin calls have been selling their stock holdings indiscriminately into a falling market. Professional money managers have been forced to sell stocks and bonds, regardless of valuation, to meet shareholder redemptions. And individual investors have been paralyzed by the falling market for fear of drawing even more blood reaching for falling knives. The market is not working efficiently. Individual equities and bonds can now be found that bear no relationship to their intrinsic value based upon their expected future cash flows and, for the first time in years, offer out sized potential returns going forward. It is times like these that individual investors have the opportunity to take advantage of this situation and significantly outperform the market. The trick now is figuring out where the market is wrongly valuing these securities and buying them for the long term.
Let's take one stock that I follow, Linn Energy (LINE), as an example. Linn Energy is an energy exploration and production company that owns long-lived mature oil and natural gas assets with slow rates of depletion and a reserve life of about 21 years. They are structured similar to a master limited partnership and thus pay out the majority of their profits in distributions to shareholders with certain tax-favored benefits. Management had the foresight to hedge their production to protect their future cash flow and thus their shareholder distributions. In fact, approximately 100% of their production is hedged for the next 3-5 years, and still a high percentage is hedged beyond that. As a result, they should be able to maintain their current distributions to shareholders despite the low price of oil and natural gas. And should energy prices resume their upward climb, they have structured about 30% of their hedges as puts allowing them to book increased cash flows but with downside protection. Despite their many advantages, the stock price has been clobbered, down 48% to $12 over the last few months resulting in an astronomical yield of about 22%.
Why has Linn Energy dropped so far despite their obvious strengths? Well, the stock price has not been helped by the fact that the largest holder was Lehman Brothers, the failed investment bank, and the position has been liquidated into a falling market. In addition, Linn Energy had raised a large sum of capital to expand production and purchase cheap assets through the use of PIPEs (Private Investment in Public Equity) over the last couple years resulting in large holdings by a number of energy related hedge funds. Many of these same hedge funds have shorted the stock to protect their investment or have liquidated their positions to meet margin calls.
So, what is an individual investor to do? Well, far be it from me to recommend anyone purchase a security, but I have been buying. I haven't been forced to meet margin calls and I am not subject to shareholder redemptions. And I love the fact that Linn's production is mature, stable, growing, and hedged. A 22% yield hedged for at least 3-5 years in a tax-favored structure? Are you kidding me! Of course, there is more to the story than what I have the time and space to address and everyone must do their own due diligence. But, Linn Energy may serve as but one example that this could, in fact, be the buying opportunity of a lifetime for individual investors who can find market inefficiencies and have the courage to take advantage of them.
Of course, these are not "normal" times for the stock market. Hedge funds subject to margin calls have been selling their stock holdings indiscriminately into a falling market. Professional money managers have been forced to sell stocks and bonds, regardless of valuation, to meet shareholder redemptions. And individual investors have been paralyzed by the falling market for fear of drawing even more blood reaching for falling knives. The market is not working efficiently. Individual equities and bonds can now be found that bear no relationship to their intrinsic value based upon their expected future cash flows and, for the first time in years, offer out sized potential returns going forward. It is times like these that individual investors have the opportunity to take advantage of this situation and significantly outperform the market. The trick now is figuring out where the market is wrongly valuing these securities and buying them for the long term.
Let's take one stock that I follow, Linn Energy (LINE), as an example. Linn Energy is an energy exploration and production company that owns long-lived mature oil and natural gas assets with slow rates of depletion and a reserve life of about 21 years. They are structured similar to a master limited partnership and thus pay out the majority of their profits in distributions to shareholders with certain tax-favored benefits. Management had the foresight to hedge their production to protect their future cash flow and thus their shareholder distributions. In fact, approximately 100% of their production is hedged for the next 3-5 years, and still a high percentage is hedged beyond that. As a result, they should be able to maintain their current distributions to shareholders despite the low price of oil and natural gas. And should energy prices resume their upward climb, they have structured about 30% of their hedges as puts allowing them to book increased cash flows but with downside protection. Despite their many advantages, the stock price has been clobbered, down 48% to $12 over the last few months resulting in an astronomical yield of about 22%.
Why has Linn Energy dropped so far despite their obvious strengths? Well, the stock price has not been helped by the fact that the largest holder was Lehman Brothers, the failed investment bank, and the position has been liquidated into a falling market. In addition, Linn Energy had raised a large sum of capital to expand production and purchase cheap assets through the use of PIPEs (Private Investment in Public Equity) over the last couple years resulting in large holdings by a number of energy related hedge funds. Many of these same hedge funds have shorted the stock to protect their investment or have liquidated their positions to meet margin calls.
So, what is an individual investor to do? Well, far be it from me to recommend anyone purchase a security, but I have been buying. I haven't been forced to meet margin calls and I am not subject to shareholder redemptions. And I love the fact that Linn's production is mature, stable, growing, and hedged. A 22% yield hedged for at least 3-5 years in a tax-favored structure? Are you kidding me! Of course, there is more to the story than what I have the time and space to address and everyone must do their own due diligence. But, Linn Energy may serve as but one example that this could, in fact, be the buying opportunity of a lifetime for individual investors who can find market inefficiencies and have the courage to take advantage of them.
Tuesday, December 9, 2008
Mark-To-Market Disaster
I was on a flight the other day on my way home from LAX and struck up a conversation with a nice lady sitting across the aisle from me. As it turns out, she was a partner with a major accounting firm. When I found that out I couldn't help myself; I just had to get her take on my theory about the origins of the current financial crisis.
As a result of the stock market bubble of the late 90's and the Enron debacle, congress and the SEC instituted a number of accounting changes, one of which is called "mark-to-market" or fair value accounting. You see, many financial institutions were holding on their balance sheet assets at their original cost, not necessarily what the assets were worth. In some cases, assets were held at far higher values than the asset's true intrinsic value. This created false assumptions about the strength of many companies' balance sheets, leaving many investors shocked and dismayed at their sudden collapse when these problems came to light. To "fix" the problem, the government determined that assets must be held on a company's balance sheet at the "fair market value" derived from what the asset would be worth if were sold today. Sounds fair enough, that is unless no fair market exists. And that, my friends, is one of the major causes of the financial distress the markets are feeling today.
You see, we now have a massive dislocation of credit markets. It started with the crisis in the sub-prime mortgage market (more on this later). Many of these mortgages given to less credit-worthy borrowers began to become delinquent and because of the complicated structure of the securities in which these mortgages were held, the buyers of these securities had great difficultly in determining their value. As a result, the prices of those mortgage backed securities (CMO's) began to fall precipitously...and fall...and fall. In fact, while many of the securities showed delinquency rates of less than 10%, they were priced as if 50%+ would eventually default. This is where mark-to-market comes in. You see, banks and financial institutions that hold these types of securities had to mark these securities on their balance sheet down to the current market value, even if they had no intention of selling the assets. But no fair market existed. And every time these securities had to be marked down, the banks had to raise more cash through asset sales or equity issuance and they would reduce lending in order to meet their capital requirements. This became a debt spiral. There were few or no buyers of the securities so the market value continued to plummet. The banks then had to mark these assets down even more or sell them into a panicked market, and they had to sell common or preferred stock diluting their existing shareholders and sending their stock prices down. And all this had been happening while most of those mortgages in the CMO's continued to be paid. In fact, the intrinsic value of those assets, determined by the expected cash flow of those assets, continues to be far higher than the market price in this dysfunctional market.
What the government must do is immediately implement "mark-to-model" accounting. What this does is require companies to hold assets on their balance sheet at a value determined by the expected cash flow if those assets are held to maturity, unless the company is holding those securities for sale or in a trading account. They should not be forced to mark these assets to market value when no functioning market exists. It also would not allow these assets to be held at cost. And it should be the government's job, as the regulator, to provide guidelines about expected default rates and assure that reasonable cash flow models are used.
If mark-to-market accounting were implemented, immediately the vast majority of banks and financial institutions would become liquid and solvent. These institutions exist to make money and they make money by lending. Lending would increase to normal levels and markets would regain their ability to function. End of financial crisis. Recession, yes, but recover would be much quicker.
Oh, yes. The nice auditor at the major accounting firm on the flight with me agreed. Smart lady.
As a result of the stock market bubble of the late 90's and the Enron debacle, congress and the SEC instituted a number of accounting changes, one of which is called "mark-to-market" or fair value accounting. You see, many financial institutions were holding on their balance sheet assets at their original cost, not necessarily what the assets were worth. In some cases, assets were held at far higher values than the asset's true intrinsic value. This created false assumptions about the strength of many companies' balance sheets, leaving many investors shocked and dismayed at their sudden collapse when these problems came to light. To "fix" the problem, the government determined that assets must be held on a company's balance sheet at the "fair market value" derived from what the asset would be worth if were sold today. Sounds fair enough, that is unless no fair market exists. And that, my friends, is one of the major causes of the financial distress the markets are feeling today.
You see, we now have a massive dislocation of credit markets. It started with the crisis in the sub-prime mortgage market (more on this later). Many of these mortgages given to less credit-worthy borrowers began to become delinquent and because of the complicated structure of the securities in which these mortgages were held, the buyers of these securities had great difficultly in determining their value. As a result, the prices of those mortgage backed securities (CMO's) began to fall precipitously...and fall...and fall. In fact, while many of the securities showed delinquency rates of less than 10%, they were priced as if 50%+ would eventually default. This is where mark-to-market comes in. You see, banks and financial institutions that hold these types of securities had to mark these securities on their balance sheet down to the current market value, even if they had no intention of selling the assets. But no fair market existed. And every time these securities had to be marked down, the banks had to raise more cash through asset sales or equity issuance and they would reduce lending in order to meet their capital requirements. This became a debt spiral. There were few or no buyers of the securities so the market value continued to plummet. The banks then had to mark these assets down even more or sell them into a panicked market, and they had to sell common or preferred stock diluting their existing shareholders and sending their stock prices down. And all this had been happening while most of those mortgages in the CMO's continued to be paid. In fact, the intrinsic value of those assets, determined by the expected cash flow of those assets, continues to be far higher than the market price in this dysfunctional market.
What the government must do is immediately implement "mark-to-model" accounting. What this does is require companies to hold assets on their balance sheet at a value determined by the expected cash flow if those assets are held to maturity, unless the company is holding those securities for sale or in a trading account. They should not be forced to mark these assets to market value when no functioning market exists. It also would not allow these assets to be held at cost. And it should be the government's job, as the regulator, to provide guidelines about expected default rates and assure that reasonable cash flow models are used.
If mark-to-market accounting were implemented, immediately the vast majority of banks and financial institutions would become liquid and solvent. These institutions exist to make money and they make money by lending. Lending would increase to normal levels and markets would regain their ability to function. End of financial crisis. Recession, yes, but recover would be much quicker.
Oh, yes. The nice auditor at the major accounting firm on the flight with me agreed. Smart lady.
I am all a Twitter
So I understand that Twitter is the new killer app. Far be it from me to argue the point. You can follow me on Twitter if you feel so inclined by going to http://twitter.com/seanowens.
Honestly, I just can't get into the whole Facebook thing. But, actually I do like Twitter. It is more simple, faster, and less cluttered. I encourage you to check it out. If you like it, let me know. I would like to follow you.
Honestly, I just can't get into the whole Facebook thing. But, actually I do like Twitter. It is more simple, faster, and less cluttered. I encourage you to check it out. If you like it, let me know. I would like to follow you.
A Bit About Me
Welcome to my See The Forest blog. My hope is that this blog will help to stir some discussion regarding timely political, economic, and social issues affecting our great country and investigate possible solutions to our most pressing problems.
My basic philosophy is that life really isn't as difficult as we make it. I am a "forest for the trees" kind of guy. There is so much noise coming from traditional media sources, let alone new media internet sources, that we often can't see the basic issues standing before us. Let's deconstruct politics, economics, and cultural issues. Let's find the basic issues involved. And let's find the best way forward.
A bit about me: I am proud to be a married father of two great kids. I am gainfully employed as a commercial airline pilot. I am a 1992 graduate of the US Naval Academy with a B.S. degree in Political Science and a 1996 graduate of Oklahoma City University with a M.B.A. in Finance. I am a former Naval Aviator having served 9 years on active duty. Politically, economically, and socially I am a conservative. I consider myself a traditionalist. I derive great strength from my catholic faith and strive, while often falling short, to live up to my religious tenets.
There are a few principles by which I live my life:
1. "Do what is right, because it is right."
2. 50-50-90 Principle (You have a 50-50 chance of getting it right. 90% of the time you get it wrong)
3. Castanza Corollary (Whatever your instincts tell you to do, do the opposite and it will turn out right)
The first one is tough. The second and third, they work every time.
My basic philosophy is that life really isn't as difficult as we make it. I am a "forest for the trees" kind of guy. There is so much noise coming from traditional media sources, let alone new media internet sources, that we often can't see the basic issues standing before us. Let's deconstruct politics, economics, and cultural issues. Let's find the basic issues involved. And let's find the best way forward.
A bit about me: I am proud to be a married father of two great kids. I am gainfully employed as a commercial airline pilot. I am a 1992 graduate of the US Naval Academy with a B.S. degree in Political Science and a 1996 graduate of Oklahoma City University with a M.B.A. in Finance. I am a former Naval Aviator having served 9 years on active duty. Politically, economically, and socially I am a conservative. I consider myself a traditionalist. I derive great strength from my catholic faith and strive, while often falling short, to live up to my religious tenets.
There are a few principles by which I live my life:
1. "Do what is right, because it is right."
2. 50-50-90 Principle (You have a 50-50 chance of getting it right. 90% of the time you get it wrong)
3. Castanza Corollary (Whatever your instincts tell you to do, do the opposite and it will turn out right)
The first one is tough. The second and third, they work every time.
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