The Fed is Petrified

You can read the text of the Fed's statement here.

A quick summary:

• Cut fed funds to a target range between zero and 0.25%
• Cut discount rate to 0.5%
• Will support financial markets by purchasing agency debt and MBS
• Will look to possibly purchase longer term Treasuries
• Will consider other methods to use its balance sheet to support markets and economic activity
• Labor market conditions have deteriorated, credit is strained, the economic outlook has weakened significantly
• If you can think of anything else the FOMC can do to further dump liquidity on the market, please send them a note...

Goldman Sachs Posts Loss

Remember when everyone thought that Goldman Sachs was immune to any downturn because they were just smarter than the plebian boobs working at other investment banks?  As it turns out, Goldman really is just another cyclical investment bank that can't escape the worst downturn the securities industry has seen since the Great Depression.  CEO Lloyd Blankfein's statement, after reporting negative net revenues of $1.58 billion and a net loss of $2.12 billion for the fourth quarter, summed up the situation nicely:  "Our results for the fourth quarter reflect extraordinarily difficult operating conditions, including a sharp decline in values across virtually every asset class."  The good news is that Goldman is still standing unlike Merrill, Lehman and Bear.  Even better news is that the government has shown its commitment to keeping what's left of the banking community afloat by guaranteeing its short-term debt via the FDIC, lending billions against shady collateral via the Fed, handing the investment banks capital infusions via the Treasury AND reducing interest rates to near-zero via the Fed.  So, let's just say that Goldman isn't still standing due to its own genius.  Regardless, if the investment bank makes it out of this mess alive, and the credit markets actually improve at some point within the next couple of years, Goldman will be poised to profit from the upturn.  But unlike those optimists who are currently buying the stock on this earnings announcement, I'm willing to wait until at least a small glimmer of hope is on the horizon.   

Fund of Funds Party is OVER

Contrary to popular opinion, the best job in America for the past ten years or so has not been that of a hedge fund manger.  Sure, rich people threw money at hedge fund managers, their prime broker let them lever up 50 to 1, and they could charge two-and-twenty on $10 billion in assets under management for barely outperforming T-bills.  No, the best job in America was that of a fund of hedge fund manager.  Why?  Because rich people threw money at fund of funds managers, their prime brokers let them lever up, they could charge two-and-twenty on $10 billion in assets under management for barely outperforming T-bills AND they didn't actually have to do any of the hard work entailed in trying to outperform T-bills.  What fund of funds managers were supposedly paid for was evaluating hedge fund managers and protecting their investors from potential fraud and losses in riskier assets due to a lack of diversification.  Fund of funds were supposed to be mutual funds for rich people.  Except with much higher fees.  This way, if you happened to be a grocery store magnate who had significant assets to invest, but didn't really have the time or patience to follow the market or care to hire your own private investigators to follow your hedge fund manager around, you could rest assured that you were paying someone a truckload of money to do it for you.  The fund of funds industry was founded on this principle.  It was a very clever money-making scheme.  Until Friday.

The most curious part of the Madoff Ponzi scheme pertains not to the rich people handing over their life savings to one guy without asking any questions.  Charming con men have always been able to talk the rich into parting with their cash.  What I find most amazing about this particular fraud is the unearthing of gross negligence in the fund of funds community.  So far, a fund of funds outfit called Fairfield Greenwich has announced the largest loss, that of $7.3 billion from its investment in Madoff's fund.  A $7.3 billion investment would be a perfectly reasonable allocation if Fairfield Greenwich managed around $1 trillion in assets.  But, alas, Fairfield Greenwich only managed $14 billion, having allocated more than half of its assets to one fund - a fund that was notoriously secretive, didn't have a legitimate auditor, or a separate custodian.  So I have to ask:  What exactly did the people at Fairfield Greenwich do all day?  I mean, other than calculate the fees they were earning on the phantom 10% returns that the Madoff fund "generated" for its investors?  After they performed all of that difficult and complicated due diligence that led them to believe that putting $7 billion into one fund was a fabulous investment decision, how did they spend their time at work?  They obviously weren't looking at confirms and making sure that all the returns tied out.  Did they even get statements from the firm?  From what I have read in other reports, the Madoff fund sent out statements that resembled this: "beginning balance $1 million, ending balance $1.2 million," without any further detail.  Weren't the crack investigators at Fairfield interested in a little bit more detail about how their returns were generated?  I am not casually throwing the term "investigator" around either, for one of the founders of Fairfield Greenwich was a former enforcement officer with the SEC, which perhaps explains why the SEC didn't unearth the ponzi scheme before Mr. Madoff's sons turned him in.    

Fairfield was not the only fund that perpetrated such negligence in its asset allocation decisions for clients.  Several other funds are on the list of offenders that had inexplicably large allocations to Madoff, with a few allocating ALL of their assets.  Did the managers of these fund of funds really think that their laziness and complacency was worth the multi-million dollars in fees that they collected?  Certainly their investors don't anymore.  Most of these funds will be sued to high heaven as investors go after refunds of fees collected on profits that never existed.  They won't survive and the founders will be tied up in a mass of litigation for years.  Furthermore, the fund of funds redemption game will begin anew.   

      

Madoff Fraud Exposes Regulatory Weakness

How do you perpetrate a $50 billion ponzi scheme?  The details are still hazy, but a few clues that something was amiss at Bernie Madoff's investment fund were enough to keep at least one shrewd advisor from steering clients into the massive fraud.  An advisory firm named Aksia, attempted to replicate the "split-strike conversion" strategy, using a quant analyst who failed to reproduce the returns indicated by Madoff's fund.  Furthermore, since all of the firm's assets were custodied with Madoff Securities, rather than a third-party clearing firm, Aksia investigated the auditor Friehling & Horowitz.  F & H only had three employees, one of which was a 78 year-old living in Florida, one secretary and one active 47 year-old accountant.  The office was in Rockland County, NY and was only 13ft x 18ft large.  Given the scope of Madoff's investment operation, the auditing firm appeared small.  Why other advisory firms and fund of funds firms didn't perform the same due diligence remains a mystery.  After all, what purpose do all of those extra fees on top of fees serve if not to fund extensive due diligence?  It is remarkable how many wealthy and sophisticated investors forked over money to Mr. Madoff given the lack of transparency.  Furthermore, it is even more incredible that some very wealthy investors were so enamored with Mr. Madoff that they handed their entire net worth over to one fund.  The Wall Street Journal has several interesting articles covering many of the issues raised by the Madoff debacle.  The victims of the fraud included many well known wealthy investors and Jewish charities.  Furthermore, an entire enclave in Palm Beach where Mr. Madoff recruited investors has been decimated by losses, with four ultra-luxury condos hitting the market this weekend in one resort, and investors calling the local high-end pawn shop on a Saturday (when it is ordinarily closed) to get loans. 

Where exactly was the SEC?  Asleep at the switch again.  According to the Wall Street Journal, the SEC investigated the firm several times over the years and came up empty-handed.  The agency's enforcement division even investigated a whistle-blower's concerns in 2007, but closed the probe without bringing a case.  Additionally, Mr. Madoff registered his firm as an investment advisor in September 2006 and was not examined within the first year, as is the  requirement for new investment advisors.  The SEC did not sue until December 11, 2008 when Mr. Madoff's sons turned their father in after his confession.  Clearly, there is something very wrong with the regulatory structure of the US securities industry if it cannot unearth a scheme this large without a confession from the guilty party.  The fact that this monumental scam went undetected for so long is mind-boggling and will be a tremendous blow to the hedge fund industry.  Make no mistake, if investors were scrambling to get their money out of hedge funds before the Madoff fraud was unveiled, redemption requests will only increase significantly on the heels of this news.  Analysts who have been calling for the industry to shrink by 30-40%, will have to revise their estimates much higher.  Try 70%.  That's if they can get around the "gates."    

Automaker Bailout Falls Apart in Senate, Grab Your Helmets

The Senate put the kibosh on the $14 billion temporary bailout of the U.S. auto industry.  Of course, the temporary bailout was merely a stopgap measure to keep the car makers operating until a more permanent bailout solution could be concocted by the new administration.  What held up the bill?  The sticking point was how soon union employees' pay should be adjusted to parity with employees of nonunion workers' at plants operated by foreign automakers in the U.S.  The Republicans wanted to reach parity in 2009 and the Democrats wanted more time because, according to Sen. Dodd, with the economy in recession, he thought it wouldn't be fair to force auto workers to accept wage cuts in 2009.  Apparently, he thinks it's completely reasonable for a bunch of autoworkers to be unemployed during the worst recession this country has seen in decades.  Without government aid, both GM and Chrysler will file for bankruptcy before the end of the year.  Wave goodbye to what remained of the U.S. manufacturing industry because once the companies go into Chapter 11 bankruptcy, it seems unlikely that they will emerge.  Unless the government is willing to provide DIP financing, they're headed straight for Chapter 7 liquidation, which is great news if you're in the market for a cheap manufacturing plant in Michigan.  Bad news if you happen to live in the Midwest, because the economy is likely to head straight into the toilet.  Although I suppose all of those out of work auto employees can just go work for AIG.  Maybe they can line up a $3 million bonus just for showing up for work.  

I'm not placing the blame solely on the Democrats, of course.  The Republicans didn't support the rescue package because of "concerns about government intervention in the marketplace."  You see, according to the Republicans, it's perfectly okay to intervene in the marketplace as long as you are keeping insolvent financial institutions afloat (i.e. AIG, Citi, Mer) and supporting bonuses for Wall Street employees.  Blue collar union employees are a whole different story.  Amazing, yet not surprising, where our legislators decide to draw the line.    

The market, of course, is officially back in panic mode.  Futures are off significantly, as investors understand that the repercussions of a bankruptcy of the Big Three will be spread far and wide.  If you thought we were out of the woods, you were sadly mistaken.  

 

RIP BCE Buyout

I must admit, I'm somewhat sad to see the BCE buyout officially fall apart.  Witnessing the litigation circus that this deal morphed into has been extraordinarily amusing.  Why the private equity group, led by the Ontario Teachers' Pension Plan of all people, was so dead-set on completing a monster deal struck at the peak of the private equity boom remains a bit of a mystery.  Perhaps the Ontario Teachers have no business investing in private equity if they are so lousy at assessing such a stark change in the investment environment?  Or perhaps, they're smarter than we think?   

In a surprising twist, the deal was killed by a solvency, or rather lack-of-solvency opinion issued by the firm's auditor KPMG.  What do you do when your auditor tells you the firm will be insolvent if the deal goes through?  You try to find another auditor to express an alternate opinion!  BCE engaged Pricewaterhouse Coopers, which delivered a positive solvency opinion.  Because it is really reassuring to know that at least one out of two auditors think the firm will be solvent.  You definitely want to base a multi-billion deal on that.  In any event, the true irony is that BCE originally inserted the solvency-certificate condition in the merger agreement as a condition of closing to protect itself from  lawsuits by existing BCE bondholders, who were pissed about the company's proposed new debt-laden capital structure.  The negative opinion killed the deal, and all involved are certainly rejoicing, with the exception of BCE and its shareholders, who would love a $34-a share take-out, with the stock currently languishing at $18.

With the auditing industry famous for putting its stamp of approval on stellar outfits such as Enron, Worldcom, Bear Stearns, Lehman Brothers and a host of other companies that were basically insolvent and went bankrupt with nary an auditor raising a flag, I've got to ask the following controversial question:  Who bribed the auditors into killing the deal?  I'm not going to point any fingers because my conspiracy theories are purely a figment of my overactive imagination, but I have a few ideas... 

 

Economic Headlines

Investors have plenty of data to chew over while the Senate takes its sweet time debating the automaker bailout.  First the bad news:

• Weekly jobless claims soared by 58,000 to a seasonally adjusted 573,000 versus analyst forecasts of 525,000 in the week ended December 6, 2008.  The four-week moving average rose to 540,500, the highest since December 18,1982. 
• Both exports and imports declined in October, but the overall deficit rose as the volume of oil imports spiked.  The trade deficit widened 1.1% to $57.2 billion versus consensus estimates from economists of a narrowing of the deficit to $54.5 billion.
• Retail sales were down 5.5% in November, and on-line sales were about flat from the previous year.
• Credit card charge-offs  are poised to rise significantly from the 6% rate reported in the third quarter.  Card industry executives have seen escalating "roll rates", the percentage of cardholders who go from late payments to not making payments at all.  Among cardholders who are between 60 and 89 days overdue, about 20% are being charged off as uncollectible, up about a third from last year.

In the deceptively good news department:

• Foreclosure filings dropped 7% from October to November but rose year-over-year 28% to 259,085.  The decline is being attributed to several moratoriums on foreclosures instituted by Fannie, Freddie, and other major lenders.  The numbers are expected to continue rising once the moratoriums are lifted.