Who's To Blame, What's To Come, What To Do?

Cedar Brook Financial Partners Subprime Commentary; February 2008

Azim Nakhooda, Chief Investment Officer

There must be fifty ways to leave your lover
Fifty ways to leave your lover

Just slip out the back, Jack
Make a new plan, Stan
You don't need to be coy, Roy
Just get yourself free
Hop on the bus, Gus
You don't need to discuss much
Just drop off the key, Lee
And get yourself free

Was Paul Simon writing about love in 1975 or was he writing an analogy for the housing market and the financial markets in general in 2007-2008? Seems to me, guys named Lee and a whole bunch of other people are taking his advice literally. They are simply "dropping off the key, and getting themselves free". That's why the banks own so many homes today.

The collapse of the residential housing and mortgage markets has been at the epicenter of the recent pain in the capital markets. It has also rippled out into the financial sector as a whole, and the global equity markets in general. Various financial entities across the world have found their balance sheets linked to our domestic subprime lending failure, and because the world markets have become intertwined by a global business environment, the contagion has been widespread. Who's to blame for all of this? What is yet to come? What to do? Addressing these issues is the purpose of this commentary.

Who's To Blame?

Let's start with the finger pointing - because in this case the targets are too big to miss. For purposes of discussion, we'll absolve the American subprime "homeowner" for now. People aren't made of stone - when a dump truck full of money is driven up to their door (literally - in the form of an easy mortgage) - it's hard to say no. Perhaps they just didn't know any better. However, those who certainly did know better were the Federal Reserve and the Wall Street banks.

In terms of the Fed, think of it this way: when I was 4 years old, my Dad could change my behavior simply by looking at me. A stern look from Dad, and I'd stop bad behavior pretty much instantly, for fear of reprisal. When I was 18, it took a little more - like taking away the car keys. The look just didn't cut it; he needed to take action; but often it was too late. Put simply, the Fed could have stopped the subprime madness in its childhood stage, by simply giving the lenders a hard look. By the time they were forced to take away the car keys, by way of lending inquiries and a rate cut stimulus, it was far too late.

More egregious than the Fed's docility during this time, has been the decision-making of the largest investment banks. The irony of their descent is that they were led there by the absence of risk. Stability begat Instability. For several years, life had been great on Wall Street. These firms were making record profits and growing their businesses quarter after quarter based on a strong economy, investor confidence, booming real estate and private equity, and historically easy access to capital. For some reason, that utopia was not enough. Greed took over. Simply making money hand over fist gave way to the desire to make MORE money than the competitor next door; thus, the creation, packaging, and selling of subprime mortgage investment products. Of course, we all know the results:

Truly staggering losses by any measure, but if one looks closer, the news gets even worse:

• Citigroup shareholders not only lost over ½ their principal value, they also received a 41% dividend cut³
• Merrill Lynch's $41 billion exposure to subprime paper was more than its entire shareholder equity of $38 billion⁴ and that huge position was UNHEDGED. So, their $22.4 billion loss (on $41 billion total) means they lost 54.6% on their own bond investment! This is the same company that gives bond recommendations and manages bond mutual funds for individual investors every day!

These firms are hired by clients to be stewards of risk. Yet, they took pure bets with shareholder capital that any Investments 101 course could tell you was too risky to meet the objectives of a growth & income portfolio. After all, isn't that the purpose of owning these stocks (ML, C, UBS, MS) as stated to shareholders? Somehow, a pack of the highest paid executives on the planet - backed by financial "geniuses" and with sophisticated models on managing risk - managed to lose $100 billion of shareholder equity in less than 1 year. If they cannot even manage their own money, how can they continually ask investment clients to manage theirs?

If we examine accountability for this fiasco, the results are as bad as the stock performance. At least when the Enron executives were exposed, they eventually went to jail. When Stan O'Neal (Merrill) and Charles Prince (Citi) were shown the door, they received a combined QUARTER OF A BILLION DOLLARS in personal severance money. This is to say nothing of the $48 million O'Neal made and $26 million Prince made in 2006, based on what are now false earnings, which will need to be re-stated.⁵ Frankly, it's hard to see a giant distinction between criminal behavior and those involved in this situation. Of course, the end result is rookie CEO's at the helm of some of these companies, at perhaps the worst possible time.

Lastly, the Wall Street banks went hat in hand to foreign governments and their sovereign wealth funds to get bailed out. These are the same sovereign funds, mind you, that tried to buy the port operations on the open market and were scuttled on security grounds. Now, however, their checkbooks are welcome in order to save our very own largest banking franchises.

Fear not patriots, we're not alone in all of this, as earlier this month the French bank Societe Generale announced $10.2 billion in losses relating to U.S. subprime mortgages and a rogue trading scandal.⁷

I am as big a capitalist as you will ever meet, but the type of greed, risk, and incompetence that we have witnessed by executives making eight figures a year, is just unconscionable. The bottom line is that the long-held mentality in the corporate boardrooms of Wall Street that Citi, et al. are "too big to fail" was proven to be nothing more than HUBRIS.

What Is Still to Come?

Perhaps the biggest risk still remaining is the proverbial 2nd shoe to drop - in this case - Credit Card Debt. As bad as the residential mortgage and real estate environment has sunk with record foreclosures, shrinking home prices, etc. - at least at the end of the day, the creditors were left with a piece of dirt. They received something as collateral, even if it was a home they didn't want to own. With the total credit card debt in the U.S. at over $800 billion⁸, this is another major risk on the balance sheets of our financial institutions. The bigger problem, though, is that unlike the mortgage collapse, the credit card debt is unsecured. If this becomes the next round of mass defaults, the lenders will be left with nothing. If we've learned that too many people were given mortgages that they couldn't afford, just consider how many people have been given credit cards that they can't afford!

The risks have spread beyond Wall Street - as other factors are contributing to the uncertainty as well:

• Weak Dollar - the U.S. dollar has weakened dramatically and the long-term effects of this currency level are still emerging. Implications include our Treasuries being less attractive for the world's reserves and a general weakening of our economy.
• Soaring Energy Prices - a weak dollar makes the cost of energy imported from around the globe go up. Given our dependency on oil and other fuels, this spells expensive energy bills for the foreseeable future.
• Tax Landscape - the White House is very much in question. Depending on who emerges in November, America's tax situation could change significantly. Both Democratic candidates have explicit plans to raise tax rates on capital gains, dividend interest, income, corporations, and estates. If Clinton or Obama were to get elected, there are many who feel that these tax policies will adversely affect the capital markets.

What To Do?

So, if the sky is falling, because of the Fed, Wall Street greed, credit cards, the dollar, oil, and taxes - then what are we all to do?! Well, there is some good news. History teaches us that despite all the recent turmoil, this too shall pass. Long-term fundamentals in the global markets have not changed and over meaningful periods of time, these markets have an upward bias.

Perhaps more opportunistically, those of you with the stomach for it have a phenomenal buying opportunity, as most excess valuation and speculative pricing has been corrected back to reasonable levels. There is a simple "buy low" opportunity for investors who have been waiting for more reasonable entry points to strategic investments areas. Emerging markets, public real estate, technology, and international core equity in particular remain attractive as long-term prospects, and have seen significant corrections in recent months.

Even our dreaded financial sector has some contrarian investors interested. Capital Research and Management (you know them as the American Funds) have been net buyers of financials in recent weeks.⁹ Historically, they are early on these trends, but absolutely correct over the long haul.

Lastly for the investor, we would reiterate our strong belief that your portfolio should be allocated beyond the capital markets. Stocks/Bonds/Cash is an antiquated asset allocation strategy; one that should be augmented with Real Estate, Commodities & Hard Assets, Hedging, Private Equity, and Secured Assets. This will, of course, be dependent on the investor's financial situation and risk tolerance. Adopting an institutional approach to portfolio management and true diversification by asset class is an all-weather solution that may protect you from the risk factors that are possibly still to come.

On Wall Street, there is a glimmer of hope that our culprits have learned their lessons. Merrill Lynch's new CEO John Thain has stressed "return to basics" as a business strategy for the firm in 2008. UBS also re-organized its proprietary trading desk to better manage risk. While credibility will take a long time to return, it's a start. Certainly, a return to fundamental business principles would be an appropriate action step for the Wall Street banks.

In Washington, the Fed has already responded in dramatic fashion with multiple interest rate cuts to increase the flow of capital. The SEC has finally awakened to the hubris on the Street and begun inquiries into the subprime situation that should yield stricter standards in the future. Lastly, the Treasury Department has worked with the executive branch to deliver a stimulus package to the lower and middle part of the economy. While the jury is still out on all of these attempts, clearly the Beltway has been spurred to action by the pain in the capital markets.

Finally, we started with Paul Simon's prognostication from 30 years ago. So perhaps it is only fair to end with his oft-overlooked partner - Art Garfunkel - and his words from "All I Know":

It's a fine line between the darkness and the dawn
They say in the darkest night there's a light beyond

The foregoing information and opinions are for general informational purposes only. The Registered Representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions. Such information or opinions is subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or offering of individual investment advice.