"Dear Ben" (er, Santa Claus)

An Open Letter to the Federal Reserve Chairman

Dear Ben Bernanke (er, Santa Claus):

Speaking for millions of my fellow investors, I want to thank you for all your efforts to date, uh, "supporting" stock prices.

I/we are certainly better off for it (at least in the short run; in the long run, direct federal interference in markets is a terrible precedent).

However, perusing my portfolio, I can't help but notice a couple of laggards.

Specifically, my meager holdings in Wal-Mart, General Mills, and Procter & Gamble have all underperformed the market averages year to date.

So, as the Fed prepares to pump more money directly into debt and equity(?) markets, here is my 2010 Christmas "wish list" for what you should buy:

100 million shares of Wal-Mart
50 million shares of General Mills
50 million shares of Procter & Gamble

The above purchases will scarcely cost you $10 billion -- a veritable rounding error relative to your $1.5 trillion balance sheet.

Considering that these are all blue chip companies, there's no reason why you shouldn't make a profit on these investments, just like you say you did bailing out Wall Street.

In return, I promise to spend some of my new-found "wealth" stimulating the economy, thereby making your job easier.

So, you see, you're not just helping me, you're helping yourself.

"Win-win," as they say.

Expectantly,

Ross Kaplan

P.S.: No need to wait for Christmas, if you're so inclined; it's Chanukah right now!

Bernanke's High Wire Act

Disconnecting the Heart Monitor

In my post last week titled, "Approaching the Zero Bound," I characterized the Fed's plan to buy hundreds of billions ($600 billion, it turns out) in U.S. debt as a "hypodermic needle to the economy's heart."

Actually, that analogy is not quite complete.

The Fed's money-injection plan, also known as quantitative easing, is like administering a hypodermic needle to the heart . . . after disconnecting the patient's heart monitor.

That's because the Fed's injection mode of choice -- buying up U.S. securities -- suppresses a key market signal: interest rates.

How's that?

Normally, when inflation kicks up, demand for loans becomes overheated, etc., buyers of U.S. debt balk, causing demand to flag -- and interest rates to rise.

Now, enter the Fed, and quantitative easing.

With the Fed guzzling U.S. debt -- goosing demand -- interest rates stay low or even go down.

As Bloomberg columnist Caroline Baum puts it (my paraphrase): 'playing with the yield curve is like trying to fool Mother Nature. Instead of increasing demand for goods and services, printing money just raises asset prices.'

Sure seems like the stock market agrees.

Approaching the Zero Bound

"An Attempted Hypodermic
Straight to the Economy’s Heart"

A fascinating, even feverish dialogue is taking place right now -- joined by some of the financial world's most influential thinkers -- concerning what will happen next week, and what economic consequences will flow from that outcome.

The elections next Tuesday?

Try, the Fed's much-signalled intention to initiate another round of quantitative easing (also called "printing money") when it meets next Wednesday.

Here is Bill Gross' take, from his perch at PIMCO, the nation's (world's?) largest investor in bonds:

Quantitative easing is temporarily, but not ultimately, a bondholder’s friend. It raises bond prices to create the illusion of high annual returns, but ultimately it reaches a dead-end where those prices can no longer go up. Having arrived at its destination, the market then offers near 0% returns and a picking of the creditor’s pocket via inflation and negative real interest rates.

--Bill Gross, "Run Turkey, Run"; PIMCO Investment Outlook (Nov., 2010)

So why do it?

Because the Fed, caught in a liquidity trap, is out of other options.

Gross again:

Ben Bernanke can’t raise or lower taxes, he can’t direct a fiscal thrust of infrastructure spending, he can’t change our educational system, he can’t force the Chinese to revalue their currency – it (more quantitative easing) is all he can do.

--Bill Gross

Will "it" work?

Gross, whose credentials are as good as anyone's, thinks the jury's out.

Proposal: A U.S. "Dividend Holiday"

Tapping Corporate America's Cash Hoard to Reward Investors & Stimulate the Economy

Money is like manure; it's not worth a thing unless it's spread around.

--Thornton Wilder

Let's see if I've got this right . . .

The economy is decelerating now because the federal stimulus to date has run its course, and additional federal stimulus risks drowning the U.S. (further) in red ink and endangering its very creditworthiness.

Meanwhile, corporations sit on the mother lode of all cash hoards -- an estimated $2 trillion for just the S&P 500.

All this, as shareholders have just suffered the worst decade investors have experienced . . ever: nominally down 20% from where they were . . . in 2000.

And that's before accounting for the stock market's sickening volatility, or a decade's worth of inflation that masks even more erosion in investors' wealth (my label for the foregoing toxic brew: 'risk without return').

Three Birds With One Stone

So, to summarize:

The challenge now is to get money into the hands of deserving people -- who will actually put it to good use -- without making future generations pay for it.

Anyone else have a light bulb go off?

Here's mine:

Give corporations an incentive to disburse their cash hoard; then, give shareholders an incentive to spend it.

The simplest way to do that would be to declare a Dividend Holiday through the end of 2010 during which the federal government would waive taxes on all dividends.

Carrot won't work?

Then consider a stick: taxing corporations on excess undistributed cash.

Either way, such a bold step would have three benefits (and few costs):

One. It rewards long-suffering shareholders.

Why is that important?

Abuse shareholders long enough, and eventually they will "take their marbles and go home."

After the 1929 crash, an entire generation learned not to put their money in stocks.

That attitude threatens capital formation, future innovation, and arguably capitalism itself.

Deprive savers of a return on their investment, and they lose their wherewithal to finance their retirements.

Guess where they'll turn to for help.

Two. It takes the money away from overpaid CEO's.

Incredibly, the average S&P 500 CEO now makes almost $10 million annually, up 700% since 1980.

Meanwhile, workers' wages during that time have stagnated, and investors -- to belabor the point --are worse off than they were a decade ago.

As the saying goes, money -- like manure -- isn't worth anything until it's spread around.

Three. It relieves the pressure on the Federal Reserve to print more money, and the U.S. Treasury to borrow more.

According to that famous physics theorem, the First Law on Holes, "when you're in one . . . stop digging!!"

Having dropped interest rates to zero and kept them there, Ben Bernanke is now resorting to raw injections of liquidity (called "quantitative easing") to stimulate the economy.

Enough!

There's plenty of money in the economy already.

The challenge is to get it circulating, productively, again.

Jeremy Grantham, Animal Spirits, and "Bubble Business"

"Don't Just Stand There -- Buy Something!"

Some people wait for a new episode of a favorite TV series (Seinfeld, The Sopranos).

Others for a new album from a favorite artist.

I look forward to Jeremy Grantham's latest quarterly newsletter. Seriously.

The man's honest, brilliantly insightful -- and a great writer, to boot:

Greenspan was lucky enough to inherit Volcker’s good work, and that gave him a base from which he could launch or blow a huge equity bubble; he also had the advantage that the country’s balance sheet was in excellent shape. Even Bernanke inherited a reasonably solid position from which to fund a second bailout. But a third time? It is hard to work out where the resources would come from to resuscitate the economy if a real shock were to be delivered by another collapse of a major asset class.

--Jeremy Grantham, "Playing With Fire"; GMO Q1 2010 Newsletter

Subscribing to the notion that the "bigger the bubble, the more damaging the bust," what is Grantham's antidote?

"We had better hope that something lucky turns up to break the speculative spirit."

Non-Exploding ARM's

Setting the Record Straight on ARM's

It's easy to think that every adjustable rate mortgage ("ARM") burned the borrowers who took them out.

After all, aren't so-called "Option ARM's" supposed to be financial time bombs?

They are, but most ARM's don't function that way (at least, the ones most common outside of Southern California, Arizona, and Florida).

Option-ARM's

With an option ARM, the borrower effectively chooses to re-pay whatever they want --including virtually nothing -- for a prescribed period of time (usually 5 years).

Any shortfall is simply added to the balance of their mortgage.

So, an Option-ARM borrower who decided to make only tiny monthly payments could easily see their loan balance double, as all the accrued interest piled up on the (unpaid) principal.

As millions have now discovered, a mushrooming mortgage balance on a house that's rapidly losing value is a nasty combination.

Plain Vanilla ARM's

Fortunately, that's not how most ARM's work.

While the formula varies by lender, the plain-vanilla version typically features an initial teaser rate that's fixed for a prescribed period of time (often, 5 years). (FYI, big banks today are offering 5/1 ARM's at 3.625%, vs. fixed, 30-year rates just under 5%).

After that, the rate re-sets annually based on a predefined formula; popular ones include LIBOR ("London Interbank Offer Rate") or 10-year U.S. Treasury notes, plus anywhere from 2% to 4%.

Another feature of ARM's is a ceiling on how much the maximum upward bump can be over the life of the loan.

Sitting Pretty

So, where does that leave people who took out ARM's in 2005, that are re-setting in today's environment of infinitesimal interest rates?

In many cases, with rates that are re-setting lower.

Thanks, Ben! (as in Fed Chairman Ben Bernanke, whose appointment to a second term was just confirmed by the Senate yesterday).

P.S.: Another reason why ARM's have bit fewer people than you might expect: they sold their home before their interest rates re-set.

Given that the average homeowner moves every 7 years, statistically, a high percentage would retire their ARM loan before the 5 year re-set date ever arrived.

In fact, that's one of the strongest arguments for getting an ARM in the first place, i.e., why pay a premium for a 30-year mortgage when your time horizon is much shorter?

Housing Market Subsidies: 'Sauce for the Gander'?

"Buying Too Many Votes -- er, Mortgages?"

Dear Jack: Don't buy a single vote more than necessary. I'll be damned if I am going to pay for a landslide."

--JFK quoting a made-up telegram from his father, Joseph Kennedy

What recalls the above anecdote is Ben Bernanke's so-far successful efforts to keep mortgage rates low -- now under 5% again -- and therefore provide support to the embattled housing market.

But in committing $1.25 trillion to the effort -- apparently, the Fed has already deployed more than two-thirds of that -- is Bernanke guilty of "buying too many votes?"

If low mortgage rates help the housing market, and a strong housing is good for the economy, what's the harm?

Three Problems

In fact, I see three problems with such heavy, government intervention.

One. It's expensive.

The cost of a $1.25 trillion program to buy up mortgages is, well . . $1.25 trillion. Even that understates the cost of government housing subsidies today.

Throw in the tens of billions pumped into Fannie Mae and Freddie Mac, the cost to the Treasury of the $8,000 tax credit to first-time home buyers, the billions being lined up now to replenish a depleted FHA . . . and the total cost is truly staggering.

Two. Scaling back long-established government subsidies is economically -- not to mention politically -- tricky.

One of the "lessons" supposedly learned from The Great Depression is that withdrawing government help prematurely caused the economy to relapse in 1937.

So too, today's Op-Ed pages are full of competing arguments that even more must be done to nurse the economy back to health, vs. those arguing that the government has already massively overreacted.

Three. Slippery Slope (or, "Target Levels for . . . Everything?")

Philosophically, what's the difference between the government buying up mortgages to support the housing market . . . and buying up equities to support the stock market?

Or, say the government wanted to knock down the price of gold. Why not just start selling from U.S. stockpiles (or announce that it intended to)?

Would we even know if that was happening?

In my experience, markets are messy, constantly gyrating as they absorb new information.

Now consider all the "un-messy" century marks currently on display: S&P 500: 1,000; Dow Jones Industrial Average: 10,000; Nasdaq: 2,000; gold: $1,000/oz.

Technical analysts no doubt can explain the foregoing simply as evidence of the market's affinity for round numbers, both as "support levels" and ceilings.

Still, it gives you pause.

Housing Market Subsidies: "Sauce for the Gander?"

So, do I have any brilliant recommendations?

I wish.

In a perfect world, the housing market would function with few or no government subsidies.

However, in a perfect world, the financial system would never melt down, nor would the government throw ten trillion (!) or so into recapitalizing the institutions that crashed it.

In an environment where so-called Too Big to Fail financial institutions are getting trillions, I have no problem with billions in housing subsidies.

There's no doubt in my mind that the latter is a better investment.

Bold Mortgage Prediction!

Mortgage Prediction: More Red Tape

Clients know that I demur when asked where I think interest rates are headed.

If Ben Bernanke, Chairman of the Federal Reserve, doesn't know with a high degree of confidence -- what chance does anyone else have?

That said, here's one major development that's easy to predict: there will be more red tape.

That's so because government, by default, is going to be more and more involved in the lending process.

In fact, it's likely to be the loan originator, the underwriter, the appraiser, the insurer, the servicer, and the securitizer (did I forget anything?).

Since the full nationalization of Fannie Mae and Freddie Mac almost a year ago, it's already playing many -- if not all -- of those roles.

If the old focus was making money (through any and all means), the new focus is not losing it.

That mindset -- plus government "process" -- is not likely to breed expediency or economy.

Saved by Zero?

Ben Bernanke's Theme Song

Maybe, someday
Saved by zero
I’ll be more together
Stretched by fewer

Thoughts that leave me
Chasing after
My dreams disown me
Loaded with danger

Maybe I’ll win
Saved by Zero

Holding onto
Words that teach me
I will conquer
Space around me

Maybe I’ll win
Saved by zero
Maybe I’ll win
Saved by zero

--Lyrics, "Saved by Zero"; The Fixx

Who knew? Personally, I had (Federal Reserve Chairman Ben) Bernanke pegged more as a crossover, Country & Western type.

If and when the Fed's monetary medicine starts to work, it'll be time for another song by The Fixx: "One Thing Leads to Another."*

*Thanks to Bob Riesman for all relevant musical input.