The Chart that the bullish narrative will have stamped all over CNBC...

Its all about the narrative. Now that momentum factors are shaping up positively, these simple and undebatable pictures will find be showing at a theatre near you.

The Comprehensible Patient

“The most incomprehensible thing about the world is that it is comprehensible.”
-Albert Einstein

I like to think that when Einstein wrote that, he was thinking about markets. In mathematics, complexity (or chaos) theory explains many of this world’s outputs through simple, repeatable, and underlying patterns. In hindsight, I guess this is why markets are always “comprehensible” by Wall Street’s finest revisionist historians.

Hindsight, of course, is always crystal clear. Unless the leaders of your organization don’t have any mirrors, you’re probably getting used to our 2009 investment Theme, “The New Reality”, taking hold at your office - transparency, accountability, and trust will be its new governors.

The leadership front is finally starting to get priority coverage in the financial media. President elect, Barack Obama, has inspired a bid this morning in the US futures after speaking to what has seemingly shocked the world in the form of a proactive plan that has a duration of 2 years rather than 2 days. There were also a couple of principles-based battles that emerged this weekend in corporate America’s boardroom. Both were long overdue.

The first was the most predictable – John Thain vs. Bank of America. The WSJ is reporting this morning that Thain is “struggling” with BAC’s management over paying himself a nifty $10M bonus. I expected nothing less of the Goldman alum. This one should be interesting to see play out.

The second was more inspiring – Lazard’s Bruce Wasserstein vs. Blackstone’s Steve Schwarzman. There is a fantastic Bloomberg article this morning comparing and contrasting the views of a levered long private equity man and why he shouldn’t have to mark his book to market versus the Brooklyn born banker’s concept of a transparency. Wasserstein knows a thing or two about private equity, folks – he owns private equity firm Wasserstein and Co. The credibility of this man’s handshake matters. Stay tuned. The ‘You Tubes” are ready to roll.

One of the main investment strategies I have been rolling against consensus with is being long China. Now heads are starting to roll on those desks who stayed short the world’s most relevant economy. Whether you shorted it 4 days ago, or whether you shorted China 4 weeks ago, it’s starting to hurt. The Shanghai Stock index closed up another 3.6% overnight, taking its four day rally to +10.3%. Since the first week of November, China is +22%. The USA is down -13%. This morning the Chinese government is floating the idea of cutting personal tax rates. This is good.

Stocks in Hong Kong raged higher on whispers of American capitalist principles blowing on shore. The Hang Sang Index had a whopper of a day, closing up +8.7%. Some of the reactive market pundits are suggesting Asia was up because India cut interest rates this weekend. I find their math trivial however, as India’s Sensex flashed a negative divergence, underperforming the region in Asian trading. “Chindia” isn’t a word, and much to the chagrin of those who tried making it up, China and India are on two very different economic policy tracks.

I covered all of our Indian and Japanese short positions into Friday’s freak-out US market open. We have been short the IFN and EWJ etfs for the better part of 2008, but that doesn’t mean we have to be short them every day. Consistently making money on the short side is a mathematical exercise that should be managed very proactively. There is no such thing as a “long term capital gain” on the short side, so I don’t manage my duration that way.

Just because I covered India doesn’t mean that their economic issues cease to exist. While they plugged in a token $4B stimulus package this weekend, that was a good 2/3 light versus expectations. India’s yield curve has flat-lined, and their debt balances are beginning to balloon. This is not good folks. This is not “Chindia”. This is a problem, and we will look for strength as an opportunity to re-short this country-level risk.

Back in the USA, I was also doing a little holiday shopping on Friday (covering and buying). I had 9 consecutive buy/cover ideas in the virtual “Portfolio”, so I’ll refer you to that part of our portal for the details ( Importantly, I opened up our wallet and took our net allocation to US Equities up to 3% - I know, call me reckless! Our US Cash position was dropped back down to 65%, and I continued to add to our mounting position in Commodities, taking that exposure to 15%. China remains the dominant driver in our International Equities position of 18%. We’re not chasing the lemmings buying China high today – trust me.

You can trust me and my team’s investment process. I trust in America’s principles-based resolve. I am confident that we will, at some point, find the new leaders of both our political and economic process. The New Reality will be a wonderful one. While timing it to the day will be next to impossible to get right, we will be able to monitor this patient’s critical market factors daily. Like any complex system, the global market is a very dynamic one. “The most incomprehensible thing about the market is that it is comprehensible.”

Have a great week,

Long ETFs

GLD -SPDR Gold Shares -- LME spot gold contracts rose over 2% in trading this morning.

OIL - iPath ETN Crude Oil – Light Sweet Crude near month contracts traded as high as 43.44 this morning after below 41.00 in late trading on Friday. Last week, OPEC president Khelil acknowledged that the group is considering enacting significant production cuts in their upcoming meeting. 

EWG – iShares Germany  - Stocks in Europe rallied, led by mining and oil shares, after U.S. President-elect Barack Obama pledged the largest infrastructure spending package since the 1950s. The DAX gained 257.21, or 5.89%, to 4639.56. DAX futures expiring this month rose 6.9 %. Audi AG (EWG: 13.6%) said deliveries rose 0.4% last month because of new models, with year-to-date sales advanced 3% to 920,700 vehicles.

EWH – iShares Hong Kong  -- China Construction Bank Corp. led the nation's banking stocks higher in Hong Kong trading on speculation the Chinese government will lower an industry tax to ease pressure on their finances. The Hang Seng closed up 8.66% to 15,044.87.

 FXI – iShares China – The CS1300 closed up 81.86, or 4.07%, to 2095.04. China’s Central Economic Work Conference, a three-day annual economic policy meeting, will start today and run through Dec. 10. The government may cut personal income tax to boost consumption and growth.

Short ETFs

SPY- S&P 500 Depository Receipts— CME futures traded above 897 this morning as a broad rally lifted European and Asian indices.

EWU – iShares United Kingdom – The FTSE is up 4.42% this morning to 4228.78. Royal Dutch Shell (EWU: 5.86%) gained 6.72%.

UUP – U.S. Dollar Index – The Euro rose to $1.29 USD this morning. The Pound traded higher to $1.49 from $1.47 USD.

FXY – CurrencyShares Japanese Yen Trust – The Nikkei closed up 5.20% to 8329.05 today. Mitsubishi UFJ Financial Group, Japan’s biggest bank, said it will raise about 400 billion yen ($4.3 billion) by selling common shares to boost capital.

Eye On Regionalism: The Legacy of Austria’s Jörg Haider

Eye On Regionalism: The Legacy of Austria’s Jörg Haider

I’m not sure if the headline made much of a splash in early October of this year on this side of the Atlantic, but when I saw Jörg Haider’s obituary notice while cruising through the NY Times, I was shocked. My first thought—he was a pretty young guy. I had followed him over the years because of my interest in European politics and had just read an article that noted the support that his newly-found party won in recent Austrian parliamentary elections.

At 1:18am on October 11th Haider died from injuries sustained when his black VW Phaeton crashed on his way home to Klagenfurt, the capital of Carinthia, the southern province where he was governor for twelve years. He was driving 142 kmh (88 mph), nearly double the speed limit, with a blood alcohol level that was three times the legal limit.

Haider was Austria’s boy, whether you agreed with his politics or not. He garnered an international reputation as a controversial and charismatic far-right politician. Some of the remarks he made included that the Third Reich had a “proper employment policy”, that SS veterans were men of “character, honor, and conviction”, and cited “foreigner overrun” (Überfremdung) when speaking about immigration in Austria, a term not used since the Nazi days. With such anti-Semitic and xenophobic comments Haider managed to become a figurehead in Austria and for an array of far-right European groups.

Born in the Upper Austrian town of Bad Goisern in 1950, Haider’s early life was formed from his father Robert, a shoemaker, and former Nazi, who joined the NSDAP (National Socialist German Workers’ Party) in 1929 at the age of fifteen, and his mother Dorothea, a teacher, who had been active in the NSDAP as a leader of the Bund Deutscher Mädel, or the female branch of the Nazi youth party movement.

His first political involvement came in 1970 as youth leader for the right-wing Austrian Freedom Party (FPÖ), a party opposed to the political catholicism of the Austrian People’s Party (ÖVP) and the socialist views of the Social Democratic Party of Austria (SPÖ). Moving through the ranks he became head of the regional Carinthian Freedom Party in 1983, and in 1989 beat out the Social Democrats to become governor of Carinthia. Under his leadership the Freedom Party moved further to the right, reflecting his nationalist, anti-immigration, and anti-EU views. A debate in 1991 over reducing unemployment payments for people he saw as “freeloaders” forced his resignation when he said: “…the Third Reich had a proper employment policy, which not even your [Social Democratic] government in Vienna can manage to bring about.”

Haider re-entered the political scene in 1999 as head of the Freedom Party and took 27% of the vote in Austria’s parliamentary elections, which gained him international prominence. The inclusion of the Freedom Party in the coalition government with then conservative Chancellor Wolfgang Schüssel in 2000 provoked international outrage and sanctions from the EU. The heads of government of the other fourteen EU members ceased cooperation with the Austrian government; other national leaders shunned diplomatic contacts with Schüssel’s government because of Haider’s politics.

Stepping down from politics in 2000 after EU sanctions, Haider returned to his seat as governor of Carinthia in a surprise 2004 election that won him 42% of the vote. The following year he broke off from the Freedom Party to form the Alliance for the Future of Austria (BZÖ), a new movement meant to reflect more moderate conservative policy.

In national elections in late September 2008 Haider’s party received 10.8% and the far-right Freedom Party gained 17.7% of the vote. The combined 29% for right-wing parties placed them on nearly equal footing with the Social Democrats, who came in first place with 29.7%.

The result was seen as a political comeback for Haider and the right-wing politics and made his death all the more devastating for his supporters. Stephan Petzner, Haider’s party secretary said, “For us, this is the end of the world.” Thomas Hofer, an independent political consultant in Vienna said, “This is the end of an era. He was more controversial than any other, but also one of the most politically talented individuals in the country’s history.”

Haider’s death led to an outpouring of grief compared by some to the mourning in Britain after the death of Princess Diana. On Saturday October 18th, 30,000 people turned out in Klagenfurt, a city of less than 100,000 people, for Haider’s funeral service. For those that couldn’t be there in person the state broadcaster ORF had live coverage. Austrian President Heinz Fischer, a Social Democrat, called Haider a “politician of great talent.” Austrians decorated the site of the accident where Haider’s sedan came to rest after flipping over several times. Even Toni Faber, a priest at St. Stephen’s Cathedral in Vienna, said: “We stand, in shock, before the death of a man who moved Austria…When bidding farewell one should consider the good sides of the deceased.”

Maybe it was just human emotion that drove the support for Haider’s death. This was the same Haider that many Austrians were ashamed of, the same Haider that said, “Austria was under siege from Turkish immigrants”, openly made fun of people based on their skin color and ancestry, and in one of his last acts established what he called a Sonderlager, a special camp for criminal asylum seekers, located on an isolated 1,200-meter-high alpine pasture. In his own state of Carinthia, which has more than 10% Slovene speaking inhabitants, Haider pursued a policy of segregation in schools and the removal of existing bilingual street topographic road signs.

Most observers see little chance for Haider’s party outside of Carinthia. Yet his death could mark a crucial turning point for Austrian politics. Anton Pelinka, a professor of politics at the Central European University in Budapest warns: “The possibilities for a rise of the far right in light of the financial and economic crisis are there.” His death could give Heinz-Christian Strache, the current leader of the Freedom Party who is known as a more vulgar version of Haider, an opportunity to position his right-wing nationalist party for future elections.

For now Austria has a new cabinet, led by the Social Democratic Party and the centrist conservative People’s Party, but the popularity of Haider, even after his death, and the rise of his Freedom party highlight the potential for continuing ethnic tensions in Austria, a theme which we have been following closely across Europe.

We will continue to explore our Investment Theme of “Regionalism” in the coming weeks. Last week’s focus on immigration in Germany relates well to Austria, a country with similar multicultural issues. Should you have any feedback on these regional pieces, I can be contacted at

Matthew Hedrick

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Eye on “Outliers”: Reviewing Gladwell's Latest

Eye on “Outliers”

This week I was travelling up to Toronto for meetings on a new business opportunity. We are looking at investing in a Major Junior hockey team. As travelling always does, this trip also gave me some quiet time to read. I picked up Malcom Gladwell’s new book, “Outliers”, and managed to plow through it over the last few days and wanted to share some of my thoughts about Gladwell’s ideas. Ironically, Gladwell also uses Canadian Major Junior Hockey to highlight one of his early and key points in the book.

As many of you know, Gladwell is also the author of “The Tipping Point” and “Blink”, which were both New York Times #1 best sellers. Gladwell was the first author, on a mass scale, to take social science research, largely in sociology and psychology, to explain events and phenomena in real life. The Tipping Point explains how seemingly small events can have massive sociological implications. Blink explains how the subconscious mind allows humans to make very accurate snap decisions. Outliers deals with trying to determine what makes some people incredibly successful and others, with seemingly comparable natural talents, much less so.

A good friend of mine, who is a PH.D student at one of the top political science programs in the country, recently emailed me to say she really enjoyed reading our morning note, The Early Look, but she sometimes thought we used too many hockey analogies, which detracted from the seriousness of the discussion. Keith’s use of hockey analogies, and the rationale of taking personal experiences and applying those lessons to investing and managing a business, are actually a topic for a future post, but needless to say I was pleasantly surprised that Gladwell’s book opened with a hockey case study given my PH.D friend’s comments. Warren Buffett cited Wayne Gretzky in his latest NYT Op-Ed piece. Maybe we hockey guys are onto something…

Outliers begins by analyzing the Memorial Cup, which is the Championship in Canadian hockey for amateurs under the age of 21. In theory, the best young hockey players in Canada, which is arguably the best hockey playing country in the world, will be competing for this championship and, ultimately, it comes down to one game between the best 18, 19, and 20 year olds in the country. Gladwell looked at this and asked the very simple question, what allows any specific Canadian kid to climb to the top of the amateur hockey in his country? And, can we define a factor or group of factors that enable some kids to outperform and reach this level?

Hockey experts would certainly theorize on many reasons as to why certain kids excel at the game and others do not. Inevitably, the rationale is always based on some intrinsic talent. Depending on who you ask, the intrinsic talent that enables certain hockey players to excel and others to underperform may be based on a multitude of factors, which could include work ethic, competiveness, “love of the game”, parenting, natural athleticism, and so on. Gladwell’s findings were actually contrary to any commonly held belief: the best predictor of success was actually birth month.

In fact, on the roster of the Medicine Hat Tigers, a finalist for the 2007 Memorial Cup, 13 of the 25 players on the roster were born in the months of January, February, and March. Obviously, having more than 50% of the players being born in a three month period for an elite hockey team is certainly an outlier versus the normal distributions of birthdays in the general population. This could be considered anecdotal if it weren’t for the prior work of Canadian psychologist Roger Barnsley.

As Gladwelll tells it, Barnsley was at Lethbridge Broncos (also a major junior hockey team) game in Southern Alberta in the mid-1980s with his wife and two kids when his wife asked him, “Roger, do you know when these young men were born?”. Barnsely’s quick response was to say their birth years, but his wife’s point quickly jumped out at him, many of the players were born in the first three months of the year. This observation led Barnsley to do a broad study of all elite leagues in Canada across many years and the conclusion was very simply that, “in any elite group of hockey players – the very best of the best – 40 percent of the players will have been born between January and March, 30 percent between April and June, 20 percent between July and September, and 10 percent between October and December.” This is an effect so powerful that the data does not even have to be analyzed, just observed.

The obvious question is, why does this phenomenon exist? The answer is actually quite simple. The cutoff date for hockey age groups in Canada is January 1st. As a result, at a young age, when a year can make a big difference in physiological development, a seven year old that is born on January 1, 2001 will be competing against kids that are up to a year younger than him , which can lead to material outperformance based on natural development of strength and motor skills. That is, the kid born on January 1, 2001 will just be much more naturally developed, which provides a competitive advantage.

In Canada, and many countries (and in many sports for that matter), the hockey system quickly filters off the better players at young age to play on travel teams or all-star teams. In joining these travel teams, the young players ultimately play more hockey, both practices and games, and against better competition. Thus, the kids that were older and more developed received another opportunity, which is that they got to play more hockey and against better competition.

Obviously, playing more against better players will lead to even further outperformance. As players move up the hockey echelon, this effect becomes so noteworthy that, as outlined above, a full 70 percent of elite hockey players are born in the first six months of the year! Therefore, if you are a Canadian parent and you want to give your kids an advantage in becoming a great hockey player, make sure they are born in the early part of the year.

Hockey is only one, although an incredibly statistically significant example, of the advantage of birth month. And while for me, a hopeful future father of NHL hockey players, an important one, the more valuable observation of this phenomenon probably relates to education.

As Gladwell points out, many parents often debate as to whether to enroll their students in kindergarten if the child is born at the end of the calendar year, which would make them one of the younger kids in class. Ultimately, many parents that actually enroll their children, rather than hold them back, likely believe that their kids will overcome the early disadvantage of starting school when they are less physically and mentally developed that their peers. In fact, this disadvantage only seems to expand with time.

Kelly Bedard and Elizabeth Dhuey, two economists that Gladwell cites, show this continued outperformance by older kids in two specific studies. The first study looks at the relationship between scores on an international test called Trends in International Mathematics and Science Study. Their analysis found that “among fourth graders, the oldest children scored between four and twelve percentile points better than the youngest children.” Bedard and Dhuey then looked at colleges in the U.S. and found that the “relatively youngest group in the class are under represented by about 11.6%”. Dhuey probably summarized this research best when she said: “I mean, it’s ridiculous. It’s outlandish that our arbitrary choice of cut off dates is causing these long last effects, and no one seems to care about them.”

Gladwell has been widely criticized for not applying academic or scientific process to his books and that he picks and chooses his research to suit his conclusions, but one thing we have to admire about Gladwell and his work - he asks the questions. And that is the start of any research process, whether it be an investment idea or physics problem. Does he definitely prove that exceptional achievement has much more to do with circumstance than innate talent? Maybe not. But what he does do is prove that parenting, patronage, community, and circumstance certainly play a major role in future success.

By the way, Keith McCullough was born on January 5th, and I was born on January 25th. I need to check the birth dates on our ECAC Championship hockey team’s roster!

Daryl Jones
Managing Director

111 Whitney Avenue
New Haven, CT 06

India's Weekend Maneuverings and Debt Problem

A smaller than expected stimulus package may be signs of things to come…

Prime Minister Singh’s government announced a series of economic measures including a 100bp rate cut and reduced fuel prices with much fanfare this weekend, but even the most dedicated India bull found the government stimulus package unveiled yesterday to be a let-down.

At just $4 billion in total with about only $2 billion (less than 0.10% of 2007 GDP) earmarked for new spending in the remaining four months of the fiscal year, the plan is less than a third of some of the amounts rumored in the press earlier in the week.

The small size of the relief package may, in part, underscore the increasingly significant role that external debt has played in the Indian economy since the start of the recent decade of hyper growth, which kicked off at about the same time that IMF repayments ended. As illustrated by the chart below, as total foreign debt levels increased, so too did the percentage of short term debt –over 20% by Q2 of this year, leaving the private sector and, by extension, the government, facing looming refinancing in the midst of a global credit draught.

Plans for the Stimulus package include a provision for a $1 billion domestic offering in March, which will be a significant increase over prior issues. Already the most recent treasury auction came to market for nearly double the size anticipated –in conjunction with an increase of government forecasts for 2009 issuances that exceeded the original target by more than 30%.

In an interview in HT’s financial journal MIN this week, Harihar Krishnamurthy, director of the treasury at the Development Credit Bank, sounded less than confident when he pronounced that the new debt issues “won’t affect the market because by the time of the January borrowing, the advance tax collected in December will come back in the system and there won’t be any liquidity problem”. In other words, by the time the check clears the money will be in the bank.

The yield curve has remained flat since coming off the highs of late July with the 10 year at 6.77 and the 2 year at 6.53 –a nominally low level by historical standards. As the foreign appetite for debt issued by Indian financials drops off on currency volatility and solvency concerns, that trend could reverse rapidly as banks have less money to lend the government. Already last month Tata Financial had to seek regulatory approval to attach warrants to a rights-offering zero coupon issuance in order to find willing offshore buyers.

In announcing the rate cut, Reserve Bank Governor Subbarao admitted that growth would be “less than expected” but there has yet to an official acknowledgement that high double digit growth is impossible for the New Year.

Being short India for the better part of 2008, we have repeatedly underscored our doubt that domestic demand can replace a drop-off in foreign trade. Now we add to that our doubt that domestic credit alone can replace foreign lending.

Andrew Barber

Eye On Re-Regulation: "Where There's Smoke"

Where There’s Smoke… Notes for the Week Ending Friday, December 5, 2008

Grin and Bair It

Sheila Bair, Bush-appointed Head of the FDIC and, according to Forbes Magazine (8/27/08) the “Second Most Powerful Woman In The World” (after Germany’s Angela Merkel) is being set up to take a fall. Ms. Bair is on record as being among the first (October 2007) government officials to warn about looming calamity in the mortgages market and its knock-on effect in the broader financial markets. More recently, her refusal to budge off her criticism of the Bush Administration’s management of the crisis, and Secretary Paulson’s monarchical handling of his private $700 billion slush fund, won her broad praise in Congress, and among the public.
Now she is being trash-talked by Tim Geithner, the man she called “a great pick” as President-Elect Obama’s nominee for Secretary of the Treasury. (“Geithner May Seek to Push Bair Out After Clashes During Crisis”,, Thursday, December 4). The Bloomberg story quotes Congressional sources: “Geithner, president of the Federal Reserve Bank of New York, has argued Bair isn't a team player and is too focused on protecting her agency rather than the financial system as a whole…” Says former Treasury official Wayne Abernathy, “The idea of having an independent actor on the stage with you who might not be singing the same tune can make you nervous. They recognize that she's a very independent person.”
Those of us with Ivy League MBAs remember the famous business school case of the Bay Of Pigs Invasion – the decision-making process surrounding that failed military action gave rise to one of the most famous B-School buzzwords: Groupthink.
In a View of the Day opinion piece in the Financial Times of Thursday, December 04, 2008, David Bowers of Absolute Strategy Research says government almost always does too little, too late; but in the current crisis the risk may be that Government is doing Too Much, Too Soon.
We remember the mad rush after 9/11 to pass the USA PATRIOT Act. In very short order, fundamental requirements of the Act were watered down in deference to Wall Street’s argument that “no one can do business under such restrictive rules.” Quicker than Harry Potter can say “Dissapear-O!” the requirements that financial institutions know the true source of funds for transactions were waived. Instead, firms were permitted to rely on other financial firms’ compliance procedures. Ultimately, there were whole sequences of funds transfers, all relying on one bank to have done its diligence. We are reminded of the flaws in this methodology by this week’s update (Associated Press, December 3, “Bank of New York Gains on Upgrade Linked to Suit”) reporting the latest development in the 2000 case where a Bank of New York executive was accused of laundering $7.5 billion of Russian money.
The purpose of oversight procedures is to prevent outlier disasters. It is instructive to scan the FINRA website for monthly regulatory disciplinary actions. There is typically a roll-call of the highest-profile, and generally best managed firms in the industry, all getting dinged for amounts ranging from five thousand dollars, up to perhaps $25,000, for ministerial glitches leading to infractions of marketplace rules. In a typical month, these will include late trade reporting, failure to timely update quotes, reporting trades out of sequence without the proper modifier, and inadvertently trading through prices when there was still liquidity in the marketplace. In this way, both market regulators, and internal compliance procedures keep the industry honest.
Large compliance catches by firms are generally the result of long hours of routine internal reviews. Mid-level compliance staffers who look at execution reports all day long and suddenly notice a pattern of trades being reported out of sequence have uncovered coordinated programs of market manipulation. Routine daily reviews have identified parking of trades, manipulations of net capital computations, traders diverting profits into proprietary accounts, and brokers perpetrating massive fraud against customers. You name it, it’s been tried on Wall Street. And you name it – we have caught it.
Government, like finance, is an art, not a science. In defense of Secretary Paulson, Chairman Bernanke – and even his predecessor, Chairman Greenspan, now the focus of a universal campaign of revisionism – it is only in the benefit of hindsight that we can tell which policies worked, and when they stopped working, and why.
Chairwoman Bair proposed using $24 billion to prop up individual families. Her analysis predicted that this investment could realistically save 1.5 million mortgages. Who knows? Maybe it would work. Set alongside the current program, Ms. Bair’s proposal looks like keeping 1.5 million families in their homes where they can continue to be taxpayers and consumers. Chairman Paulson’s approach, on the other hand, is the ultimate in Trickle-Down marketology. It is the financial markets equivalent of a screen pass in football: the quarterback waves 700 Large in the air, then lobs a bloop over the heads of the defenders and into the waiting arms of – not to single anyone out – Jamie “We-don’t-need-the-money-but-we’ll-take-it” Dimon.
Successful organizations plan for worst-case scenarios. Best-case scenarios take care of themselves; the fat part in the middle of the bell curve creates neither tremendous wealth, nor unacceptable risk to the institution or the marketplace. Prudence – what the world of regulation calls Best Practice – dictates that there be someone on the team to oppose the Group’s Thinking.
We recognize there have been severe deficiencies in the regulatory system. But pouring cash into the hands of the already-wealthy and requiring nothing in return is not a cure, particularly now that the competence of the recipients of this windfall has been called into question. Giving an addict free heroin keeps him from committing crimes, but it neither cures the addict, nor benefits society.

According to the Financial Times ( Wednesday, December 3, “Treasury Tackled over TARP Concerns”), the Government Accountability Office (GAO) has expressed grave concerns that the $700 billion in TARP monies are being doled out without controls in place to ensure compliance from the institutions receiving the monies, and without any metric to determine what effect the TARP money is having in the marketplace. It is the financial equivalent of a Black Hole. It does not surprise us that Neel Kashkari, head of the TARP program, sent GAO a note saying that he “disagreed” but “welcomed discussion on ‘general metrics’ for evaluating the overall success” of the program. Oh, we forgot – Mr. Kashkari comes from Goldman Sachs. We guess it’s all right, then.

Sheila Bair is the Fly in Secretary Paulson’s Ointment. Good so. Let someone with brains, command of facts and figures, and a really big regulatory hammer to wave stand in the room and be the sole dissenter. Why should Hank Paulson, Ben Bernanke, George Bush – and now Timothy Geithner – be the only ones who have the unassailable right to be wrong? And even when they get it right, lockstep is always wrong-footed.

Mr. Geithner was irked by Ms. Bair’s stubbornness during the rush to complete the $300 billion Citi guarantee. It appears Mr. Geithner was leading a desperate charge to Get It Done Now, while Ms. Bair demurred based on key fundamentals: my Agency’s job is to protect deposit holders; my Agency may be prohibited by law from financing this transaction; no one has explored the ramifications. And just plain old – I don’t agree with you, and I am not going to cede responsibility just because all your guys are ganging up on me.

The legal argument should not be taken lightly, by the way. With major law firms downsizing, merging, or just plain shutting their doors, there are now record numbers of lawyers out of work in this country – and many of them are smart. When the dust settles, do we foresee the possibility of lawsuits being launched against the Government for urinating away our money? Would you take a one trillion dollar lawsuit on contingency? Say, against Barney Frank for “rolling the dice” (his words, not ours) on the residential mortgage market? Against Secretary Paulson for the nepotistic appointment of a 34-year old Wunderkind to run an opaque $700 billion give-away program whose beneficiaries are the Secretary’s golfing buddies? We just bet there are lawyers out there in America already working up the legal theories. Quoth King Henry II: “Will no one rid me of this meddlesome priest?” And Thomas Becket was slain. We fear the Tim Geithner is even now whetting his blade to do the bidding of his own King Henry.

Where does this leave us – and where does it lead to?

Thursday’s Wall Street Journal (“SEC Tightens Rules for Ratings Firms”. Thursday, December 04, 2008, page C3) quotes New York Senator Charles Schumer: “None of the rules adopted today are a substitute for the larger regulatory reform that is coming next year.” Here is what we see as a likely scenario. And remember: You heard it here.

President-Elect Obama is masterful. He is highly intelligent and fearsomely well organized. We have high hopes that he will run as well-executed a Presidency as he did a campaign. And, let’s be honest, he is a ruthless and extremely effective politician.

President-Elect Obama is both wise and absolutely correct in not offering specific policy guidance on the current crisis. There is, as he has observed, one President. In fairness, the Obama Administration is inheriting one hell of a mess, and it is no wonder that he doesn’t want to step into this alligator pit until he absolutely has to.

We suspect that, true to the successful pattern of President Clinton – nay, true to his own successful maneuvering during the campaign – President Obama will run with the Conservative trickle-down he is inheriting, because that is what the power base of the country wants, and it is anyway too firmly entrenched to flip over in one administration. Congress is getting ready to toss not just a bone, but an entire cow to the auto industry. Meanwhile, the Democrats will no more go after Vikram Pandit than they will after Mom and apple pie. They may require Mr. Pandit to subsist on one dollar for fiscal ’09, but that is not the equivalent to the 1.5 million mortgages that will not be saved by refusal to implement Chairwoman Bair’s plan.

As we go to press, Ms. Bair is quoted (“”FDIC’s Bair Sets to Shatter CRA ‘Myth’”,, Friday, December 5th) as saying, “only one in four higher-priced first mortgage loans were made by CRA-covered banks during the hey-day years of subprime mortgage lending. The rest were made by private independent mortgage companies and large bank affiliates not covered by CRA rules.”
“Let me ask you,” she continues, “Where in the CRA does it say to make loans to people who can’t afford to repay? Nowhere.” Plain English: the irresponsible lending practices that led to today’s market meltdown today arose from 75% private-sector greed, and 25% irresponsible government regulation. To us, “only one in four” sounds like a defendant arguing that robbing “only” three banks is “hardly a spree”. Add to this the high praise Ms. Bair has received from Chris Dodd and Barney “Roll-The-Dice” Frank, and we admit to being somewhat uncomfortable. Still, Chairwoman Bair is the only member of Team Obama who can be characterized as the Loyal Opposition. For this reason alone, the country deserves to have her on the job.

We suspect that the Obama Administration will combine the knee-jerk excesses of Team Bush, with the Spread the Wealth mandate on which President-Elect Obama won election. The machine will be designed to take in hundred-dollar bills and spit out quarters, and the regulators of the banks and financial marketplace will be charged with ensuring that the change-making process runs smoothly and that every coin and bill is accounted for.

In terms of marketplace regulation, we fear a retrenchment of rules-based Old Timers, certainly in the initial stages. Senior regulators have spoken thoughtfully about Principles-Based Regulation, but much as it makes sense, it is a generational change.

Note the following: Tens of thousands of people are out of work on Wall Street. Many of them truly deserve to be, because there has never been an enterprise in the history of humankind that so over-rewarded mediocrity – nay, sheer incompetence – as the investment banking and brokerage industries.

Venality and dishonesty, by their very nature, attack the lowest of the low-hanging fruit, and Wall Street has been the home of Those Who Soon Part the Fool From His Money for the better part of three decades – intermittent blips and bear markets notwithstanding.

What these former Wall Street professionals are now doing is sending resumes to the SEC, on the premise that a Government Job is a Safe Job. And therein lies the rub: the entrenched regulatory infrastructure is the Rules-Based infrastructure. Not just at the SEC, but across the regulatory spectrum. We are aware of pockets of excellence in the regulatory system, and of senior-level regulators who are staffing their teams with exceptional former Wall Street professionals, with a specific goal of bringing in people who truly understand the industry from the ground up . Still, we predict that, under an Obama Administration, the bifurcation of the marketplace will continue apace: money will be thrown in large quantities at the large financial institutions – now add in large industries – and regulation to protect the small investor will run riot, at least in its initial stages. The palliative will be tight controls on executive compensation (“Will no one rid me of these meddlesome investment bankers?”), but the fundamental deficiencies of the rules-based regulatory system will persist until a new generation of regulators, bred from seasoned Wall Street and commercial banking professionals, is able to move into the management, and the rank and file of the regulatory agencies (“Will no one rid me of these meddlesome regulators?”). We hope there will be enough elasticity in the system to give this process time to take hold, but we believe there is not. In preparation for the next phase of the evolution of the American marketplace, we have decided to learn Mandarin.

We wish the new Obama team success on the economic front. They will need laser-like focus, determination, smarts, and a blessing or two to pull this all together. In the interest of staving off Groupthink, they need a Fly In The Ointment. We respectfully urge President-Elect Obama to appoint Ms. Brooksley Born to head up a major regulatory effort – it doesn’t matter which one, just get her into the government with some real authority. And keep Sheila on the team. Trust us on this one, Mr. President-Elect. Some are accusing her of hogging the ball, but she may be the only player who can prevent you getting sacked in your own end zone. What quarterback wants to go down in the record books as losing the Super Bowl by a safety?

Will No One Rid Me Of This Meddlesome Economist?

Finally, a government policy with some teeth. Do you remember the old joke – “I read so much about the dangers of smoking, I gave up reading”? The Wall Street Journal (Monday, December 1, Page A1) reports that Latvia’s state counterespionage and anti-terror agency recently detained for questioning one Dmitrijs Smirnovs. Mr. Smirnovs, a 32-year old university lecturer in Economics, was quoted in a newspaper roundtable as advising people not to keep their money in Latvian banks, nor in the lat – the local currency. The Journal article quotes Teodors Tverijons, head of the Association of Latvian Commercial Banks, as saying “We are a small country, and panic would have very grave consequences.” This is, said Mr. Tverijons, a “matter of state economic security.”

Not knowing how far the tentacles of the Latvian Secret Police may reach, we do not care to offer an opinion on the internal affairs of a sovereign nation. We merely note that some governments are very effective in dealing with dissent. Mr. Smirnovs was released after two days of questioning, and he has not been charged. Mr. Smirnovs, while not guilty of any crime, is clearly Not A Team Player.

Mr. Tverijons has a point. Imagine the consequences of a financial panic in such a small country as Latvia. Or in such a large one as the United States. Is the next step House Arrest for Sheila Bair?

We are watching.
Moshe Silver
Director Of Compliance

Keith R. McCullough
CEO / Chief Investment Officer

Early Look

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