YouTubing" Larry Summers' "Meet The Press" Interview...

Below I have paraphrased parts of the Larry Summers interview from the January 25th segment of Meet The Press (questions and answers were all words they used… and I shortened the Q&A for the sake of hitting on their most critical points).

DG: David Gregory – Interim Moderator for NBC’s Meet The Press
LS: Larry Summers - Director, National Economic Council
KM: Keith McCullough - CIO, Research Edge LLC

DG: If you have a hole in the economy that’s a at least a trillion, maybe two trillion, don’t you need that stimulus?
LS: David, we have what economists call a multiplier… we surveyed a range of economists, and to a lot of experts both Democrat and Republican… and the President took a balanced point of view between new investments… and also tax cuts, because we recognize we have to help households and businesses to be able to spend.

KM: Backing out the socialist verbiage from the real economic formula of GDP = C +I + G + (ex-im), stimulus means (G), as in government spending, and we should not mistake it for legitimate (I) Investment. Summers knows this – he also sounded like he knows the real (G) number is larger than the proposed $825B. As the market’s expectations for (G) increases, the US Dollar should begin to weaken again (like it is today). Does (G) have a multiplier effect? Sure… but God help us if Obama and Summers are depending on that “range of economists” who missed proactively preparing for this market crash altogether. The only thing worse than one or two “economists” being wrong is a whole room full of them in Washington pandering to a new Administration.

DG: Only $250B worth of stimulus this year (according to Goldman Sachs)… only $250B worth of impact this year, don’t you want more of a jumpstart?
LS: The President has committed through a letter from his OMD Director, Peter Orzag, that ¾ of this $825B program will be spent in the first 18 months… we are doing everything we can … but we aren’t going to rush things to the point of being wasteful… speed is a crucial concern… but these problems aren’t going to be solved that fast. We also have to be mindful of having the right kind of plan that will carry us forward over time.

KM: My math has 0.75% of 825B = $618.75B worth of stimulus being spent in the first 18 months. That’s a big number, and one that could get a lot bigger as the winds begin to blow towards the next election cycle. Transparency and accountability rules are what the President is talking about – let’s see if he can deliver on his rhetoric and print that number, on time. I agree that managing this number reactively is not the patient solution that this country needs – the political pundits and the media want the money spent yesterday, with their crackberry and a coffee on the side – be careful who we are feeding rhetoric to here.

DG: If the size of the package is important… if the deficit is a concern, why not put some of that spending off until later?
LS: David, respectfully, I would disagree with the Washington Post – there are cops being laid off across the country, saving their jobs is saving jobs … its helping the economy, its protecting our neighborhoods… responsibility is integral to the Presidents style of leadership.

KM: In English, this is a big spending Democrat talking – oh baby is he going to spend it, and then some… they won’t worry about the debt until it’s too late. This is the Robert Rubin school of American leverage – ask the folks over at Citigroup or Goldman how that treated them.

DG: Bush tax cuts - why would you want to raise taxes right now? Why not put that expiration date off until say 2013? Why is that a bad idea?
LS: 2013? First it’s a bad idea because we simply can’t afford it! We have a trillion dollar deficit… but understand this, there will be tax cuts for the other 95% of Americans.

KM: This was the funniest question Gregory asked – reminding me that he wasn’t in the area code of being capable of having a real Tim Russert like economic debate – 2013? Even Summers looked at him funny! Then he gave him the obvious answer.

DG: Banking Crisis – $700B has been dedicated, will more money be needed down the road?
LS: we’re gratified that Congress has given the President the authorization he needs to unlock the $700B that the Bush administration worked with congress to create… the Presidents financial recovery program is going to be very different from what we have seen so far – it’s going to emphasize transparency – it’s going to emphasize accountability… perhaps most importantly, the priority has to be getting credit flowing again so that the economy will operate…

KM: Blame Bush for the “burden” but be “gratified” that he got you the the bag money – this is so hypocritical that it’s very sad… the rest of Summers answer I can sign off on – Transparency, Accountability, and Trust – but that’s something I have been saying for 14 months. Thanks for the knucks Mr. Summers!

DG: Will more money be needed? Do tax payers have to expect we are not done paying it?
LS: We can make important progress and get started with the support that has been provided… what ultimately will be necessary is something that will play out over time… we are going to be proactive… the President is going to do what is necessary, but only in the context of responsibility… in the context of trust…

KM: There is that Research Edge lingo again – that’s right Mr. Summers, you need to be “proactive” as you come to realize that the answer to this questions is simply YES.

DG: Why can’t you just make them lend?
LS: sure it does… who knows what the government could do… it wouldn’t be responsible for an institution to raise its lending without having capital - frankly that’s why there needs to be more capital – but they need to lend more in a way that’s consistent with their solvency and their capital adequacy…

KM: Summers was clear on this and it was his unifying point across the interview – he needs to give them more and more bailout moneys before he can make them lend it – after all, “who knows what” a socialized government can do?

DG: what do you say to someone who is trying to prepare for their future? They have lost confidence – they say what do I do?
LS: This is why I believe President Obama was elected – this is why his call for an age of responsibility as we manage our own finances, as we do our own jobs, is so very important … people need to work hard and play by the rules… those of us responsible for economic policy need to do everything we can to make this economy work…

KM: Other than hope and pray, I agree that people need to start managing their own finances in a self directed way – what I do not agree with is having my government feel like they are the ones responsible for “making this economy work.”

Keith R. McCullough
CEO & Chief Investment Officer

US Housing: Bullish Bottom Forming?

One month of data does not an intermediate “Trend” make , but this is a data point that the bears were not prepared for. This month’s existing home sales came in +6.5% higher than last month’s # (see charts below), and more importantly, inventories came down hard, as a result.

The bears will cling and claw to the fact that 45% of these home sales came in “distressed” situations – but who cares? aren’t distressed homes still homes? No, these aren’t Wall Street homes – sales in the Northeast were actually down -1.4% again – but don’t sales in the West and the South being up +13.5% and +7.5% matter? You bet your Madoff they do… unloading the Main Street inventory overhang in this country matters, big time.

Months of supply came down to 9.3. This is down significantly from the peak and the 11.2 months recorded in November. As the facts change, I do – these facts are bullish; particularly in the face of a zero percent Fed funds rate, and an Obama administration focused on getting banks to lend to those seeking new lows in 30 year mortgage rates.

Bottoms are processes, not points…

Keith R. McCullough
CEO & Chief Investment Officer

The Year Of The Ox

The Year Of The Ox - asset allocation012609

"The Ox is the sign of prosperity through fortitude and hard work. This powerful sign is a born leader, being quite dependable and possessing an innate ability to achieve great things. As one might guess, such people are dependable, calm, and modest. Like their animal namesake, the Ox is unswervingly patient, tireless in their work, and capable of enduring any amount of hardship without complaint."
-Attributes Of The Ox (Wikipedia)
The best news in global macro this morning is that most Asian stock markets are closed for Chinese New Year. This means that the positive momentum that continues to build in the Shanghai Stock Exchange will live at least until next week when trading resumes, and the Asian markets that were under assault last week at least get a breather!
China's stock market is up almost +9% for 2009. This compares favorably with the SP500 which is down -7.9% year-to-date, and all other major stock markets around the world. With the TED spread narrowing, interest rates being cut to zero, and stimulus starting to flow, there is no longer the same "Liquidity Crisis" that global financial markets faced in the fall of 2008. Those, like the Chinese, who own the both the liquidity and duration of their own investments are in the catbird's seat to buy up assets from forced sellers.
What we have now is an "Illiquidity Crisis" that continues to assert itself where countries and companies alike need to meet their maker - the marked to market maker that is.  This, of course, goes hand in hand with the Crisis in Credibility that we have been harping on for the past while. If you said, thought, or assumed you could wait this out before The New Reality's rules of transparency and accountability revealed your illiquidity problem, your Depression may be as severe as Nouriel Roubini will remind everyone in Davos, Switzerland this week.
With most of Asia closed for the holiday, Japan was front center being 'You Tubed'. This socialized bureaucracy continues to perplex the "valuation" buyers, but as Marty Whitman says, "a bargain that remains a bargain... is no bargain." Japan closed down another -0.81% overnight at 7,682, taking it to -13.3% for 2009 to date, underperforming American stocks (ex horse and buggy whip US Financials) by a significant margin.
I have long been short Japan, and I see no fundamental catalyst that could sustain a rally in Japanese shares in sight. That said, everything has a price... and I will likely be booking another gain here on the short side in the near term. Re-short Japan on an up day, not a down one - rinse and repeat.
Although they we don't have to pull out the paddles yet, the global equity market patient (ex-China) is back in the emergency room. Make no mistake, the year to date performance of the US stock market has put many investors who don't own the duration of their investments behind the eight ball, and this will have an impact into month end later on this week.
In our Hedgeye Asset Allocation Model, I am down -1.34% for the year to date. Losing money is unacceptable. I do not blame the market - I look in the mirror, unlearn, and re-learn so that I can be flexible enough to get back to winning. Being long a 6% position in Gold helped offset losses in US Equity exposure last week. For the week, the model portfolio was down -0.21%.
In Russia, although stocks are trading up a hopeful +5.6% this morning, these guys are having a heck of a time re-learning any of history's lessons. When I re-read the attributes of the Ox, I think of the opposite force of nature in Siberia, or the office Hank Paulson is thankfully packing up this morning in Washington. Reactive, emotional, and wrong are quite different attributes than dependable, calm, and patient. History will write herself for Putin and Paulson alike - that you can lever up a long bet on. Although the Nikkei in Japan is still over 6% higher than its October 2008 low, the Russian Trading System Index is -4% below hers. Vladdy, the global equity and currency markets have voted.
In the intermediate term, Russia's failure and Paulson's exit are net positives for both American military and financial relevance in The New Reality. Although Tim Geithner is far from a comforting answer to everything that I'd rather forget, he is likely going to be confirmed by the Senate today as the new head of the US Treasury - so... we are all going to have to deal with him now - he will be held accountable by our You Tube.
Can Geithner pick up right where Hank "The Market Tank" blew up? For sure... that's probably why the US stock market is headed back to the emergency room - market participants are going to need to see what happens when we drop this guy in the dunk tank before he gets anyone's vote of confidence.
Confidence seems to be manifesting itself into the "re-flation" trade again. Last week, the CRB Commodities index outperformed the SP500 by a good 400 basis points after gold and oil put in +7% and +27% week over week moves, respectively. This was all the more impressive when you consider that commodities re-flated in the face of an appreciating US Dollar. This isn't supposed to happen - but neither is the US Treasury market ever supposed to go down.
The bubble in US Treasury Bonds is the last big one that remains. Can it pop? You tell me... there are plenty of expert bubble watchers out there these days who will surely chime in. The cost of long term capital shot up +30 basis points last week, taking 10 year US Treasury yields to 2.62%. This morning yields on the 10 year have moved 3 basis points higher yet again to 2.65%, and from a quantitative perspective, yields are starting to break out from the shark line we have been using at 2.34%.
Shark line? That's the line where the shorts get eaten. If you are short yield (long bonds), that's bad. We don't like being short the sharks - we prefer being long the ox. This situation needs to be monitored very closely, as the bond market is shaking. Don't forget that the Japanese and Chinese own us on this front - any material level of selling  down their respective exposures will require Obama, Volcker, and Summers to dress up like Ox this winter. "The Ox is the sign of prosperity through fortitude and hard work." The days of the quick crackberry fix are over - this is going to take time.
Best of luck out there this week.

The Year Of The Ox - etfs012609

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Despite my initial gut, it makes a ton of sense. If my price math is right, the big winner is ZQK as it mitigates balance sheet risk. VFC buys eps leaving Nike as the stand alone candidate for TBL.

I didn’t see this one coming… The buzz out of ASR (Action Sports Retailer trade expo) is that VF Corp is buying DC Shoes from Quiksilver. There are two things to consider. 1) Does the deal fit strategically for VFC, 2) why in the world would ZQK sell its fastest-growing business, and 3) what does this mean for the investment case for each.

1) Does The Deal Fit? At first glance, my sense would be ‘No’ given what appears to be meaningful overlap between DC Shoes and VFC’s Vans. But the reality is that distribution is radically different, with Vans geared disproportionately toward company-owned stores, National Chains, and Shoe Chains, and DC geared towards athletic specialty and department stores – and at a 30% premium to Vans. VFC gives DC a platform to grow in Europe – a region where skate is a solid market, but one where DC has largely failed to grow under Quiksilver’s leadership.

Another consideration is that with VF Corp growing Vans, Reef, and The North Face footwear, it increasingly needs scale as the Asian factories gain leverage in this new reality where factories are closing, and pushing costs to US brands and retailers that are losing leverage on the margin. This would help VFC in that regard.

Another factor to keep in mind is that VFC was one of two likely buyers for Timberland. If this deal goes through, it’s basically up to Nike to step in and buy Timberland.

2) What is ZQK Thinking? Why sell its fastest-growing division? This is a function of ‘want vs. need.’ Does the company want to divest DC? I know for certain that the answer is No. But with the stock just over a bone, and with the EBITDA multiple well above the earnings multiple – it’s clear that the balance sheet matters far more than just about anything business-related.

So what would ZQK look like ex-DC? It’s impossible to tell for sure given that lack of any price disclosure. ZQK bought DC for about $100mm in 2004 when DC was at $100mm in revs and 9x EBITDA. On one hand, multiples have been crushed – which is stating the obvious. In addition, DC has failed to realize any scale benefits, and margins are still sitting near 10%. On the flip side, ZQK has grown DC from $100mm to about $475mm. If I assume 10% EBIT margins, 3% D&A, and a 5x cash flow multiple – then it suggests about $300mm in cash to ZQK. That’s not to mention divesting ZQK’s biggest working capital drag (footwear is the biggest drag after the now-divested hardgoods business). Based on those assumptions, my math is that this divestiture would be accretive.

Backing this business out of ZQK, my math leaves me with about $0.35-$0.40 per share in earnings. Not bad for a $1.50 stock whose debt/EBITDA goes from 5x to 4.2x with such a deal (and from over 8x with hardgoods). That’s not to mention that this would leave ZQK with a core apparel business (Quik and Roxy) where it could refocus on getting margins back into the double digits – something I thing is very much within reach.

3) What Does this Mean for the Stocks?
• ZQK: If this deal happens in the ballpark of the numbers I discussed, my math suggests a value today for ZQK at least 2x where it went out on Friday. A year out (if the co can realize margin goals) then we’re talking much higher.

• VFC: This would conveniently come at a time when VFC’s base business is fizzing out, and earnings expectations are way too high for 2009. The purchase price in question will not break VFC’s bank, and will help the company grow earnings – even if not organically. Again, this is all price-dependant, but at face value this is a positive for VFC.

• TBL: Bad for TBL. There were two likely suitors. VFC and NKE. A field of one would not help TBL’s bidding dynamics.

• Other bidders? Nike would not touch DC, in my humble opinion. Not because it does not like the category. Quite the opposite, actually. Mark Parker (CEO) is very much in tune with the relevance of the skate consumer. But that is why Nike has developed its own skate brand over the past 5 years. Keep in mind that Nike bought Hurley to better understand the skate consumer. Now Nike skate (6.0, etc…) eclipses Hurley in size. Nike’s motto is ‘why buy another brand when we can beat them organically with our own?’ Regardless of whether or not they can win, as long as they believe it, then they’ll deploy the capital internally as opposed to externally – and likely get a higher ROI. I’d be surprised to see other bidders here unless the announced price is egregiously low.

LIZ: Bill… C’mon Man!

When your stock goes from $40 to $2, you just miffed the Q, and you secured credit lines by the skin of your teeth – DO NOT go public with a strategy to add high priced retail stores in a recession.
Don’t know if anyone caught this, but Reuters on Friday picked up on an interview with LIZ CEO Bill McComb. The punchline is that Mr. McComb discussed the revamped (Mizrahi) Liz Claiborne line, which will initially come out at price points about in line with current offerings. He then notes growth opportunity in Europe and Asia. I’m ok with that.

But then he went on to talk about going into higher price point products, and expanding this into more company-owned full price retail stores.

C’mon man! Why’d you have to say that? Regardless of your plans, you have not exactly earned the right to grow. You just tanked the quarter – again – and finally secured required credit lines to maintain the status quo. I’m not against thinking about growth in the long-term strat plan – just don’t articulate this to the Street!

My vote? Sell the Liz Claiborne brand to Wal*Mart/Li&Fung for 0.3-0.4x revs, and monetize Juicy/Lucky and Kate Spade. Net out the debt, blow out corporate, buy out long-term liabilities, and view monetization of any other brands as a call option. All that still gets me to a value in the high single digits.

The simple fact that the Board has not yet acted with the stock price going from $40 to $2 shows either 1) incredible vision, 2) incredible stupidity and/or 3) severe lack of acknowledging any fiduciary responsibility to shareholders.

This thing gets one more quarter of my patience.

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

We Hold These Truths

“I walk on untrodden ground. There is scarcely any part of my conduct which may not hereafter be drawn into precedent.”
- George Washington

The pageantry of the Inauguration having come and gone, the cheering millions have retired to their homes to warm themselves in the aftermath of one of the coldest Inauguration Days on record, and Barack Hussein Obama sits at his new desk in the Oval Office. He is no longer the First Black President of the United States, no longer the First African-American President of the United States, and he is not three-fifths of a President of the United States.

He is now the President of the United States. And he has work to do…

Let My Market Go
“I don’t want to get the math wrong.”
- Timothy Geithner, in confirmation hearings

We listened with a mix of disbelief and resigned disappointment to Timothy Geithner’s confirmation hearings. Mr. Geithner was asked several times whether he thought it correct that Secretary Paulson diverted the TARP money from its intended use – that of purchasing toxic assets – and instead paid it out in the biggest year-end bonus in Wall Street history. Geithner took pains to remind the hearing panel that he was not Treasury Secretary at the time. He then answered that, given the options, the money was put to the best available use. Indeed, he said, had the money not been given to the banks, the global economy would be in far worse shape today.

We did not hear anyone substantially take Mr. Geithner to task over his demur – “I only work here” – that he did not make the decisions to deploy the TARP moneys. This is a significant failing on the part of the Senate panel. We recognize that there is an Obama love-fest in the air, coupled with a manic panic over the global financial situation. This should not be a reason for dispensing with deliberation. The US tax code is so unreasonably complex that even the incoming Treasury Secretary can’t get it straight, allegedly…

But Geithner was intimately involved in pulling the TARP over our eyes; nor did he avail himself of the hearings to distance himself from Chairmen Paulson and Bernanke. Rather, he promised much more of the same. Why should large banks that have mismanaged their businesses be rewarded and urged to suck up other large banks in an environment where all large financial institutions are exposed to market instability of Miltonian scope?

Kansas Republican Senator Pat Roberts pointed out to Mr. Geithner that there are 347 healthy banks in his state. Our question is why should 347 banks in Kansas with no toxic assets festering on their balance sheets be elbowed out of their own markets as the money center giants seek to stabilize their businesses by expanding into regional banking? Because America has consistently rewarded growth for its own sake. The school of Bigger Is Better, fueled by the perceived inexhaustibleness of America’s natural wealth, values the optical result, and not the process.

For the same money – probably far less – the Feds could assign large poorly managed banks to networks of local caregiver banks. The local bank executives can create a nationwide Kiwanis program to rehabilitate the giant banks, and possibly even some of the bankers. Instead of having BofA buy Merrill Lynch, the brokerage and banking assets could be pieced out among a national network of banks with offices in cities where Merrill has brokerage operations. The notion of Economies of Scale is a canard, because oversight and management processes, support systems, infrastructure, legal and compliance are what always get cut when financial firms merge.

Professor Luigi Zingales, of the Chicago Booth School of Business, interviewed on Bloomberg radio (January 21) said that, while the real economy-shattering problems reside in a small handful of the very largest banks, many smaller ones will be gobbled up in the Great Rolling-Up the Treasury has financed. Writing on line (, January 19, “Yes We Can, Mr. Geithner”) Professor Zingales advises “it is important to keep in mind the interest of the country does not necessarily coincide with the interest of the banks.” Nobody is listening.

We agree with the Senate panel: The current deployment of TARP funds was not the program we were promised. Neel Kashkari now requires all banks in receipt of TARP funding to submit a report of their use of the assets. His timing makes it seem that someone older and more seasoned (Hank Paulson?) pulled him aside and said, “Hey, Kid! We got a new President. You better document what you’re doing.” This is routine in our industry. Firms put compliance policies in place and nobody follows up. Management issues detailed oversight program, then goes into a panic when they get an audit letter and discover there are no records, because nothing was ever implemented.

Mr. Geithner’s testimony leaves us wondering what Son of TARP will look like, and concerned that it will be launched without a transparent oversight mechanism. Worse, we fear the consequences for non-compliance will be mild to nil. Not getting the next ten billion does not look like much of a punishment. It is clear that this is going to be a very long process. As was noted by our CEO, Keith McCullough, Geithner is using the confirmation hearings to manage global expectations on both the time line and magnitude of the recovery. Looks like there will be many sequels. After “Son of TARP”, expect “Return of TARP”, “Revenge of TARP”, “Bride of TARP”, and of course, “Abbot and Costello Meet TARP”.

Mr. Geithner, you have several thousand well-managed local banks across the nation, most of which are in a position to take on a few tens or hundreds of millions of the troubled assets you seek to dump. Instead of backstopping those who got us into this mess, why not turn it over to those who have no need of our largesse and grant them not a bailout, but a safety net? The societal and market effect of this program so far has been to concentrate monopolistic power into the hands of the truly incompetent. This is crony capitalism that outdoes anything the Russian Oligarchs could come up with. This is no time to Dance With The One What Brung You.

Talk about getting the math right, Mr. Geithner, without a revolution in management and truly dire consequences for non-compliance, your plan is asymptotic: the line representing the amount of our money you throw at the problem, as it approaches infinity – and it will – will never intersect with the problem at a point of resolution. In this equation you cannot solve for N.

The More Things Stay the Same, The More They Stay The Same
“We must run as fast as we can
just to stay in the same place.”
- The Red Queen

Whither financial industry regulation, what with the massive government push on the side of the tottering giants? The Senate panel’s refusal to rake Mr. Geithner over the coals is reminiscent of the atmosphere of panic in which the USA PATRIOT Act was passed, with damned few actually reading the document.

Here is our scenario. The mismanaged banks that bought the world’s largest retail brokerages have already been given an endless stream of cash to promote this suicidal business model. The notion of Principles-Based Regulation remains an academic exercise and a topic for op-ed writers. It will be a long, hard slog to get our trillion dollars back from the likes of BofA and John Thain. Meanwhile, in the real world, there will be a crackdown on smaller and newer financial firms as examiners Get Tough On Crime. Legitimate small operators will be hampered by excessive pressure to implement meaningless regulations as examiners with no experience in the industry read down their audit checklists.

Reality check: as legitimate operators waste resources struggling to comply with regulatory requirements that do not apply to their business, criminals will simply ignore the rules and steal investor money quickly. The regulatory agencies are already so overburdened that there are firms that have not been audited in five years or more. When they finally get around to you, the time lag between a FINRA deficiency letter and an enforcement action is likely to be at least six months. If you have a good lawyer, maybe a year and a half. And ultimately, all FINRA can do is toss you out of their club, or make you pay a fine for the privilege of staying in.

The notion of a consolidation of Federal agencies in a merger of the SEC and the CFTC is possibly a very bad idea. The SEC’s embedded bureaucracy transcends the worst in Levantine obscurantism and remains in a constant state of muffled war with a changing cast of political appointees – the Commissioners. Folding another agency’s personnel, procedures and legacy record-keeping into this morass will create a quagmire that will throw the regulatory process into reverse for a long time to come.

Mary Schapiro has much to contend with in picking up the detritus left by Chairman Cox. She must balance self justification over FINRA’s failure to nail Bernie Madoff, with cracking the whip over the forward-going SEC Madoff investigation. She must deal with the present crisis in the financial markets and all its new avatars as they arise. She must use all her political wiles to cajole together some new regulatory beast, whose identity is not yet known, though the world believes its hour has come.

Who will get the assignment of designing the new approach to regulation? Why, a Rules and Principles Committee, of course. Novus ordo seclorum will have to wait until things quiet down. And when things are quiet, nothing new gets implemented, because the SEC absolutely requires panic to motivate institutional action.

The CFTC think the SEC are incompetent and rebel at the notion of being absorbed into the mega-bureaucracy. Still, we fear the SEC may carry the day. Remember that in America, Bigger Is Better – and Biggest Is Best. It will be easy to explain to the public why the SEC – household name agency – needs the additional resources and staff of the CFTC. The public has never heard of the CFTC because so few retail customers trade commodities. Even for all the embedded structural inefficiency of the SEC, it would be hard to explain why the Commission is being dismembered and handed over to people who regulate soy beans and pork bellies. The public would have a difficult time grasping it. Congress… fugeddaboudit. On such perceptions rests the fate of the world.

The Usual Suspects
“I am shocked! Shocked!”
- Claude Raines in “Casablanca”

It was obvious to all of Wall Street that Bank of America’s acquisition of Merrill Lynch was nothing short of suicidal. It was clearly obvious to John Thain – no fool he – and to Merrill’s heads of both sales and investment banking, both of whom fled within days of the merger. Was it not clear to BofA, not to the regulators and legislators who were rushing to force this deal through?

The SEC inquired specifically regarding personal enrichment of Merrill Lynch executives as a result of the transaction, only to be slapped down by the law firm of Wachtell Lipton (, January 23, “The SEC Was Asking Questions About John Thain”). In response to the SEC’s inquiry of October 15, Wachtell Lipton wrote “Bank of America has not reached agreement with Mr. Thain or any other executive officers of Merrill Lynch on compensation arrangements in connection with their continued employment following completion of the merger.” Translation: we would sooner eat dog food than tell you what’s under the hood in this deal.

What is particularly striking about this exchange is that Wachtell Lipton was BofA’s law firm, not Merrill’s. Apparently, the ghastly amounts of money being flushed away were either not known to the BofA executives and board of directors who approved this deal. More likely, BofA found out about the numbers in the midst of the transaction and realized that, if the information became public, even Hank Paulson would not be able to justify financing this deal.

Bank of America was doing the Government a favor by sucking up what would have been a very high-priced bailout. BofA, in return, stood to receive a big check once the deal closed. One suspects that BofA CEO Ken Lewis, who “forced Mr. Thain’s resignation Thursday, unhappy with the way he handled a big quarterly loss” (WSJ, January 23, page 1, “Thain Ousted In Clash At Bank Of America”) was tossing Thain under the bus. We assume NY State Attorney General Cuomo’s investigation will reveal that Lewis and the board knew of the losses and excess involved and sat on the information, rather than jeopardize their check from Washington. Watch out, Mr. Lewis, the bus is about to shift into reverse.

Everyone who understands the brokerage business recognizes that this business model is over. Indeed, no one recognizes it more than the brokers themselves. And so We The People have paid tens of billions to finance the acquisition of 36,000 stockbrokers by Morgan Stanley and BofA, including billions of bonuses. If we don’t give our brokers bonuses, the argument goes, they will leave. And if we lose our brokers, how can we give the taxpayers their money back? Alas, no one thought of not taking away the taxpayers’ money in the first place. And just for the record, the Smith Barney brokers who are taking one billion dollars in stay bonuses will be out the door the moment their contracts run out, taking the next up-front check on offer.

It comes as no surprise that Merrill Lynch paid out bonuses early, before the BofA transaction closed (Financial Times, January 22, front page, “Merrill Paid Bonuses As Losses Mounted Ahead Of Sale To BofA”). We are talking about a discrepancy of only $3bn - $4bn. As Jackie Gleason says, “A mere bag ‘o shells”. What puzzled us was the abrupt departure of two of the most significant Merrill team leaders, Bob McCann and Greg Fleming, respectively heads of Banking and Sales. How could BofA not have locked key players into long-term management contracts? Where was BofA’s management? Where their lawyers and board of directors? The exchange of letters between the SEC and Wachtell Lipton shows us exactly where they were.

So now what?

The SEC, grotesquely dysfunctional, will expend all its energy as it struggles first to survive, then in a turf war over the regulatory sector. Congress will not step in to regulate the financial industry where the rubber meets the road – at the level of investors being scammed – because they are too busy spending a trillion dollars here, a trillion there on “shoring up the financial sector”.

Look for the most seasoned and aggressive state regulators to step in where FINRA and SEC are too incompetent to tread, starting with Andrew Cuomo. Merrill and BofA shareholders voted to approve the merger on December 5th, one day before Andrew Cuomo’s 51st birthday. He could not have been given a better present.

Meanwhile, back to Mr. Geithner, we are clearly being given More Of The Same. If a global excess of liquidity led to the proliferation of bad investment paper – once all the decent investments had been bought and taken off the market – which led to discarding risk parameters, which led to the global economic crisis, does it really make sense that the cure for this malaise is to inject yet more money into the markets?

This is the “Efficient Secretary Hypothesis”: the theory that markets are incapable of taking care of themselves, and that government meddling is called for. This is based in the mistaken notion that the work of economists such as Hyman Minsky provides a prescription for dealing with crisis, whereas in reality, economists provide not prescriptions, but descriptions. We fear this may turn out to be Financial Lysenkoism.

How would it look if the government did nothing and let the markets crash, roil and rebuild on their own? Let businesses fail or prosper? Stood aside and permitted those with cash and an appetite for risk to take their chances, while permitting the faint of heart to remain on the sidelines? Permitted capitalists and risk takers to fail or succeed on their own, instead of rewarding monumental incompetence and hijacking the life savings of generations in an experiment in economic diddling?

But no one ever got elected on a platform of Doing Nothing We Can Believe In.

Moshe Silver
Director of Compliance
Research Edge LLC

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