Large Banks and Obama's Overhaul Proposal

That’s why we are seeking reforms to protect consumers; we intend to close loopholes that allowed big financial firms to trade risky financial products like credit defaults swaps and other derivatives without oversight; to identify system-wide risks that could cause a meltdown; to strengthen capital and liquidity requirements to make the system more stable; and to ensure that the failure of any large firm does not take the entire economy down with it. Never again will the American taxpayer be held hostage by a bank that is “too big to fail.”

Now, limits on the risks major financial firms can take are central to the reforms that I’ve proposed. They are central to the legislation that has passed the House under the leadership of Chairman Barney Frank, and that we’re working to pass in the

Senate under the leadership of Chairman Chris Dodd. As part of these efforts, today I’m proposing two additional reforms that I believe will strengthen the financial system while preventing future crises.

[...]Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated
to serving their customers.

[...]I’m also proposing that we prevent the further consolidation of our financial system. There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy. The American people will not be served by a financial system that comprises just a few massive firms. That’s not good for consumers; it’s not good for the economy."

-President Obama Jan 21, 2010

The big banks it seems will no longer be able to profit via cheap funding from the Federal Reserve. Be that is may, the banks were able to make healthy profits last year, with the exception of Bank of America as it absorbed Merrill Lynch and took loan losses from credit cards and mortgages.

Goldman Sachs continues to make massive profits in its major segments of business: $8.40 per share for a total of $4.95 billion. They are broken down as follows: investment banking ($1.6b in Q409, up from $899m in Q309), trading/principal investments ($6.4b in Q409, down from $10b in Q309), and asset management ($1.6b in Q409, slightly up from $1.4b in Q309). In the first 9 months of 2009 Goldman set aside $16b for its 35,500 employees.

Morgan Stanley just recently turned around in the final 3 months of 2009 as they were late to recovery. Net income was $413m, but overall in 2009 they lost 93 cents per share on a diluted basis. They have been getting a lot of attention due to their large compensation and bonus pool which amounts to 62% of revenue. One of the best things Morgan Stanley has going for it is the absence of a big consumer-based (retail) book of business. In 2009, they set aside $14.4b for its 62,000 employees.

Bank of America lost a total of $2.2b in 2009, mostly due to retail customers' inability to pay their mortgage. Also, they charged off a large amount in order to pay back TARP. It was their first loss in 20 years (last one was during the savings and loan debacle). In the 4th quarter alone they lost $5.2b or 60 cents per share. They have set aside $10.1b to cover potential loan losses in the future, a gigantic number for such a provision.

What's Happening in Greece?

Greece can bring down the European Union! Well maybe that's an exaggeration, but in a report by a Moody's analyst a mention of "slow death" for Portugal and Greece was made. Although Greece isn't the powerhouse it was thousands of years ago, its currency is the euro and they are one of 16 members of the European Union. A crisis in either Greece or Portugal can have a scathing ripple effect across larger Eurozone members which would eventually hurt the "recovering" global economy. Of course, with the growth in China and USA out of the abyss, Europe is less threatening than it appears to be.

PIGS, the contemptuous name for Portugal/Italy/Greece/Spain, are under pressure as the rating agencies are hitting them with negative outlooks. The deficits being run in these countries are being supported by low interest rates, but as soon as institutional investors pull the plug on cheap financing, things could start to crumble. There are ways to protect portfolios from this, one of them--and the most direct way--is to short the currency. Another is to buy put options on ETFs that have exposure to these countries.

California Furthers Its Financial Issues: Debt Downgraded

Just what we need--more difficulty in getting out of a terrible $20 billion deficit. Standard & Poors' recent downgrade puts general obligation bonds 7 notches down from the coveted AAA rating to an A-. The state already had the lowest rating in the Union and as the credit crisis ran its course things got worse. California will now have to pay a slightly higher interest rate on new and refinanced debt, exacerbating the state's budget crisis. It's a downward spiral that has just begun; hopefully with enough cuts in spending and fiscal conservatism we will see the $20 billion gap close going forward. Tax revenues have declined in the wake of the real estate bubble bursting which caused unemployment to rise (the states biggest source of revenue is taxes on employed individuals as well as businesses).

Investment opportunities abound in the municipal bond market. A 30 year California bond now yields 7.7%, and that's after taxes (muni bond interest is usually not taxable by the federal government and if you reside in the state that pays interest on the bond, the state tax is also usually exempted). For a more in-depth look at California muni bonds check with your local investment advisor, as this is general information and your situation may differ.

Federal Reserve Posts Record Profits For 2009: $52.1 BILLION

Where did the capital and production capacity come from to generate such a successful year? This money comes from a different source than the $700 billion TARP fund. The source: keystrokes (we'll come back to this). Quantitative easing, Repurchase Agreements, Securities Lending, Commercial Paper Facilities, and other programs created in late 2008 allowed the Fed to purchase mortgage pools, Treasury Debt, Commercial Paper (short term corporate loans), Fannie Mae/Freddie Mac bonds, and consumer credit receivables. The Fed will turn over a big portion of the profits to the Treasury, about $46.1 billion. Here is a visual of the Fed's expansion:



Keystrokes create billions and trillions of dollars in most modern societies that can be later destroyed or absorbed. If I enter the number 1,000,000,000 on one side of my balance sheet I will need to offset that with something. My job would be to manage the credit risk of the people I'm lending $1b to so that I can continue to provide a lending service. It sounds like I'm getting interest on debt that I couldn't afford to buy in the first place, which is true, but a mechanism like the Fed has to exist to expand and contract the money supply in different economic cycles. They are the only ones authorized to do this currently.

In the picture above The Fed entered liabilities into their accounts and offset them with the aforementioned assets: Treasury Debt, Commercial Paper, Credit Card Receivables, Mortgage Pools, and so on. This was why we kept hearing that the Fed was the lender of last resort. The private debt markets (banks and investors) had literally stopped lending to us and did not want to refinance existing debts. As the Fed bought these assets as a lender of last resort (remember your company's debt or your personal debt is someone else's asset) the debtors like consumers, the US Treasury, and private corporations continued to make periodic payments of principal and interest.

The interest portion of the debt accumulated to the $52.1 billion number we saw. The issue is with the principal...what is it worth? If the health of the economy does not improve or if credit contracts even slightly once more, the debt will be marked down in value and could potentially drive down the value of the dollar since dollars are backed by what the Fed holds as assets and what the market deems those assets to be worth. In reality the currency of any fiat system is backed by government enforcement of that currency as legal tender.

Source: econbrowser.com, Federal Reserve Press Release, The Associated Press

Tax Topic: Roth IRA Conversions

There has been a lot of press regarding conversions, especially now that it is 2010 when the IRS is officially set to lift a provision that precludes tax-payers making more than $100,000 from converting their Traditional IRAs to ROTH. This opens the doors to a tremendous tax planning strategy to millions of Americans holding tax-deferred IRAs and defined contribution that has been out of reach for years. This may be even more compelling if plan assets are depressed in value.

One of the most attractive gems in the 2010 provisions is that you can defer tax payments if the conversion occurs this year (tax-payers making less than $100,000 have been able to convert but have had to pay taxes in the year of conversion). If a tax-payer converts this year they will owe half of the taxes on April 15th of 2012 and the other half on April 15th 2013.

If most of the Traditional IRA is made up of non-deductible contributions, the ROTH conversion makes a lot of sense. Also, if you expect to be in a higher tax bracket in retirement or expect to see a hike in overall tax rates (due to unprecedented government spending) then this strategy will work well. The main advantages are hedging against a rise in taxes, tax diversification (tax-free source of income in retirement), and estate planning (no minimum required distribution and spousal continuance).

A couple of things to look out for:
-If the conversion pushes the tax-payer into a higher tax bracket, this strategy may lose efficacy. Converting a partial amount that keeps in the same bracket is optimal.
-The taxes owed should not come out of the IRA, as there is a penalty on monies not converted. Taxes owed should come from existing taxable assets or savings.

This should be considered general guidance; a complete analysis of individual tax-payer situations should be done before acting on any strategy.

IRS Circular 230 Disclosure: This communication was written in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction(s) or matter(s) addressed herein by persons unaffiliated with Monoceros Capital Management, LLC. Monoceros Capital Management, LLC and its affiliates do not provide tax advice. Accordingly, to the extent this communication contains any discussion of tax matters, such communication is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties. Any recipient of this communication should seek advice from an independent tax advisor based on the recipient’s particular circumstances.

Sources:
Financial Advisor Magazine, January 13, 2009 - Roth Conversion Rule Changes Will Help Many Advisory Clients, by Ben Norquist and Michael Slemmer
Internal Revenue Bulletin: 2008-12
fivecentnickel.com - Look before You Leap: Roth IRA Conversions in 2010
401kLookUp.com: Rules You Must Know to Convert a 401(k) to a Roth - IRS Notice 2008-30, Minimum Required Distributions on Inherited Roth IRAs & Restrictions for Beneficiaries, July 1, 2008
SmartMoney: New Math for IRA Savings by Peter Keating, April 1, 2009
Comparison of Roth 401k, Roth IRA, and Traditional 401k Retirement Plans by John E. Buckley, Economist, U.S. Department of Labor

Conspiracy Theorists: Government Shoring Up S&P 500

By my calculation, the S&P 500 has rebounded an astounding 70% since its March 2009 lows! $600 billion of new cash needed to lift the market's capitalization by $6 trillion is puzzling...where did all that money to bid up stocks come from?

TrimTabs (an institutional research firm) CEO Charles Biderman expresses a possible explanation, "We know that the US government has spent hundreds of billions of dollars to support the auto industry, the housing market, and the banks and brokers. Why not support the stock market as well? We have no way of proving this,” Biderman said, “but what we do know is that it was neither the economy nor traditional sources of capital that created the boom in equities.” According to Biderman, the Fed or Treasury could have easily manipulated the market by covertly buying futures contracts at a monthly pace of $60-$70 billion.

It would make for a great movie if it actually happened, but it was the Fed's liquidity injections and Treasury's borrowing binge that made its way into risky assets through financial institutions and institutional investor borrowing cheaply and buying higher yielding assets. The amount of money required to lift global equities, commodities, bonds, cross currencies, and anything with risk is beyond what our government can influence. Risk appetite increased. You can't and shouldn't short stocks when the Fed's rates are near 0%. People and institutions alike need yield and when banks as a group are offering 0.25% then the former group turns to other assets; hence the rise across the board. Not to mention, the markets had been severely over-sold due to irrational expectations of another Great Depression.

The growth in conspiracy theories has risen dramatically since the markets became unglued in late 2008. The PPT (plunge protection team, or more formerly the President's Working Group on Financial Markets) has been brought up more than ever before since its inception in March of 1988. In response to the October 1987 stock market crash, President Reagan established this group to provide recommendations on private sector solutions and maintain integrity, orderliness, and competitiveness of financial markets. Most of all, this was theoretically put in place to boost investor confidence.

Psychologically, this can be described as a cortex response to a limbic system-driven behavior. Exogenous forces, according to the conspiracy theories, are what cause events. So when corporate earnings are good and unemployment is low, stocks go up. Since earnings have dropped and unemployment has risen, the cortex-based reasoning is that someone or something is artificially pushing stocks higher. The market is forward-looking about 18 months and is a highly dynamic and complex system with many participants. So many profit-seeking participants that it would be extremely difficult to get away with any kind of mass manipulation.

Sources: Minyanville.com and Marketwatch.com

"Countrywide" Dodd Will Not Seek Senate Re-election in CT

There is some speculation as to why Dodd will not continue as Senator of Connecticut: low approval ratings, inability to secure seat once more, failed presidential bid, or political damage due to favorable treatment by Angelo Mozilo of the now Bank of America subsidiary Countrywide.

His power grew enormously as he authored and co-authored some major pieces of legislation: $700b TARP, $787b Stimulus, Credit Card Reform, and now the $900b Healthcare bill. His party has had growing concerns, though, despite his influence that he wouldn't win a mid-term election, so he is stepping down for the good of the group.

What will the Senate Banking Committee look like now?

Residential Housing?

With the tax credit expiring in Spring, the Fed slowing or completely stopping the purchases of Fannie and Freddie mortgages, mortgage rates on the rise, and a still brittle jobs market--will housing continue to improve? We still have quite a bit of foreclosure inventory that has yet to hit the market.

It's hard to say yes, not because it's a loaded question but because so much fundamental data is working against a sharp rise in prices. The latest pending home sales numbers were dismal (16% drop from October to November) as the $8,000 tax credit was extended. It goes to show how our government is propping up the market.

More to come...

Federal Open Market Committee Minutes of the Board

Today the Fed releases minutes of its meeting that occurred three weeks ago. Why do we care and what should we look for?

The minutes reveal changes in monetary policy that can and will affect markets around the world. They contain all economic data that the Fed has compiled to make decisions on which direction to take interest rates. They also reveal whether any FOMC members voiced dissenting opinions...

This is what we look for: more and more dissent from current policy. The more dissent the more volatility. Depending on our exposure, volatility can work for us or against us, but either way, there will be volatility. The talk last time--released Nov 24--discussed asset sales, and there seemed to be disagreements as to whether that would be a smart decision in light of intentions to raise short term interest rates. Asset sales would undoubtedly affect longer term interest rates (10/30 year Treasuries).

A palatable solution to an exit strategy discussed was a combination of term deposits (paying interest on deposits at the regional banks) and reverse repo's (selling loans with the promise to buy them back in the future).

The Federal Reserve has a dual objective to maximize employment and have stable overall prices.

The new minutes will be out today at 2 pm est...

Still Losing Jobs...

Planned layoffs in December 2009 fell to 45,094. That's as positive as it gets. There were economists and some institutions that forecasted growth in the job market, I still think we're a ways away from seeing real job growth. In some way, the number is somewhat a relief as the numbers for December 2008 were so bad (166,348 jobs lost) that it makes today's numbers look small.

2009 showed a total loss of jobs of 1,288,030, most of which came in the first half as bank failures and housing continued to collapse. 2010 may show some positive number, but to make up for all the lost jobs is a tough proposition in the next couple of years. We're going to have to learn to do more with less for awhile.

This data is from the Challenger Job-Cut Report which can serve as a leading indicator for new jobless claims.

Brokers Flee Large Firms, Start Their Own

Independent advisers are gaining ground on Wall Street firms to manage Americans' $5 trillion in savings. Wall Street firms are shrinking in market cap size and in their share of the retail-investing public.

As large firms' reputations are tarnished and some completely vanished, brokers and clients are making the move to independents. Cerulli Associates' research shows that in 2009 $188 billion moved out of large Wall Street firms and into independents, they forecast that in 2010 there will be even more funds transferred.

Having said that, large firms still held a large piece of the pie: 48% at the end of 2008 while independent firms handled 19%. Cerulli now estimates that by 2012, the big-firm share will down to 41% and the independents will be up to 23%. The balance is managed by small investment firms, banks, and insurance companies.

Large firms are fueling this movement by pushing out (making operating expenses higher) brokers, and the brokers are now approaching independent firms they never thought would be worth pursuing. The payout to brokers may be reduced substantially, from 40% of revenue generated to 20%!

These moves have caught the attention of discount brokers like Interactive Brokers, Scottrade, TD Ameritrade, Fidelity, and Charles Schwab. Brokers and advisers need a platform to clear trades through, custody assets, manage client statements, etc, so these discount brokers are picking up the slack. They are wooing brokers in a big way, and clients like the fact that the firm doesn't sell proprietary products or make big bets on structured finance (CDO, CDS, Equity Derivatives).

Source:WSJ

A Look Back: Last Decade of Investing

A $10,000 investment on Dec 31, 1999 would have turned out like this:

*Venture Capital $8,800 (1999 funds)
*S&P 500 $9,090
*Raw Materials $13,803 (Similar to CRB Index)
*Residential Real Estate $15,000
*10-Year Treasuries $18,000
*Gold $37,852

Hindsight and all that...