Issue #18

This issue, was originally slated as a diatribe on Inflation and Stocks, but the apparent death of easy money has trumped it. The credit cycle isn’t easy to understand, let’s see if Cheech and Chong can help us out.

Cheech: “Hey Dude, my bank won’t approve our home equity line increase to redo our pad!

Chong: “Duh!” “Of course not Cheech.” “Haven’t you heard, the banks are all afraid that they are upside down on their loan portfolios, due to the rising defaults and sinking housing market and the folks who shouldn’t have been buying houses to begin with.”

Cheech: “But I know a bunch of those Boomers and Gen X-ers who were making money hand over fist with condo’s in Miami and whatnot.”

Chong: “Indeed. The flippers did make money, lots of it, but that game is over.” “And anyway that’s not the big deal, the big deal is that Private Equity needs something like 300 smackers to close all the recent mergers and buyouts.”

Cheech: “What’s the big deal Chong- what’s $300 million in a $14 Trillion economy these days.”

Chong: “Um, your right Cheech, any of these big companies can borrow $300 Million, but were talking about “B’s”.

Cheech: “Huh?”

Chong: “Billions . . . Cheech, billions.”

Cheech: “Didn’t somebody once tell me that if you owe the bank 100,000 dollars, you have a problem.”

Chong: “That’s right Cheech, and if you owe the bank $100 Million.. .”

Together: “Then the bank has a problem!”

Cheech: “So I guess, If we are talking like, dude, um, 300 billion, you could say the banks have a problem.”

Chong: “Yes you can Cheech, you can indeed say that.”

Cheech: “So what’s the real deal Chong? Is my Bali money for my Christmas Safari safe . . it’s in a CD at JPMorgan?”

Chong: “Well Cheech, that’s the billion dollar question for all those shareholders of JPM stock. Actually, your CD is safe, but the equity in the house of Morgan is in question.”

Cheech: “So you mean Chong, that that’s why JPMorgan’s stock fell in the last two weeks from $50 to $44, shaving off a cool $20 billion in market capitalization?”

Chong: “You’ve got it Cheech.” “The market has marked down the price of JPMorgan stock, because they don’t know how much of a hit JPMorgan is going to take on its loan portfolio.”

Cheech: “Well, isn’t that a big hit Chong, I mean, how big is their loan portfolio with these shaky loans Chong?”

Chong: “No-one knows exactly Cheech, their loan portfolio is about $600 billion, perhaps like, 10% of these loans could be termed higher risk. But that doesn’t include all those complicated derivatives.”

Cheech: “But wait a minute Chong, isn’t this fear about those bad housing loans; and maybe some private equity buy out’s, not derivatives?

Chong: That’s true Cheech, we haven’t heard them waving the red flag about JPMorgan’s derivative business yet, but if this thing keeps unraveling, they will.

Cheech: “But Chong, what about this private equity danger you spoke of? Isn’t private equity just a way to buy back shares of a company because it is trading too cheap, and thus, make the company a part of another company, or a private, closely held company again (like my daughter’s in-law’s dry cleaner business (you should see their cash flow!)

Chong: “Right again Cheech, but remember, your Daughter-in laws doesn’t need $12 billion to buy back stock and debt.” “Yesterday JP Morgan admitted that they couldn’t find a buyer for the $12 Billion that Private Equity firm Cerberus needed to close their deal of buying out the Chrysler division from Daimler Benz. So Morgan and their syndicate of seven other banks are going to assume $10 Billion in loans themselves, because they couldn’t find any institutional buyers willing to buy the debt.”

Cheech: “But Chong, isn’t their always a price for anything?

Chong: “You truly amaze me Cheech, I thought you were dazed and confused all through our Economics classes, now you quote me market forces? Milton Friedman would be proud.”

Cheech: “Isn’t he dead?”

Chong: “I don’t know, it’s not important.” “The important thing was that the credit desks shut down this week, and JPMorgan and their cohorts are screwed, and have to take on $10 billion in debt.”

Cheech: “Why doesn’t JP Morgan just walk away Chong, let the deal die?”

Chong: “That’s the right question Cheech. I’m not really in the loop on this one, but probably because JP Morgan made like several billion dollars last year in fees doing deals like this, and they already promised to get the deal done (which is why they get paid those astronomical advisory fees of $10-$100 million for a deal like this”

Cheech: “So what’s the bottom line Chong, my Bali money, my 401k, what do I do?”

Chong: “You have a 401k Cheech?

Cheech: “Course man, heck we’re boomers aren’t we Chong, we all have 401k’s.” “So what do I do”.

Chong: “Sorry dude, go work with a professional.” “ Don’t do anything rash, there’s so darn many petro-dollars and Asian savings sloshing around, that this sell off will probably run its course in a few weeks. And if it get’s really bad, Ben Bernanke will bail us out with a rate cut.”

Cheech: “But he’s like the real deal, a Fed head that actually says what he thinks.”

Chong: “That’s right Cheech, but he’s still got to wear them Greenspan pants, protect the put and all that.”

Cheech: “You lost me Chong”

Chong: “Cheech, the system doesn’t allow for systemic failure any more.” “Remember Y2K, why didn’t anything go wrong?

Cheech: “Well, I was making lot’s of money marketing for some Dot-com.”

Chong: “Of course you were Cheech.” “The Fed pumped money like crazy, and the Bankers gave it to the Dot.com kids, who blew it on dopes like you and bad business models.” “Remember the Asian meltdown in 1998 after Russia defaulted on their loans in August, and the Long-Term Capital blew up and destroyed the credit markets?” “What did the Fed do?”

Cheech: “Didn’t they call an emergency meeting Chong, lower rates inter-day?”

Chong: “You bet they did. And what happened in September 2001.

Cheech: “Didn’t the buildings go boom, and the Fed came to the rescue again with lower rates?”

Chong: “They did indeed.” “And they will do it again.”

Cheech: “But if the Fed would stop bailing us out every time people are reckless and ignore risk, wouldn’t they then be more cautious with their money, and wouldn’t banks be more cautious, Wall Street’s power brokers be more cautious?” “And wouldn’t that keep the costs of things going up less quickly because there would be less money in the system?” “Isn’t this like a Merry Go Round that won’t stop, and every time crazy stuff happens, we pump more money into the system, and destroy the value of the dollar?”

“Isn’t this series of Fed interventions into the money supply, this dependency on cheap money- while the masters of Wall Street can do whatever they want (like make $20 million a year, and then get bailed out by the Fed), isn’t that all like wrong for democracy, wrong for society, wrong for our souls?”

“Hasn’t this Federal Reserve a created a hazard, because their interference and support of easy money have institutionalized reckless risk-taking?” “Doesn’t this mean that the US. Financial system itself is the modern Moral Hazard, Chong?”

Chong: “Bingo Cheech!” “But, don’t worry about Bali: a beer might cost $18, but you will get your money back from the House of Morgan” “That’s a promise as good as Gold, you’ve got the Greenspan Put on your side.”

Cheech: “But Chong, didn’t Greenspan like Gold?”

Chong: “That was 1966 Cheech.” It’s late, will do more on that another day.”

~And we’ll have fun.fun.fun ‘til Daddy take’s the T-Bird . . .

Blessings,
Daniel A. Barnes, CFA

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

This entry was posted on Friday, July 27th, 2007 at 11:13 pm and is filed under Insight Newsletter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.