• The U.S. Federal Reserve has opted to hold the federal funds rate at 0% to .25% and “continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” the central bank said in a statement yesterday (Wednesday). Information the Fed received since its last meeting in April suggests “the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months.”

• As unemployment in the United States is expected to keep rising, the world’s largest economy may need another stimulus package, billionaire Warren Buffett said in a Bloomberg Televisioninterview. “It looks like we’re going to need more medicine, not less,” Buffett said. “We’re going to have more unemployment. The recovery really hasn’t got going.” Buffett, who like many economists sees the unemployment rate surpassing 10%, said the economy “hasn’t turned yet. There’s no telling how long it will take. It will happen.”

• The Methodist University Hospital Transplant Institute in Memphis, Tenn. confirmed a weekend Wall Street Journal reportthat said Apple Inc. (Nasdaq: AAPL) Chief Executive Officer Steve Jobs had a liver transplant. The confirmation came with the permission of Jobs, who has an “excellent prognosis.” The hospital did not say when the transplant took place, but The Journal puts the procedure at sometime in April, citing an unnamed source. Billionaire investor and Berkshire Hathaway Inc. (NYSE: BRK.A,BRK.B) Chairman and Chief Executive Officer Warren Buffett weighed in on the controversy on whether Jobs should have revealed his condition to investors in an interview with CNBC: “If I have any serious illness, or something coming up of an important nature, an operation or anything like that, I think the thing to do is just tell the American public, the Berkshire shareholders about it. I work for ‘em. Some people might think I’m important to the company. Certainly Steve Jobs is important to Apple. So it’s a material fact.”

• Although gas prices are significantly lower than they were at this time last year, fewer Americans will be traveling on July Fourth weekend, according to a survey by AAA. The auto club expects 37.1 million travelers, or 12% of the U.S. population to take a trip of 50 miles or more from home this year, a decrease of 1.9% from last year and a 12% decrease from 2007, months before the recession began. Factors such as the rising unemployment rate and sagging personal incomes are to blame for the drop in travel, AAA said.

• The world’s largest seed maker suffered a 14% drop in profit and disclosed plans to cut 900 jobs, blaming the deteriorating performance of its mainstay revenue source. Monsanto Co.(NYSE: MON) reported a net income of $694 million, or $1.25 per diluted share on revenue of $3.1 billion for the third quarter. That compares to a net income of $811 million, or $1.45 per share on revenue of $3.5 billion in the same quarter last year. Executives were not expecting a drop in performance of the herbicide Roundup, once a primary revenue source for the company. Several generic products hurt the prices for Roundup and profit on the product is expected to drop by half this year, Monsanto said. Shares for the company closed yesterday (Wednesday) at 76.16, down 3.9%.

• The Securities and Exchange Commission (SEC) voted unanimously to institute tough new rules for money market funds to help avoid a repeat of what happened when the collapse of the Reserve Primary Fund triggered a flurry of redemptions in the $3.6 trillion market. The proposal will prohibit money market funds from buying illiquid securities and requiring them to hold at least 5% in liquid securities such as cash. “These proposals are designed to increase the ability of money market funds to weather future economic storms,” said SEC Chairman Mary Schapiro. “The stability of money market funds in times of turmoil is enormously important both for investors and for the securities markets. The proposals also would improve the operations of money market funds and oversight of their investments during calmer times, which can further protect funds and increase public awareness of potential risks.”

• The worst recession in 60 years has taken its toll on everyone, including the millionaire’s club. According to a report from Merrill Lynch Global Wealth Management and consulting firm Capgemini, the number of people with assets of between $1 million and $30 million fell by 14.9%, BusinessWeek reported. The drop in millionaires represents the largest decline in the report’s 13-year history, said Ileana van der Linde, a principal with Capgemini. “We’ve never seen such a decline in all the years we’ve been doing the report,” she said. The recession has now reduced the cumulative wealth of the world’s millionaires by 19.5% to $32.8 trillion.

Source: Investment News Briefs Thursday, June 25, 2009

What happened in the past when cash reached these levels?

• In September 1974, cash on hand reached $604.5 billion, representing a record 1.21 times the U.S. stock market’s capitalization. That preceded a 31% gain in equities between October 1974 and March 1975.
• In July 1982, just as a 20-month bear market was ending, cash as a percentage of the U.S. stock market’s value rose to 95%. The S&P 500 began a six-month, 36% advance. According to Bloomberg, the eight previous times that cash peaked compared with the market’s capitalization, the S&P 500 rose an average 24% in six months.

This time, of course, it didn’t take nearly as long for the market to rally.

Still, the greatest appreciation so far has been in smaller stocks. That’s normal in an early bull market. But if the bull market continues, the big, blue-chip stocks are likely to lead the market higher for two key reasons:

• First, there is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. Investors tip-toeing back into the market are likely to gravitate here since these stocks are the safest.
• And then there is the growing influence of cash-rich sovereign wealth funds…

Sovereign Wealth Funds – The Financial Assets of a Country

Sovereign wealth funds are the financial assets of a country – usually part of the national savings – that are owned and organized into a state-controlled fund and put to work to earn a higher return on investment.

(Sovereign wealth funds are not the same entities as foreign exchange reserves, which are often used for short-term currency stabilization and liquidity.)

In the past, most countries put their liquid assets to work in foreign currency deposits, government bonds or gold. (The hard-working Japanese and Chinese, for example, have kept our interest rates low by maintaining a steady appetite for U.S. Treasury obligations.)

But with the dollar relatively weak and interest rates on Treasuries near record lows, U.S. government bonds are not generating the kind of returns you write home about.

So world governments are slowly moving money into global equity markets. And the sums involved are fairly staggering.

Sovereign Wealth Funds Control More Than $7 Trillion…

According to The Economist, sovereign wealth funds already control more than $7 trillion today. The exact amount is impossible to ascertain due to lack of transparency.

But China, Saudi Arabia, Singapore and the United Arab Emirates alone are known to control more than $2 trillion. And more money is being allocated to these funds all the time.

What does this mean for you as an investor?

Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe. Quite frankly, they are the only companies that can easily absorb buying on this scale.

For example, take a look at the Dow Jones Global Titans Fund (NYSE: DGT). It holds the world’s 50 largest publicly traded companies.

World-Class Diversification in a Blue-Chip Portfolio

When you buy this cheaply valued blue-chip portfolio, you’re getting world-class diversification.

Companies like:

• Exxon Mobile,
• IBM,
• Proctor & Gamble,
• Wal-Mart,
• Coca-Cola,
• Nestlé,
• Toyota Motor,
• Roche Holdings,
• Samsung Electronics

… Are just a few of the names that are major holdings of the DGT fund.

These firms will almost certainly be an early stop for U.S. investors who get frustrated with low yields and start venturing back into the game.

These same companies are a natural home for sovereign wealth funds – and the growing trillions they control.

History shows that cash on the sidelines always grows itchy with time. The Dow Jones Global Titans (NYSE: DGT) is a good way to take advantage of it – ahead of the crowd.

Source: Sovereign Wealth Funds: $7 Trillion Reasons to Stay Invested

Most, however, have been forced into selling to meet an avalanche of redemption requests for January 1.

This massive selling is another reason why the market fell so quickly. Could we get a little rally after    January 1?

Institutions will have to reinvest this money. Treasuries and money-market funds are returning next to nothing. The stock market could be the beneficiary by default.

But the Bernie Madoff (is it pronounced “Mad Off” or “Made Off” – as in made off with the money) $50-billion rip-off (Good news: he may have cheated investors out of as little as $30 billion!) may trigger a new rush by institutions to get their principal back. A lot of funds of funds had exposure to Madoff.

That would mean more selling and could blunt a bear rally. Thanks a lot, Bernie.

A Fitting End to a Lousy Year

The sheer fraud and greed of rating agency analysts and executives is staggering. That no one has gone to jail, and none of the agencies have been shut down is a travesty of justice on an infinitely larger scale than Bernie Madoff’s Ponzi scheme. Until depositors, bankers and investors regain confidence in the quality of ratings we rely upon to measure financial stability and creditworthiness, the tremors that underlie the credit crisis will drag on indefinitely.

Letter and number ratings – such as AAA, Aa1, BBB and Caa1 – are financial shorthand for the due diligence supposedly done by rating agencies after they’ve examined an issuer or a security’s financial structure, and evaluated the likelihood of its being able to pay interest and principal at maturity. Investors rely on the objectivity and fiduciary responsibility of the rating agencies to publish fair, accurate and uncompromised assessments.

By law, certain investors must rely on the ratings of a handful of Securities and Exchange Commission designated “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, most state insurance regulators require that only assets rated in the top four ratings categories by NRSROs are eligible investments. Similarly, money market funds can only invest in securities with the highest NRSRO ratings. In fact, innumerable institutions – public and private, and domestic and international – mandate asset quality levels predicated on the major rating agencies’ due diligence.

Standard & Poor’s Ratings Services, Moody’s Investors Service (MCO) and Fitch Ratings Inc. are all SEC-designated NRSROs. They are the largest, best-known and most-profitable ratings firms in the tiny, $5 billion-a-year universe of ratings firms. S&P is a part of The McGraw-Hill Cos. Inc. (MHP), while Fitch is a subsidiary of France’s Fimalac SA.

Moody’s was spun out of financial publisher Dun & Bradstreet Corp. (DNB) as a public company in 2000. Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B), apparently having spotted a diamond in the rough, bought into D&B before the divestiture, and ended up with a hefty 19% stake in Moody’s after the spin-off was completed.

The problem with the business of rating the issuers of securities, and rating the securities they issue – such as mortgage-backed securities and collateralized mortgage-backed obligations – is that the rating agencies are paid by the issuers to rate them. Objectivity aside, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. It’s like all the contestants in the Miss World pageant paying the judges with country funds … who’s not going to be judged beautiful?

What was even more problematic in the scheme of the ratings business model was that analysts didn’t understand how to analyze and rate the very complex cash flow structures of these new collateralized mortgage-backed securities. Not wanting to lose business to their competitors, who were all in the same boat, they used the same rating model structures that they used to rate corporate bonds, though the two different securities had nothing in common.

It was like asking your local car mechanic to certify your Citation V jet – just before you take off for a transatlantic flight to London. God help you if there’s a problem.

And there were problems. Lots of them. According to a Feb. 15 “Review & Outlook” piece in The Wall Street Journal, Joseph Mason, professor of finance at Drexel University, studied collateralized debt obligations rated “Baa” by Moody’s and determined that they were 10 times more likely to default than equivalently rated corporate bonds. The article went on to say that an S&P spokesperson, when asked if they actually examined the underlying mortgages in the pools, answered: “We are not auditors; we are not accounting firms.”

While S&P – and to a lesser degree, Fitch – were just playing the game, Moody’s actually ran away with the ball. An eye-popping and brilliant April 11 Journal article by Aaron Lucchetti exposed the unseemly underbelly of Moody’s greed. What stood out the most in the article was Moody’s willingness – under the direction of Brian Clarkson, who joined the firm in 1991 and became president and chief operating officer – to bend over backwards to accommodate issuers of mortgage-backed and structured finance paper. Clarkson was willing to switch analysts if clients complained, which several did, including Credit Suisse Group AG (ADR: CS), UBS AG (UBS), and Goldman Sachs Group Inc. (GS).

Under Clarkson, Moody’s expanded and grabbed a huge piece of the deal-ratings-market pie. By 2006, the company was rating $9 out of every $10 raised in mortgage securities. For all of that year, the firm’s structured finance group generated more than $881 million in revenue, about 43% of Moody’s revenue. And in 2007 it was estimated that the firm rated 94% of the approximately $190 billion in mortgage and structured-finance CDOs floated during the year.

But there was some concern, including some from insiders. Former Moody’s analyst Mark Froeba told The Journal that “there was never an explicit directive to subordinate rating quality to market share. There was, rather, a palpable erosion of institutional support for rating analysis that threatened market share.” In the same article, former Moody’s executive Paul Stevenson was quoted as saying that “the most recent problem is that the rating process became a negotiation.”

Clarkson, the Moody’s president and COO, didn’t do too badly negotiating his compensation, either. In 2006 he made $3.8 million, while the firm’s chief executive officer, Raymond McDaniel, made $8.2 million. Clarkson “retired” under pressure this past May and McDaniel, the CEO, added the title of president to his mantle.

Eventually, the always-late-to-the-dance SEC awoke to the realization that it was supposed to be watching the watchers – the ratings agencies. While hundreds of billions of dollars around the world was invested in Wall Street’s pay-to-play version of Illinois gubernatorial politics, many heartbroken and flat-out-broke investors discovered that what the rating agencies had determined to be “AAA” rated securities were not the princely investment-grade securities those three letters said they were, but were toxic Amazon frogs instead. Of course, that calls for an investigation. And so it was.

A 10-month “examination” by the SEC, concluded in July, uncovered, believe it or not, “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.” Brilliant!

According to the report, which included as exhibits several e-mail exchanges between analysts at unnamed ratings firms, there was an obvious degree of knowledge and complicity in playing the ratings game. In one exchange, an analyst said that their ratings model didn’t capture “half” of the deal’s risk but that “it could be structured by cows and we would rate it.” And in another even more famous exchange dated Dec. 15, 2006, a manager wrote that the firms continued to create an “even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Have any heads rolled? No. Have any fines been levied or any firms closed down? No. The SEC apparently went back to sleep, having since been intermittently aroused by the failure of The Bear Stearns Cos., the bankruptcy of Lehman Brothers Holdings Inc. (OTC: LEHMQ), the nationalization of American International Group Inc.(AIG), and a few other minor nap-interrupting events, including the bailout of Citigroup Inc. (C). I’m only sorry that the Commission’s disjointed hibernation should once again be interrupted by the petty crime of a simple Ponzi scheme artist. Well, maybe now they can finally get some rest. For the sake of our future, someone please disband this band of sleeping fools.

Shortly after the July examination was made public, in an acknowledgement that it might be under unwarranted attack, S&P announced that it was considering ways to take volatility and stability into account in its ratings. But, in a simultaneous burst of clarity, S&P suggested that it feared that a more disciplined and functional ratings model would make it harder for issuers to raise capital. Only days later, in fact, S&P went on the offensive, calling SEC proposals to boost disclosure and mitigate internal conflicts of interest too costly for the ratings businesses. Among the proposals that were pushed back was one to require a separate ratings structure and ranking system for structured products.

Fast-forward to Dec. 3, and the unveiling of the SEC’s latest proposed rules changes. While the toothless wonder folded up like a pup tent once again on all substantive changes that would have created a more transparent and honest playing field, it did manage to sneak in some suggestions, including those that said:

• The rating agencies can’t rate debt they help structure.
• Analysts can’t participate in fee negotiations.
• Analysts can’t be given gifts worth more than $25.
• Analysts must disclose a random 10% sampling of their ratings within six months.
• The ratings agencies must maintain a history of complaints against analysts.
• And that the agencies must record when an analyst’s rating for structured debt differs from a quantitative model.

Calling these proposed rules changes baby steps is like calling the Grand Canyon a ditch.

Because Wall Street didn’t like the idea, what got dropped from the proposed changes were rules to create different structures for rating different products. And the most egregious of the dropped rules was a proposal that ratings firms make public all underlying information they use in making their ratings. Which is exactly the transparency needed.

There is an overwhelming heaviness to the credit crisis that bears on our economic future. It is the inordinate weight of established, self-serving power brokers driving dump trucks full of ill-gotten gains over any clarion call for transparency. The underlying currency of capital markets must be clearly and objectively rated instruments, whose value is determined by free markets. Until confidence is restored in the producers, products and the purveyors of financial services, thirsty investors are unlikely to partake of any new punch.

Source: Fraud and Greed of Trusted Rating Agencies Helped Spread the Credit Crisis

So along comes Stein with a mea culpa for missing the recent stock market crash.  OK, so a lot of genuinely smart people didn’t think it was going to be as horrific as it turned out to be.  But Stein chalks it up to just one little misstep of the otherwise brilliant Paulson-Bernanke-Geithner team.  “I did not foresee the catastrophic mistake, as I view it, by Treasury Secretary Henry M. Paulson Jr. to allow Lehman Brothers to fail,” Stein writes. “That failure left a gaping hole in the financial services industry, and blew away confidence that the Feds knew what they were doing.”

Actually, Stein is sort of onto something here.  At the time Lehman blew up, Paulson & Co. had already engineered the demise of Bear Stearns and the full government takeover of Fannie and Freddie.  Nothing appears to have happened to alter my hypothesis at the time of Lehman’s demise about why it was allowed to happen.  But looked at from the Paulson interventionist standpoint, it was a blunder of the first order.  Lehman’s downfall pretty well doomed AIG (NYSE:AIG) and put a host of money-market funds in grave danger.

At this stage, it was obvious to all that Paulson & Co. were pretty much making it up as they went along.  Stein writes, “After Lehman, I felt sure that the government would realize its mistake and issue blanket solvency guarantees to banks. But that didn’t happen, the stock market fell apart, credit went icy cold and the wheels started to come off the economy. This also took me by surprise.”

This smacks of disingenuousness, an after-the-fact conceit that, “If I’d been in charge, I’ve have known which levers and pulleys to manipulate to make everything just so.”  So what does Ben think ought to be done now?  Well, it has nothing to do with the free market he allegedly reveres.  “The need for the government to take action seemed so clear — and still seems so clear that I cannot believe a day passes without its happening. But the days pass, nothing happens, and I am proved wrong again. And I lose some of my life savings and it hurts.”

Yes, the government is now going to own a piece of insurance companies, just as they’ve moved to own a piece of banks — but government is “doing nothing” in Stein’s view.  It’s enough to leave you speechless.

But no, Stein has one more whopper to lay on us before bringing this column to its merciful end.

And, closer to home, a talented makeup artist who works with me almost daily in my TV appearances asked what happened to people in a recession. (She is young.) I said that fear and insomnia happened to most people but that a few million would actually lose their jobs and millions more would lose income.

“What do they do?” she asked, looking worried.

“They find other work or live off their savings,” I said. “They certainly cut back on their spending.”

“What if they don’t have any savings?” she asked. “I don’t have any savings,” she said. “No one I know except you has any savings.” She looked extremely worried.

This is perhaps the main lesson of this whole experience. It is basic but still unlearned: human beings must have savings. This is not just a good idea. It’s the difference between life and death, terror and calm. So start saving right now, and don’t stop until you die.

Ben, where the hell were you all these years when Alan Greenspan was — by his own admission to Jon Stewart — discouraging people from saving by slashing interest rates, thus encouraging them to speculate wildly, first on tech stocks, then on real estate?

The only redeeming thing about Stein’s column is a postscript in which he says a windfall profits tax on oil companies is a dumb idea.  Yes, it is, Ben.  But you and Kudlow and Cavuto and the rest of you shrieking jackasses don’t help make the case when you’ve been so stunningly, breathtakingly wrong about everything else when Greenspan and Bernanke and Bush were running this country off a freaking cliff.  So do us all a favor:  Just shut up.  SHUT UP!  Go away for a while.  Your “free market” patina is going to make it damn near impossible for genuine free-marketeers to state their case for the next couple of years, at least.  We’re left to cry, not unlike pathetic hardened communists confronted with the demise of the Soviet bloc, “But what’s been happening isn’t really a free market!”

Oh well.  If you can’t change any minds, at least you can take a step to recover from whatever whacking the market has recently dealt you.

Source: Ben Stein’s mea culpa

A U.S. Securities and Exchange Commission investigation into credit-rating companies found the firms improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

A 10-month review of Moody’s Investors Service, Standard & Poor’s and Fitch Ratings found analysts contributed to fee discussions and weighed losing clients over certain ratings, the Washington-based SEC said in a report released today. Employees also cast doubt on the quality of some ratings, the SEC said, declining to link firms to specific findings.

“We uncovered serious shortcomings at these firms,” SEC Chairman Christopher Cox said today at a news conference. “When there were not enough staff to do the job right, the firms sometimes cut corners.”

Pension and money-market funds bought AAA-rated securities backed by mortgages to the riskiest borrowers because they offered higher returns than government bonds with the same ratings. In many cases, credit raters were paid by investment banks selling the bonds, prompting regulators and lawmakers to question their independence.

The SEC report describes an e-mail in which an analyst refers to the market for collateralized debt obligations as a “monster.”

“Let’s hope we are all wealthy and retired by the time this house of cards falters,” said the e-mail, which was sent Dec. 15, 2006, to another analyst at the same firm.

Mike Burnick at Sovereign Society says,

A look inside one of these [subprime mortgage] bonds tells a frightening tale. A US$80 billion sub-prime asset-backed bond issued by Deutsche Bank in 2005 is still rated AAA by S&P and Moody’s. Yet, 18% of the mortgage loans in the security are in foreclosure.

Additionally, lenders have already seized 15% of the properties underlying the loan values for this security. Another 10% have been delinquent for more than 90-days.

Another Morgan Stanley Capital sub-prime mortgage-backed security has credit support of 64% relative to the number of delinquent mortgages loans in the pool. But the credit should be at least twice the delinquent mortgages to maintain a top rating.

Why This Junk Isn’t Rated As “Junk”

Technically, much of this so-called triple-A rated debt should have been downgraded long ago. So why hasn’t it? The simple answer is: Fear of too much “collateral damage.”

According to Bloomberg, “Financial firms own high-grade collateralized debt obligations, which package securities such as mortgage bonds and slice them into pieces with varying risk. As the underlying mortgage bonds are downgraded, those securities will also lose their ratings and tumble in value.”

There’s a huge potential “contagion” effect that would ripple through the financial system if Moody’s or Standard and Poor’s dared to downgrade these shaky sub-prime credits across the board. For instance, a bank holding US$100 million of AAA-rated sub-prime bonds needs just US$1.6 million in capital backing such a highly rated credit. – that’s a lot of leverage. And such leverage is fine, as long as the bonds remain triple-A rated.

Should the bonds get downgraded to below investment grade however, under global accounting rules, a bank must put up additional capital. In fact, it would take US$16 million in capital to back US$100 million in non-investment grade bonds.

That’s 10 times as much capital required in the event of a credit ratings downgrade. Wall Street just doesn’t have that kind of extra capital lying around. Bear Stearns found this out the hard way over the weekend. That’s why I expect the major ratings agencies, perhaps abetted by the Treasury Department and the Fed, to continue covering-up the true health of US$650 billion in outstanding sub-prime bonds.

Burnick concludes that:

At the risk of sounding like an alarmist, I just have one question. What happens to confidence in the U.S. financial system (not to mention the dollar) when people wake up and realize these fairy tale markets (held up by fantasy ratings) turn into a nightmare?

The Fed is merely monetizing Wall Street’s mistakes yet again, while leaving future generations of taxpayers with an even bigger tab to settle, and higher future inflation to fight.

But there’s just no time for such ponderings now, we’re in the midst of a full-blown financial crisis after all. Damn the financial torpedoes, full speed ahead with the monetary printing press.