Comrades

I thought we won the Cold War. The Berlin Wall fell, pushed over by Ronald Reagan and his crusade for individual rights and free markets--free from as much government as he could dismantle during his political life.

And I remember the Great Communicator’s famous 1987 speech, during which he urged the Soviets to “tear down this wall.” It did come down, and in just four years the Soviets fell, and their Union was dissolved.

Back in the US, the big fight against communism was being fought even harder. Reagan worked across the political aisle that separated Democrats from Republicans and was able to bring an end to a long history of massive government intervention in the lives of all taxpayers.

The tax reform act of 1986, along with several other bipartisan reformations, went quite far to liberate capital and the economy. But it wasn’t enough.

The idea that “bigger government is better” was still being fought, even as it was crumbling in the former Soviet Union.

We might have celebrated the end of the Cold War and the conquering of the Soviets, but now who’s winning?

Last week I detailed my concerns over the proposed bipartisan bailout of the big investment banks. I wrote that it’s a very bad episode of government insinuating itself deeper and deeper into US credit and capital markets, perhaps much more so than governments in the centrally planned economies of old.

The title of the government operation is TARP--as in we’ll just throw one over the whole mess so taxpayers won’t see enough to become incensed. The Troubled Assets Relief Program is in jeopardy as of this writing. It seems that as more and more folks took a peek underneath it, the more opposed we became.

And rightfully so.

The deal sets up a massive, nearly trillion-dollar fund to be run at the sole discretion of Treasury Secretary Henry Paulson. He’d be able to buy just about anything, from bad debt to common stocks of banks to real estate.

The plan would extend to foreign banks as well as US banks--without a eurocent from taxpayers outside the US.

As Paulson’s plan gestated on Capitol Hill, it was extended to potentially set pay rates for executives of banks that sold assets to the TARP, effectively putting compensation and management decisions in the hands of the US government.

The plan would also continue to allow the Securities and Exchange Commission (SEC) to add more stocks to the list of those already getting special treatment that forbids the short-sale of those shares on any US exchange. And to enforce that, it would force private investment groups to disclose all holdings to the US government for approval.

You’re getting the same feeling in the pit in your stomach that I am right about now.

Going forward, the government would effectively be setting policy for lending and investing for the bulk of the US markets.

Do we want the US government--or any government--to be the lender for everything from corporations to car and home loans? And do we want the US government to be sitting on management teams and boards of directors setting policy? And do we want government to have a say in which companies get deals and which won’t?

Do we as investors want to have to concern ourselves with whether politicos are going to promote a company or a mutual fund before we buy?

The thought on Capitol Hill was, until late in the week, that the answer was yes. The times had gotten so bad that many thought perhaps Capitol Hill has the best collection of economic and business minds and should run the nation’s banks and brokerages and have a hand in every other business.

But the last time the government grabbed the reins of private enterprise--instituting price and wage controls, running banks and financials, taxing us at rates as high as 70 percent--it didn’t work out all that well for investors. Just take a look at how the S&P 500 fared from 1929 through 1979.

Over those 50 years, when the US government participated in a similar manner in the private markets after intervening to prevent financial failures, the average annual return for stock investors worked out to be 2.5 percent per year. And there were plenty of years with negative returns. The average rate of inflation during that time was around 3.9 percent. Stocks didn’t keep up.

Meanwhile, isn’t it funny that some of the biggest failures among the banks and financials over the past several weeks have come without government bailouts?

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Bear Stearns was bought by JPMorgan Chase (NYSE: JPM), and, yes, there were guarantees made by the Fed that if Morgan found landmines it would step in to help disarm them. But the deal was done, and it worked out quite well for Morgan.

Now the biggest bank, Washington Mutual (NYSE: WM) is also being bought by Morgan--without the Federal Deposit Insurance Corp having to pay off depositors.

Merrill Lynch (NYSE: MER) was bought out by Bank of America (NYSE: BAC), and now we have Mitsubishi UFJ Financial (NYSE: MTU) in the process of buying out Morgan Stanley (NYSE: MS).

If we really are in such a crisis that the US government has to become the lender and manager of last resort, why are these deals getting done in the private sector?

Granted, some, such as Lehman Brothers (NYSE: LEH) and American International Group (NYSE: AIG), are getting liquidated. But in both of these cases, the private sector is eager to shuffle through the carcasses to buy what they want.

To get a real handle on what needs to be done, we need to know how we got here. Let’s start with the banks.

Banks are regulated by a series of government agencies that have some rules of the road for the private sector to deal with. For nationally chartered banks, it starts with the Office of the Comptroller of the Currency (OCC). This outfit sets the rules and polices for national banks in terms of their capital and credit. For thrifts such as Washington Mutual or federal savings banks such as Everbank Financial Corp, the Office of Thrift Supervision (OTS) sets guidelines. State banks are under the jurisdiction of the respective local regulatory bodies.

Responsibility for regulation is split among the various authorities, but oversight comes down to basic rules of capital.

And what failed was the supervision of how assets were counted as capital. For banks, assets that aren’t held for sale, and thus not counted as primary capital, are carried at full face until either the bank or the regulators deem the assets to be impaired. And along the way, reserves are built up to supposedly offset potential hits to assets.

The trouble with this system is that it’s rarely enforced. As mortgage, consumer and corporate loan assets became impaired regulators did little to crack down on how they were valued. Even worse, reserve build-ups were very slow over the past few years.

There’s another level of regulation in the form of the FDIC. The FDIC has the ability to step into any bank, national or state, as well as any thrift if it determines that insured deposits are at risk.

It can demand increases in reserves as well as a build-up of capital, but it has little enforcement authority other than stepping in and seizing banks. And over the past year the FDIC has been demanding a ramp up in reserves--only to be fought by the Internal Revenue Service (IRS) on the ground that a build-up of reserves reduces current taxable revenues.

With FDIC insurance, there’s little market participation in the risk pricing for deposit liabilities for banks. After all, for depositors with less than $100,000, it doesn’t matter where you bank, with one that has massive capital or one that’s on the rocks.

The FDIC has wanted to use the insurance premiums charged to member banks as a means of using the market to price in risk, but member banks and Congress have continued to balk.

Even if a bank has continuing issues, it gets pretty much the same rates to insure its deposits as a well-run bank. Think of this in terms of your own insurance world, such as for your cars.

If you drive well and have had no accidents, you get a break on your insurance; you know that if you regularly get tickets and total your cars, your insurance premiums will go through the roof. But if the FDIC was your insurer, it wouldn’t matter; you’d derive no benefit by driving responsibly, nor would you suffer for driving like a madman.

The Federal Reserve Bank is the lender of last resort for banks in terms of their reserve balances. The Fed can also step in to review member banks if they appear to be using the discount window for overnight lending assistance too many times.

But under the leadership of former Chairman Alan Greenspan and current Chairman Ben Bernanke, the Fed has actually done little to use more punitive lending rates. In addition, on the capital front, Greenspan was one of the major champions of more flexible valuations for capital assets under the so-called Basel II agreement, which sets international capital standards for banks.

Under Basel I, assets had various haircuts or value discounting based on what they were. For example, US Treasuries are discounted less than mortgage bonds. But under Basel II, the fixed rules are eased at the discretion of the banks to model risk and come up with their own discounting.

The bottom line on the commercial bank side is that we have a series of rules of the road that banks should have been following. And the cops that were supposed to enforce them were turning blind eyes.

Let’s now look at the investment banks and brokerages.

The Securities Exchange Act of 1934 established capital rules for brokerages similar to those covering banks. The rules were pretty straightforward. Brokerages such as Merrill Lynch or Edward Jones had to maintain enough capital against debts to ensure effective management of markets and investors.

The 1934 Act set in motion limits on how much leverage brokerages could have. And basically it came down to 12-to-1, which is pretty heavy. But there was a safeguard. A similar process for asset haircutting noted above for banks was put in place for brokerages. This was codified further in an addendum adopted by the SEC in 1975.

The haircuts were fixed for specific assets that were counted as capital assets. Treasuries were discounted less for having less market risk, while common stocks and mortgages were discounted more based on higher market risk.

This worked pretty well, despite some massive implosions in the 1980s that resulted in the dissolution of EF Hutton and Drexel Burnham Lambert.

Let’s skip along to 2005. Under the leadership of the Fed and its guiding Basel II principles, the SEC made a move to allow the largest of brokers--it labeled them Consolidated Supervised Entities (CSE)--that had capital of $5 billion or more to make their own valuation models. Guess which ones made that cut: The same ones that are now either gone or on their way to being liquidated or taken over.

The new rules allowed these mega-brokers to use their own judgment over haircuts, and it went further by allowing much more gearing of their capital, to as much as 40-to-1.

The net result was that the SEC, along with the Financial Industry Regulatory Authority, had little effective policing powers under the deals. This didn’t stop them from stomping all over smaller brokerages for violating the older capital standards. Only the big guys got the passes.

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And the markets had little concern, because, as investors, we know we’re protected from broker failure by the Securities Investor Protection Corporation (SIPC). Like the FDIC, SIPC insurance obviates the need for consumers to price risk.

Now we know that the assets held as primary capital by banks and brokerages are worth a whole lot less than what these same banks and brokerages were claiming. We could have used the market to price in that risk, and we could have allowed the market to decide which banks and brokers were too risky to do business with. But we didn’t.

Do we keep going down the same path? This means keeping government bureaucrats in charge of policing capital; they’ve done such a bang up job in the past. Or do we let the free market decide the outcome now and going forward?

As a former banker and broker, I believe it comes down to eliminating non-disclosure of assets and liabilities. And if we are going to have insurance programs for banks and brokers, insist on market pricing and disclosure of risk and risk premiums to the marketplace. That way the market can price risk and reward better business.

Otherwise, perhaps it would be better to start digging out those nice, itchy wool uniforms and addressing each other as “comrade.”

The outcome is going to be painful either way. The capital and credit markets have to go through big reckonings. And the sooner we force disclosure, the quicker we can go about rebuilding.

The worst example is how the Japanese dealt with their last credit fiasco of similar proportions. Even after the 1980s-era blowout, banks in Japan still have bad assets on their books. And that nation’s economy is still paying the price, having yet to pull itself out of a long-term recession.

Rip the band-aid off, and let’s let the markets price in risk.

To soften the blow, there are alternative plans to make some shorter-term loans available via the Fed. And perhaps we could do some backstopping for individuals, but only for the short haul.

We’ll pay a price for this, but we don’t have to accept a repeat of the same government mangling of the credit markets.

What will work for us as investors will be high-quality government bonds and high-quality corporates. Keeping the cash coming in is the best way to ride out a slow economy.

In the Same Boat

Well, comrade, it looks like we’re all in the same boat, one that’s ready to sail away with concepts like free markets and personal financial responsibility. Yes, these are indeed very dark, dire times.

Because we’re all in that figurative boat, perhaps a journey on a real one would help alleviate some tension while providing an opportunity to strategize on how to invest in such an environment.

Later this fall, I’ll be leading a cruise of like-minded folks just trying to keep more of what they have while earning a decent return--with the least amount of government involvement and taxation.

We’ll talk about out what investments will help our portfolios grow while enjoying warm waters from Miami, on to island stops including St. Barthelemy, through the Panama Canal and finally to Costa Rica.

Click here for details. 

Dead Guys of the Week

When it comes to the Cold War, one man was right on the frontline everyday. He wasn’t literally fighting, but he was recording the major players and bringing it all into our homes and offices via the Colombia Broadcasting Service (NYSE: CBS).

Bob Bjarne, who was with CBS from the storm shelter years of the 1950s all the way through the shakeup years of the 1980s, is dead at 77 years. A master of many tasks and talents, Bob made his vision work for viewers. He directed Face the Nation as well as what was the Morning News before it was turned into a chit-chat show.

A true news guy, Bob fought hard to keep more of the news budget and staff intact while many saw what eventually proved out, that more Americans didn’t want real news. (Instead, give them cutesy tidbits and lots of screaming and sensationalism, a bit more sports and Hollywood chatter and you’ll sell more ad time.)

During those heated years of the Cold War, Americans did need some diversions from the fear that they were moments away from having to duck and cover. For many, professional wrestling was a great diversion.

Some of you remember Gorgeous George, Nature Boy, Buddy Rogers and, of course, Walter “Killer” Kowlaski, who’s dead now at 81 years.

Speaking Engagements

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the presidential election in the seat of the federal government.

Join Roger Conrad, Elliott Gue and me for the DC Money Show Nov. 6-8, 2008, at The Wardman Park Marriott.

Click here or call 800-970-4355 and refer to priority code 011363 to register as my guest.

I’ll also be appearing at the following events:

• North Bay Investors Forum, Santa Rosa, CA, Oct. 11, 2008
• The World Money Show, London, England, November 2008
• The 2008 KCI Investing Cruise, Dec. 1-12, 2008

If you’re interested in having me or one of my cohorts address any investment or professional groups, please e-mail me at paymeweekly@kci-com.com with ideas or suggestions.