Winners and Losers

It is very easy to consider the free market as nothing but a vehicle to decide winners and losers. However, it is more than that. It is a vehicle to restore order and balance, insuring that the fundamental principles of economics are obeyed.

In the events of the past weeks, we have seen stalwarts such as Merrill Lynch and Co., Lehman Brothers, Bear Sterns, Freddie Mac and Fannie Mae all begin to fade into obscurity.

As this is the political silly season in the U.S., politicians are quick to point blame at each other, some of which is well deserved. However, the current troubles are the result of violating basic economic principles. Yes, I repeated the phrase, because it bears repeating.

Companies in the U.S. can safely take on debt (leverage), if their cash flow permits it. Additionally, debt can be used to lessen taxes. However, with debt comes risk. Failure to properly evaluate risk can result in being over leveraged and unable to pay back the debt. That is exactly what we have seen in this current economic situation.

Individuals took out mortgages well in excess of their ability to pay. These mortgages were bundled, chopped into pieces (tranches), and sold. Lehman, Merrill, etc., bought these seemingly low-risk securities and then used them as collateral for new debt. In both the individual and corporate cases, they were over-leveraged. People have been missing mortgage payments. The tranches with bad mortgages have lost value. That value which was used as collateral is now insufficient to pay back corporate loans. Badda bing, badda boom, companies go out of business.

Let this be a lesson, conservative risk management rewards in the long run. Bank of America, JPMorgan and Goldman Sachs, while taking it on the chin in the short run, are well positioned to weather this storm. The market is correcting the excesses and that's exactly what it is supposed to do.

Ken Lewis Cleans Up

Its good to be the king, or CEO of a major bank. Ken Lewis, the CEO of Bank of America, is looking quite smart.

Forbes did an article about the whole Freddie/Fannie mess call "BofA's Bailout Benefit" on September 8th.

The article calls out how Mr. Lewis was panned for his purchase of Country Wide, the large and failing mortgage company. Many thought BofA was chasing good money after bad. However, with the bailout of Freddie Mac and Fannie Mae, he is looking crazy like a fox.

From the article: "The Ladenburg Thalman analyst (Dick Bove) argues that Bank of America, and Countrywide, have the existing infrastructure to start buying and securitizing loans on a large scale. He even said in a phone interview that Bank of America's capital levels would allow it to guarantee mortgage payments. This promise to pay has been Freddie and Fannie's traditional role in the U.S. housing market."

Naturally, one questions if a company like BofA can handle the securitization and guarantee of mortgage payments, do we really need Freddie and Fannie anyway?? Arguably, the answer is "No." In my previous post "Taxpayers Cover Freddie's Fannie," I state the bailout is a done deal, but what to do with the Freddie and Fannie is an open question.

It would seem that a market solution may be the best solution after all. Yes, you can hear me grinning, as that is a common theme of mine. Although widespread home ownership is valid policy objective, let's keep the government out of it to the greatest extent.

Again, from the article: "“I would be shocked if Bank of America isn’t happy about how this worked out. For years, banks have been asking for Fannie and Freddie to be cut back in size because they have they an unfair advantage," said Bove.“The government says Fannie and Freddie handled 80.0% of the market this year and someone has to handle that market share.”

There you have it, companies such as BofA are well positioned to handle a piece of the hopefully dismantled Freddie and Fannie. The next question is whether other banks of similar size have enough capital to do the same. If Citi, JPMorgan Chase, and Wachovia can get their capital coffers refilled, then maybe this will be a reality. However, if they can't get their collective acts together, expect to see more Barney Frank (D-MA) and government intervention.