This is what I sometimes call a “Great Garbage Post.”  I’ll cover a lot of ground, so bear with me.

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).  Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.  If the management and other stakeholders do not like those terms (or something like them), then don’t bail them out.

Now, realize I’m not crazy about “lender of last resort” powers being in the hands of the government, but if we’re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.  There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.  This should only be done for institutions where significant contagion effects could affect other financial institutions.  The objective is to create a firewall for depositors, and the rest of the financial system.

2)  Bear Stearns.  Ugh, a bank run.  A testimony to leverage.  Book value is only fair if one can realize the value over time.  High leverage implies a haircut to book value in bad times, because the value of the assets can go down dramatically.  Will they get a buyer?  I don’t know, and I wouldn’t trust JC Flowers.  If what Jamie Dimon might be thinking is what the Bloomberg article states, then I think he has the right idea: keep the best businesses, dissolve the rest.

But remember, during crises, highly levered financial institutions are vulnerable, unless most of their financing is locked in long-term.  Most investment banks don’t fit that description, particularly with all of the synthetic leverage in their derivative books.

3) The downgrades on commercial bank credit ratings will continue to come, particularly for those that were too aggressive in lending to overlevered situations, e.g., home equity lending.  Home equity lending is very profitable in good times, but then it gets overcompetititive, and underwriting standards deteriorate.  Then a lot of money gets lost, as in 1998, where most of the main lenders went under.  In this case, most of the lenders are banks, and they aren’t concentrated in that line alone.

4)  Home builders are taking it on the chin.  Consider this article about joint venture failures of homebuilders.  It is my guess that we will see a few of the major homebuilders fail.  It will take us to 2010 to reconcile all of the excess inventory.  Personally, I would guess that the stable home ownership rate is still below the current level by maybe 2% of the households.  We tried to force homeownership on people that were not ready for it, people who didn’t have enough financial slack to make it through even a slight recession.

5) I find it amusing that Bob Rubin, the only guy in the Clinton Administration that I liked, says that few people anticipated this bubble. (Sounds like Greenspan, huh?)  Well, in a sense he’s right.  Probably fewer than 1% of Americans anticipated these results, but there were enough writers in the blogosphere that were saying that something like this would come (including me), that some could take warning.  As in the tech bubble, there were a number of notable commentators warning, but no one listens during the self-reinforcing cycle of the boom.

6) I am sticking with a 50-75 basis point move from the Fed in the coming week.  They want to move aggressively, but they don’t want to use up all of their conventional ammo, when they are so close to the “zero bound.”  They might disappoint the markets, but not on purpose.  They will tend to follow what the markets suggest.

7) This Fed is more willing to try novel solutions than in the Greenspan era.  Even so, I expect them to run into constraints on their ability to deal with the crisis, which will force the Treasury Department (yes, even in the Bush Administration) to act.

8)  The glory of “core inflation” is not that it excludes the most volatile classes of goods, but the ones for which there is the most excess demand.  Food price inflation is running.  Farmers can’t keep up with the demand.  Poetic justice for the hard-working farmers of our country, who have had more than their share of hard years.  Agriculture is one of the industries that makes America great.  Let the rest of the world benefit from our productivity there.

9)  This is one of those times where one can get a “pit in the stomach” from considering the possibilities from a financial crisis.  As leverage dries up, those with the most leverage on overvalued asset classes get margin calls, leading to forced liquidations.  As it stands now, many credit hedge funds are finding it difficult to maintain their leverage levels, and other hedge funds are finding their lending lines reduced.  This forces a reduction in speculation, and the prices of speculative assets.

10)  Be careful using the ABX indices.  They are too easy to short, and do not represent the values that are likely to be realized in the cash markets.  The same is true of the CMBX indices.  This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral.  (CMBS was a specialty of minewhen I was a mortgage bond manager.)

11)  Two interesting articles on character and capitalism.  This is a topic that I havea lot to say about, but every time I sit down to write about it, I am not satisfied with the results.  Let me make a down payment on an article here.  Capitalism is good, but Capitalists often abuse it.  Short-sighted capitalists play for short-term advantage, and end up burning up relationships.  Longer-term capitalists play fair, because they not only want deal one, but deals two, three, four, etc.  They play fair because they will do better in the long run, even if they are intelligent pagans.  (Christians should play fair anyway, because their Father in heaven looks at their deeds.  If we love Him, we will please Him.)

Economics isn’t everything.  Smart businessmen know that a good reputation is golden.  They also know that happy employees are more productive.  Suppliers that get paid on time are more loyal.  These are the benefits of ethical, long-run thinking.

12) In closing, a poke at quantitative analysis done badly.  Consider Paul Wilmott, or William Shadwick.  With bosses over the years, often they would ask me a seemingly simple quantitative question, and I would reply, “Here’s the standard answer: XXXXX.  But there are many reasons why that answer could be wrong, because the math makes too many assumptions about market liquidity, investor rationality, soundness of funding sources, etc.”  Most quants don’t know what they are assuming.  They are too good with the math, and not good enough at the human systems that inadequately lie behind the math.

As a quantitative analyst, I have generally been a skeptic.  At times like this, when the assumptions are breaking down, it gives me a bit of validation to see the shortfall.  That said, it’s no fun to be right when you are losing money, even if it is less than others are losing.

When I go to prayer meeting on Thursday evenings, I have recently begun requesting prayer for the economy and policymakers.  Ordinarily, I resist doing that, because it usually doesn’t sound right.  I remember one time two years ago explaining why we should pray about a given economic issue, and my dear wife said, “Let me get this straight.  We’re praying for the World Economy, that we don’t have a disaster?”  But when I was asked to explain my concern recently, I said, “Things are breaking in the financial system that no one a year ago would expect to break, and the costs could be high.  A second Great Depression is not impossible, and a repeat of something similar to the 70′s is more likely, minus the ugly clothes.”  That said, I am satisfied with praying for my daily bread, and the daily bread of others.

I didn’t expect to start the post this way, but that’s what’s on my heart.  Things are breaking that should not break, but what is happening is consistent with what I have been writing about here and at RealMoney for the past four years.  I am not a bear by nature, nor a bull.  I just try to analyze economic situations from a holistic perspective, and what I have seen over the past four years, was a massive increase in leverage that was not sustainable.  This affected the investment banks as well, and in this case, Bear Stearns in particular.

Confidence is tricky.  The investment banks are more highly levered than mortgage REITs, and we have seen the fallout there, even though real estate is more stable than the assets financed by most investment banks.

This is why in investing, I write about having a provision for adverse deviation, or in Ben Graham’s terms, “A margin of safety.”  With leverage, one should always calculate the maximum amount of  leverage consistent with prudence, and then take several steps back from there.  What is permissible in the boom phase has little relevance to the bust phase.

Now, I tell my children, “Don’t blame the Ump.”  In sports, if it is call of an umpire or referee that is the difference between victory and defeat, then you did not deserve to win.  You did not gain a commanding lead in the contest.  In this situation, Bear Stearns played close enough to the edge that rumors could begin to push at their short-term financing base, creating a crisis.  Investment banks must be like Caesar’s wife — there can’t be a hint of impropriety (with respect to financing).

Now, with a downgrade in credit ratings, Bear Stearns will have to find a buyer.  Why?  Major financial companies that lend have to have A-1/P-1 commercial paper ratings in order to make money.  The ability to borrow at cheap rates in the short run is important to profitability.

Naked Capitalism has some good points on this topic.  I would echo on the mortgage exposure.  More important is not being liked.  According to friends of mine, Lehman got rescued privately during the LTCM crisis because they convinced creditors to support them.  Bear walked out on the LTCM bailout, and it still leaves a bad taste in the mouth of Wall Street.  Wall Street does have honor, in a twisted way.  They remember who were their friends during tough times.  Bear was not one of them.

When there is a lot of worry around, it doesn’t take much to kick a marginal firm over the edge.  Bear had ample opportunity to move to lower level of leverage, and did not do it.  Now let’s talk about the rescuer.

The Omnipotent Federal Reserve

The Fed can’t run out of bullets, because it can always print money.  That comes with an inflation price tag attached, though.  In this case, they are providing funds freely to J. P. Morgan to the extent that they lend to Bear Stearns.  Now, I know why the Fed did this.  Bear Stearns my be small in a market capitalization sense, but is large when one considers all of the debts that they have, both in the cash and synthetic markets.  (As an aside, I was analyzing some muni bonds of a major issuer today, and it amazed me that Bear Stearns was their #2 counterparty.)

Now the Fed has Fed funds, the discount window, TAF, TSLF, and more.  I am not here to fault them for lack of creativity.  I am here to fault them for (like Bear Stearns) overtaxing their balance sheet.  There is only so much that the Fed can rescue before it chokes, because they (at that point) have no more safe assets to pledge.

I sold my capital markets exposure earlier this week, and I am glad that I did, late as that was.  The Fed is not big enough to rescue all of the investment banks, nor could they rescue the GSEs, without creating significant price inflation.  What a mess.  Avoid the depositary financials, and those that lend and intermediate aggressively.  This is not a time to be a hero in financials.

Keynes said, “In the long run, we are all dead.”  Now, those of of us who believe in Jesus Christ would object, but that’s not my purpose for writing here.  At present, the FOMC is pursuing a short-term strategy to reliquefy the short-term markets through the TAF and other means, leaving the long-term inflationary results to play out as they will.  As they do this, they listen to the strains from banks and other lenders and ignore the price signals from food and energy, which are in greater demand globally.

Long-term rationality would have the Fed stop about now, because the present yield curve is adequate to stimulate the economy. I argued that at RealMoney, when the Fed started raising rates above 3%.  Overshooting would lead to bad results.  The same is true here on the flip-side. Lowering rates by too much will create its own troubles,

The Fed likes to talk about its “independence,” but really it has little, unless it is willing to make some politically unpopular moves, and not lower rates much further.

I’ll tell you what I expect: the FOMC will lower the Fed funds rate by 50-75 basis points at the meeting on 3/18.  They follow the market; they don’t lead it.  Even though loosening does little good for dodgy financial companies, they loosen in hope that they might end the leverage crisis.

This is an off-topic post for people who want to read the Bible, but have never been able to make it all of the way through. In my opinion, it is difficult to understand Western Civilization without having read the Bible. No single book, or collection of books has had such a profound effect on the cultures of Western Civilization, both positively and negatively. I.e., people react for and against what the Bible says.

I write this because I have met many people in my time who have said that they wanted to read the Bible, and started to do it, but couldn’t get through the five books of Moses. A few would tell me that they made it through the books of Moses, but could not make it through the prophets. Almost no one made it to the New Testament.

Face it, as a collection of ancient books, the Bible has a lot of different literary genres, and some are more congenial, and some less congenial to the modern mind. The Bible is an intricately woven set of books written over a 2100 (or so) year time span by 44 or so human authors. There are many themes and symbols that get visited and revisited in many different ways. Even for someone who does not want to believe the Bible as true, there is an appreciation to be had in it as literature. Think of it as a book with recurring themes that ties them all together from beginning to end. If I have to give an analogy, think of an author who has several different story lines that converge at the end of the book. In that, the Bible is similar.

Think of the following:

Where did man come from, and where is he going?
Why is there suffering? Why is there joy?
Why have the Jews (a relatively small group) been critical to the history of the world?
Why is Jesus Christ (Y’shua Ha’mushiach) so controversial?

Anyway, back to the practical. What I am about to share with you is what my family does every evening at our family devotions. We read a chapter of the Bible, talk about it, pray, and sing two psalms. When my kids were little, we would go straight through the Bible, and eventually my dear wife Ruth would say to me, “Why do I have to wait three years to hear the Gospels, and then I hear them all at once?”

Good question. With that, I set about to find a way to go through the Bible systematically, but not linearly. I divided the Bible up into its main genres:

• Books of Moses and Old Testament History
• Wisdom Literature, minus Psalms and Proverbs
• Psalms
• Proverbs
• Prophets
• Gospels and Acts
• Epistles (Letters)

After that, I counted the number of chapters in each book and group, apportioned the Psalms and Proverbs into ten groups each, paying attention to logical dividing lines in each set, and calculated how they could be evenly interspersed as seven groups of writings. The list came out as follows:

Genesis
Psalms 1-14
Matthew
Proverbs 1-3
Job
Romans
Isaiah
Psalms 15-27
Proverbs 4-6
Exodus
I & II Corinthians
Psalms 28-41
Proverbs 7-9
Leviticus
Mark
Jeremiah
Numbers
Psalms 42-57
Proverbs 10-12
Deuteronomy
Galatians
Acts
Psalms 58-72
Proverbs 13-15
Ephesians
Joshua
Philippians
Lamentations
Proverbs 16-18
Psalms 73-89
Judges
Ezekiel
Ecclesiastes
Colossians
Ruth
I & II Thessalonians
I & II Samuel
Proverbs 19-21
John
Psalms 90-106
I & II Timothy
Song of Solomon
I & II Kings
Proverbs 22-24
Daniel
Titus
Psalms 107-119
Philemon
Hebrews
Hosea
Luke
Proverbs 25-27
I & II Chronicles
Joel
Psalms 120-134
Amos
James
Obadiah
Jonah
Micah
I & II Peter
Proverbs 28-31
Nahum
Psalms 135-150
Habakkuk
Zephaniah
Haggai
Ezra
Zechariah
John’s Epistles I, II & III
Nehemiah
Esther
Malachi
Jude
Revelation

I can’t improve on the Bible, but reading it in this way still gives the thrust of its progress, while keeping people from boredom from “genre overload.” It has proven very useful to my family as we read the Bible, and keeps things fresh as we switch from genre to genre, while still moving through the Bible linearly overall. It has worked well for my family the last four times through the Bible.

If this list proves useful to you, and it actually enables you to successfully read through the whole Bible, please drop me a note.

With all of my family and guests gone or asleep after a big Thanksgiving Day at my house (17 people), I reflect on what I am thankful for.

• My relationship with my God, Jesus Christ.
• My wife of 21 years (today).  What a good woman, and what a help she has been to me.  Among many other things, she helps me focus on what is truly important in our short mortal lives.  At the church that I met her at, she was regarded as the “prize” of all the young women there.  I can tell you that their opinions were right.
• My eight children.  Some do better, some do worse, but in aggregate, they are all doing well.
• My congregation; good friends all, and they are a real support.
• My friends, including the readers of my blog.  We all need friends.

Now for the broader stuff:

• Though our civil liberties have been degraded by the misguided “War on Terror,” we still have significant liberties in the personal, political, religious and economic spheres.
• Our economy still prospers, even amid bad monetary and fiscal policy.
• Development in the developing world is screaming ahead.  As (classical) liberal economic economic policies are embraced across the globe, poverty is being reduced globally, which is something dear to me.
• I haven’t made a lot on investments this year, but I’m still doing adequately.
• I have several possibilities for how I will work as I labor to support my family.  (Perhaps an announcement coming soon…)
• I’m grateful that my views of the Fed, residential real estate, and the debt markets have largely proven correct.
• I’m even grateful for my losses; they keep me humble, and teach me a lot about investing.

That’s what I am thankful for; I hope you have it as good, or better, than me.

I’ve been asked about the website name a number of times lately, so I want to explain the reasons behind the name.  Now, two of the reasons were listed on my first post:

Every now and then I do a post to talk about the blog itself, and my future plans for it.  While talking with an old friend of mine, who founded and majority owns a company that makes the best commercial lawn mowers in the world (full disclosure: I own a little less than 1%), I told him about my blog, and he thought it made perfect sense for me to do it.  Regardless of the eventual result, he said that I was building my brand.

I never thought of it that way before, and much as I like contributing to RealMoney.com, I am putting more of my thinking, and the better part of my thinking here.  So where am I going with the blog in the near term?

• Finishing off the portfolio reshaping.  RealMoney will see the results of this second, and the blog first.
• I have five news compendia posts coming on Economic Theory, Macroeconomics, Speculation, Derivatives (yes, Bear, subprime, and more), and Miscellaneous (the grab bag).
• I also plan on improving some of the permanent pages, particularly my bio, fleshing out the investment books that I have learned from, and fleshing out my investment performance, so that I can publicly display it to readers (I’ve had a great last seven years).

Now, my ultimate goals are to either start an investment newsletter or start my own investment shop.  I have described what I would do on the following permanent pages (newsletter — investment management).  So far, I have gotten about 20 bites on the newsletter, but I would need a minimum of 100 to make me quit my job to do that.  As for investment management, I am actively interested in any seed investor that would be willing to fund me.  Aside from that, I am still working with a fellow who is looking to revolutionize the health insurance industry, who if he gets funded, would like me to be his CIO.  We’ll see.

Because my main calling is to be a good husband and father, I can live with delays in my longer-term planning; things are going well.  I also have a calling to my church, which is having its annual meeting this coming week.  I can’t tell whether I will be posting more or less while I am at the conference; I’ll see what I can do.

Regardless, have a great week as the second quarter finishes up.

The most recent closing high in the S&P 500 was on June 4th.  Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.  That’s why I wrote late on Thursday at the RM Columnist Conversation:

	David Merkel
	Bonds and Stocks Decoupling? They were only Together by Accident.
	6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.  In this case, it was the bond market.  Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.  But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.  One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.  Volatile markets scare inexperienced investors into making the wrong moves.  My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.  As I stated in the CC on Friday:

	David Merkel
	Rebalancing Trades
	6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

1. Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
2. Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
3. Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
4. Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
5. Forcing a review process at certain price levels
6. Taking the emotion out of selling and buying
7. Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.  My methods are designed to be able to cope with volatility and some back smiling.  Why can I go on business trips or vacation and not worry about the markets?  Why don’t I get scared by many of the negative macroeconomic situations out there?  First, I trust in Jesus; my life is not just the markets.  But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.  You’ll get to see how I make choices in my portfolio.  Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.  Have a great weekend.

Full Disclosure: long CX TNP LYO NE