March 2010 Market Update – Bank Holdup!

The scene of the defenseless bank employee being held up by a dangerous armed robber has been the material for so many movies and TV plots. This scenario is now being played out in the headlines with an important twist; this time the Banker is the dangerous robber and we, the U.S. taxpayers, are the innocent victims.

I cannot remember another instance in the nation’s history of a cadre of wealthy businessmen so callously holding the nations’ economy hostage. Why not just let the banks fail? When banks close the economy collapses as happened in the 1930’s. The government had to rescue them but now they add injury to insult by threatening to walk out if they do not receive the outrageous amount of compensation they demand.

They have also stonewalled any attempt by Congress to rein in the enormous risk taking they engage in, namely, the trading of derivatives.

These are the sharks that have infested the financial waters we used to swim in so profitably. Until they are under control, we will be swimming in the bay.

Here is a perfect example of what I mean by “sharks”. The SEC is attempting to ban “Naked Access” trading, (no, this is not a new form of airport security) it is the practice by which brokerage firms loan out (for a fee) their computer code to traders unknown to the exchanges or regulators, for the purpose of bypassing the normal controls. This is synonymous with loaning your drivers license to a 10 year old, but in this case to a 10 year old on steroids. These traders are not building retirement portfolios. They are trying to gain microsecond advantages in executing trades. Traders using naked access can execute a trade in 250 to 350 microseconds, while placing the trade through his stock broker would take 550 to 750 microseconds. This can mean the difference between winning and losing on a high risk trade.

Why should we care? We should care because mistakes made by these unknown traders can cause havoc in the markets. For example, in 2007, a trader using Credit Suisse Groups’ code mistakenly entered an algorithm that routed “hundreds of thousands” of cancel requests for trades that had never been placed. The exchange was completely jammed up for the day. This is the type of nonsense that has entered our financial life in the last few years and needs to stop.

THEMES FOR 2010

There are really just two important themes to follow in 2010:

1) Withdrawal of stimulus funds by Central Banks that have supported the world economies for the last two years. Trillions of dollars have been injected into struggling economies around the world to replace the dollars normally entering the cash flow stream through bank lending. Banks still cannot make new loans because old loans are defaulting.

No one knows how much of the world’s economies will be left after those monies are withdrawn.

Central Banks must stop printing new money for fear of sparking runaway inflation. However, there is the danger that the stimuli will be withdrawn too quickly and send weak economies into a downward spiral. This spells deflation. Deflation occurs when prices fall because there is not enough demand at current price levels. With less profit from lower prices companies must lay off workers. This reduces the amount of money from wages in the system available for new purchases. Less demand requires further price reductions and hence the downward spiral.

Many states are in such dire straits that withdrawing the stimulus money is unthinkable. California, whose economy is larger than most countries, is completely broke. Illinois has not paid its public school teachers in months. And Arizona is selling the State Capital building to raise money.

2) Financial Reform – The Financial Crisis Inquiry Commission has begun hearings in Washington. The Chairman of the committee, Phil Angelides, compared the behavior of the banks to a shady car salesman “selling a car with faulty brakes and then buying a life insurance policy on the buyer of the car”. This in reference to the practice of making bad loans and then selling them as AAA rated securities to investors.

We can only hope that the result of these inquiries will be the political will to make meaningful changes in the way Wall Street operates.We should be thankful that this commission even came about since the banking industry did everything in their power to block its formation and nearly succeeded.

WHAT IF . . .

If derivatives were outlawed, would we be in the stock market? NO, we are not day traders, we are long term investors. We look for companies whose earning potential is good for the foreseeable future so the value of our stock goes up. How can you gauge the viability of a company when its products are currently being purchased with stimulus driven money? Buying a company’s bond is a different matter. The company just has to still be in business when the bond matures. But a stock owner has to see profits to justify their investment. We cannot gauge, at this point, what a company’s possible profit will be after the stimulus.

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