Madoff's Curtain Call: Sell When Transparency Is Absent

Rather than focusing on the Bernard Madoff story, what the markets need to be concerned about today is the failure of the Federal Reserve to disclose the recipients of more than $2 trillion (and growing) of emergency loans from the US government. The US tax-payer should also be worrying about the assets the Fed is accepting as collateral against the loans being granted. If there is a lesson in the Madoff saga, it is this: exit or sell XLF in circumstances where transparency is or appears to be at a high premium.

The Fed’s email response to a request for the information by Bloomberg is self-explanatory in this regard. “Notwithstanding calls for enhanced transparency, the Board must protect against the substantial, multiple harms that might result from disclosure,” said Jennifer Johnson, the secretary to the Fed’s Board of Governors (Bloomberg, December 12, 2008). “In its considered judgement and in view of current circumstances, it would be a dangerous step to release this otherwise confidential information.”

Arguably, Bernard Madoff’s motivation for not revealing the status of his investment advisory business was quite different. But, at the end of the day, the message the Fed is sending is eerily similar: our books contain information which will create chaos in the bond and equity markets. In justifying its request for disclosure, Bloomberg stated that the list of emergency loans and collateral “are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression.” But it is evident that tax-payers will have to be content with the Fed’s “just-trust-me” stance. How then does the Fed expect analysts and traders to price or value entities which currently need bailout money to survive?

General Electric (GE), for instance, has consistently maintained that its balance sheet is not exposed to risks from funding-maturity mismatches (i.e. borrowing short-term to invest or lend long-term), and that the selling of commercial paper to the Fed and the tapping of the FDIC guarantee mechanism were actions taken in order to retain competitive yield parities. But what the markets really require is a credible assessment of whether, and which, American companies can survive today’s credit crunch without government aid. In other words, must General Electric and American Express (AXP) be priced on the assumption that the tax-payer will continue to subsidize their operations until the global economy makes a decisive turn for the better? The competitive yield argument is disingenuous, without additional facts.

Bloomberg’s predicament, mirrored by various fund managers this weekend, is best illustrated by Lucy Douglas, executive director of Virginia-based Reporters Committee for Freedom of the Press. “There has to be something which they (the Fed) can tell the public because we have a right to know what they are doing” Ms. Douglas said late last week. “It would really be a shame if we find this out 10 years from now after some nasty class-action suit and our financial system has completely collapsed.” The Fed Governor and the Treasury Secretary are apparently working on the principle that time is the biggest healer; but investors must decide today whether they should sell, short, buy or hold shares in entities which are at the mercy of tax-payer dollars.

The Madoff experience is telling us to quit (and short) any company which has become part of the bailout process, now expected to exceed $8 trillion, simply because the lack of transparency itself is major red flag which cannot be ignored. The Fed may ensure that no such company goes into bankruptcy, at least through 2009. But whether government money translates into verifiable earnings next year is another question altogether.

Disclosure: Author holds a short position in XLF

Comments

[iknoknot:]

point made, and agreed.

why take the 'short' risk on xlf when you have skf?

--ikk

2008 Dec 15 03:30 AM

[malach hamo...:]

Tough act to follow, but how about this:

There is still no way for accountants to determine the dilution effect to participants in the Treasury bailout; everyone will be giving some warrants, etc.; but how and when they negotiate Treasury bow-outs from their companies will affect the dilution from these equity-lite deals. And the arbitrary manner in which Treasury can assert itself regarding these warrants makes it impossible to assess their impact on future earnings.

2008 Dec 15 05:26 AM

[Burton A. J...:]

Yes, what's the secret?
There's no secret who has to pay.
No, I don't trust the Fed or any other Federal agency.
Yes, it's inevitable that things will get worse under the pending administration.

Burton A. Johnson, M.D., J.D.
President, Burton A. Johnson Portfolio Management

2008 Dec 15 12:03 PM

[Al/ALG:]

You got to be kiding!!
In the GE case, they are paying interest on the the short term funds they borrow from the program. On the FDIC insurance they use for other loans, to they pay the Government an insurance premium. These two products offered by the Treasury are great but hardly a large Government Subsidy.
By not mentioning that GE pays for participating in these programs...You are, to use your verbage, DISINGENUOUS.

2008 Dec 15 02:10 PM