Regulators Should Have Read the Writing on the Wall

Once the multi-billion dollar rescue plan for the financial system finally gets underway later this week, and the last of the big investment banks, the founding fathers and propagators of the derivatives jungle, become ordinary banks, we will be able to begin asking the searching questions, to study and ruminate on what we had here before the onset of the tsunami that threatened to drown the US economy, and why we received no warning of the impending storm.

On second thought, I arrived at the conclusion that we did indeed receive advance warning but the authorities failed to act on it. The tech stocks bubble in 2000 was the first earthquake, and the investment banks, driven by their incessant greed, were its primary instigators. But the earthquake then was limited, with no tsunami waves following, and the resulting damage was fairly small and limited mainly to one sector - technology.

The authorities should have had the presence of mind to realize back then that if the work methods and incentive system that the investment banking sector was built on did not undergo a radical change, and were not subjected to regulatory supervision, the next disaster would be far greater, which is exactly what has happened now.

Since time immemorial the purpose of banks was to provide loans and nothing else. With the progress of time, a new generation of investment banks came into being whose purpose was to advise on offerings, mergers and acquisitions, and it was a short trip from there to the production and marketing of a plethora of investment vehicles.

Give an investment banker a field to play on, and he will waste no time in building towers in the air. A decade ago their field was the burgeoning Internet industry, and on it they built a staggering pyramid of fantastic offerings, which they then skillfully marketed to the portfolios of their in-house customers, or to their colleagues in the form of swaps, making themselves a tidy profit in the process.

Worth mentioning in this regard is the famous email sent by an analyst, considered a "rising star" at the time, to his close friends warning them to avoid a junk offering like the plague, on the very same day as he warmly recommended it to the bank's customers.

When the markets collapsed following the implosion of the tech stocks bubble, the banks soon found themselves a far larger field to play on - real estate. The tsunami of today originated in the real estate bubble which had begun to develop just as the tech stocks bubble was winding down, and it was to there that creative bankers headed in droves, since where a lot of real estate is being bought, there is a huge mortgage industry with endless opportunities to produce and sell leveraged securities.

The free market economy had little trouble shouldering the damage caused by the collapse of the technology sector at the beginning of the decade. Today, however, it will take $700 billion in taxpayer money to rescue the US economy from collapse - the result of the over-creativity of greedy bankers, who this time round operated in the mortgage market.

Turning nuclear waste into gold

The famous economist John Mauldin, writing in his weekly letter to investors, describes how collateralized debt obligations [CDOs] were conceived. In his letter, entitled "Betting on Financial Armageddon", Mauldin argues that the credit rating companies are just as much to blame as the banks themselves. The idea was to take various types of mortgages, most of which were very risky sub-prime loans, and only a few of which were safe, and package them together. At the credit rating companies most of the bundle would be rated AAA.

"Taking nuclear waste and turning it into gold," is how Mauldin describes the process at these CDO packing houses. "Will we ever forget Charlie Prince’s line, the CEO of Citigroup (C), saying that, 'As long as they are playing music, you have to get up and dance?' just a few weeks before the market imploded," he mused.

Warren Buffett, on the other hand, repeatedly warned that these dance parties could come to a sorry end, because there would be no one outside to blow the whistle to signal they are over. There are no clocks on the walls and the people at the party won't know it's over until the club goes up in flames, Buffett warned. The only thing he got wrong was the extent of the blaze, since the big fear is that the damage caused by the blaze has spread way beyond the clubs.

At the end of the most volatile trading week since October 1987, the three main indices were down 14% on their level in January, with the relatively robust Russell 2000 Index the only exception, with a decline of just 1.6%, after climbing 4.6% the previous week. The sharp gain in small cap stocks may well have been caused by the absence of pressure by short traders, who have always found small stocks an easy prey. Having been placed under tighter regulation, they have been forced to steer clear of small stocks, and cover naked short positions. We could also be on the verge of a tangible shift in investment to small stocks, a healthy sign that usually shows the market has finally hit the floor.

Returning to Buffett, last week he gave Iscar and Eitan Wertheimer the green light to acquire a Japanese company for $1 billion. Wertheimer said, during Buffett's visit to Israel following the acquisition of Iscar by Berkshire Hathaway Inc. (BRK.A) (BRK.B) two years ago, that with the backing of Buffett, they would look for big acquisitions overseas. My bet, at the time, was that they would actually go for a member of my portfolio, tracked by "Globes" - Iscar's US competitor Kennametal Inc. (KMT), which currently has a market cap of $2.4 billion.

Iscar does not have a major presence in the US, but it is very strong in the East. It has factories in, among others, South Korea, China, and now, also in Japan, where a lot of its customers are. I believed then, that by acquiring Kennametal, Iscar would have also beaten a path to Buffett's own backyard in the US, which is a mega market for it, but Buffett and Wertheimer may have felt that the impending recession in the US would provide cheaper opportunities in the future, including, possibly, Kennametal itself. I will continue to hold on to my holding in Kennametal, which has turned out to be a good investment. In the two years since Buffet was here and I bought it, the share has gained 20%, against 2% on the Nasdaq.

Chambers: No sign of recovery yet

Last week's keynote analysts day by Cisco Systems Inc. (CSCO) went largely unnoticed in the heat of the dramatic events. The focal point in the presentation given by CEO John Chambers was the unequivocal reiteration of the company's long-term guidance, meaning annual growth of 12-17% over the next three to five years. This growth rate has been thrown off kilter since the onset of the credit crunch in the summer of 2007, and at one point was as low as 10%. Chambers is hoping, based on what his customers have been telling him, that the recovery will begin to take effect in early 2009, although he qualified this by adding that this timeline may have been postponed slightly by last week's events in the banking sector.

Chambers singled out three key growth engines for the coming years. He expects the enterprise sector - 40% of Cisco's sales - to see an increase in the building of large computing centers for data storage and virtual solutions, with the network playing an increasingly important role, which is why Cisco's potential growth here could be substantial.

As for the service provider sector - 35% of Cisco's sales - Chambers expects to see the stepping up of the transition to next generation networks, because of the increase in networked video applications, and the massive rollout in developing countries. The third growth engine, called collaboration, comprises all the means of voice and video-based communication between individuals, and between employees and enterprises, and Cisco is developing and marketing a range of platforms for this particular market.

Disclosure: None

Published originally by Globes [online], Israel business news - www.globes.co.il

© Copyright of Globes Publisher Itonut (1983) Ltd. 2006. Republished on SeekingAlpha with full permission.