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Warren Graham's Legal Blog: August 2007

Warren Graham's Legal Blog

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Location: New York, New York, United States

I am a practicing lawyer who lives and works in Manhattan, and specializes in Bankruptcy, Corporate Restructuring and Creditors' Rights, Commercial Litigation and Real Estate Law. I grew up in the New York City Area, and am a graduate of the University at Buffalo (B.A. 1976) and Fordham University School of Law (J.D. 1980). I have a wide variety of interests, but am particularly interested in history, politics, economics/finance and religious affairs, and am a frequent writer on a variety of those topics, and others. On a personal note, I'm a 54 year old man, married for 27 years, with two daughters, ages 24 and 20, respectively. Legal topics of interest may be found on my blogsite, http://warrenrgrahamlegal.blogspot.com, while non-legal commentary may be found at http://warrenrgraham.blogspot.com. The content of these sites will be centralized and easily accessed locations for both legal and non-legal analysis and commentary, as well as a description of my legal practice for clients and potential clients. Keep checking back, as I expect the content to change and grow regularly.

Friday, August 31, 2007

A Friend Like Ben

Ben, most people would turn you away
I don't listen to a word they say
They don't see you as I do
I wish they would try to
I'm sure they'd think again
If they had a friend like Ben

From the Song Ben
Copyright 1972 Walter Scharf/Don Black
Performed by Michael Jackson

Beautiful words, right? The tune, if you know the song, is quite lovely as well. The irony, of course, is that Michael Jackson is singing this beautiful song to a RAT. That’s right, a large, hairy, dirty, nasty (and aggressive) rat! The song is the musical theme for the film of the same name.

The “Ben” I wish to speak about, however, is Ben Bernanke, Chairman of the Federal Reserve Board. He is no rat. Quite the contrary, although I do not know him personally, he exudes, to all outward appearance, integrity and professionalism.

The Wall Street Bulls, however, may well view him as a rat. Unlike Alan Greenspan, who bowed (kowtowed, even) to political pressure after September 11 and reduced the Fed Funds Rate aggressively, to prop up panicked capital markets, Bernanke is, for the most part, keeping his powder dry, in order to determine whether the recent turmoil and sub-prime mess is, indeed, a threat to the overall economy.

Greenspan’s actions did, in fact, help to buoy a sinking market, as well as to minimize and shorten the recession of 2001-2002, just long enough for the tech bubble to be replaced by a real estate bubble. The latter bubble was, it seems, almost entirely a function of historically low rates brought to us by Mr. Greenspan. It also was the source of the sub-prime loan fiasco and predatory lending practices, which enabled people with questionable creditworthiness either to purchase homes they could not afford, or to use their existing homes as “piggy banks” for seemingly limitless consumer spending sprees. In the interim, these lenders raked in huge origination fees, and the economy hummed, as the people spent, and spent and spent. All the while, the lenders knew (and the borrowers should have known) that a day of reckoning awaited; a day on which the teaser mortgage rates would reset. Those days are upon us now, and nearly everyone, it seems, from the sub-prime borrower to the lenders, to the hedge fund managers want Mr. Bernanke, Greenspan’s successor to bail them out. Thus far, though under unimaginable pressure from the Bush Administration and the aforementioned business and consumer groups, it appears that Bernanke may not be so willing to play ball.

Bernanke, you see, does not seem to understand the Fed’s brief as being a bulwark against the foolishness of consumers and the greed and irresponsibility of the business community. On August 30, second quarter GDP was revised upward to 4.1%. That suggests robust growth in the economy. Unless the sub-prime situation has totally reversed that trend (and there is simply no data, one way or the other on that point, as of yet), a responsible Fed would certainly have to question the wisdom of lowering rates into such a burgeoning economic engine. Interestingly, many of the “talking heads” of the business community tell us that the economy continues to be strong, and the envy of the world while, in the same breath, frantically urging Bernanke to ease. Why? Are they persuaded that a recession is upon us? Perhaps a few are. But most economists tell us that we should expect growth (slower growth, but growth, nevertheless) through the end of 2008.

No, I believe that the agenda behind these calls to arms is much more parochial and transparent. The concern for marginal homeowners on Main Street exhibited by the very highly compensated denizens of Wall Street is touching, to be sure. But what is really driving this train is that the economic and political power centers want the capital markets saved from their own excesses. They want the bull market to continue its previous meteoric rise, and they want the financial services industry to evade the consequences of its mismanagement and greed. Significant rate reductions will likely achieve these results, but will also trigger a further collapse of the U.S. Dollar and, if the underlying economy is really as sound as the numbers would suggest, such a move risks overheating it, and bringing back that which the Fed claims to detest above all: inflation.

Bernanke is resisting, but the jury is still out as to whether he can take the pressure. What is at stake is not only the potential danger of an overly accommodative Fed outlined above; Mr. Bernanke’s role as the Chairman of an institution supposedly independent of political forces is being put to the test.

So, for the Bulls, the question is, is Ben a Friend or a Rat? Only time will tell.

Warren R. Graham
Copyright 2007

Monday, August 27, 2007

OLE, EL TORO!

I am certainly no expert on bullfighting, and have no real wish to become one. Despite those who laud it as a legitimate expression of a certain weltanschauung, and its accompanying culture of machismo, I find it hard to watch, as the outcome is inevitable and cruel. What I know on the subject (which may or may not be accurate), is derived primarily from having read some Hemingway and watching the film Blood and Sand repeatedly (more for my appreciation of Rita Hayworth, than of Tyrone Power or of the bullfighting scenes, truth be told).

Most of the cheers in the bullring are, of course, reserved for the bravery and skill of the matador, but there are occasions in which the bull is deemed to be an exceptionally worthy adversary, and is accorded noisy accolades by an appreciative crowd.

Just the opposite is true on Wall Street, and on the airwaves of its most ardent cheerleader, CNBC. In those precincts, the bull and only the bull is celebrated. Try to imagine a world (at least since the days of JFK) in which the major news reporting organizations did everything possible to extol the virtues of government policy, and to squelch any hint of dissent. Unthinkable? Repressive? Un-American? In fact, many have argued (this is a subject for another article, and not this one), that the mainstream media, which sees its role as the Public’s watchdog, is, therefore, nearly always hostile to the incumbency.

For those who have a hard time accepting the prospect of such obeisance in media, I invite you to sample a few hours of the daily fare on CNBC (which, although in my judgment, the most egregious of the business-reporting media, is not alone in its role of hyping the bull).

On a typical day, the morning shows open with a discussion of the current status of stock futures. If they are ahead of “fair value,” all is right with the world, since it augers a strong open. If not, the hosts of those shows either downplay that news, or almost literally try to coax them up, by pointing out those reasons why the market should be going higher. This very morning, for instance, a guest pointed out that she thought the chances of a recession had been increased by the recent market turmoil and credit crunch. After chiding her for “introducing the ‘R’ word” into the discussion, the host, Mark Haines took issue with her assertion that consumer spending would likely suffer, since, he said, the consumer sentiment index (which had, at that hour, not yet been released), would show consumer optimism. He based this on the “consensus” of experts. Under pressure, this guest backpedaled and suggested that the recession (if there was to be one) would be short and mild. Whew!

It must be said that, at the same time CNBC reports the tribulations of the sub-prime mortgage market and the damage it has done to what is “otherwise” a very healthy economy, it continues to provide an advertising forum, both on television and on its website, for companies advertising low cost, easy credit mortgages. Those are the same genre of companies that are being accused of having made predatory loans to innocents, and cajoling them into either buying homes they could not afford, or refinancing to cash out their equity for a variety of purposes.

On today’s website, in his feature “Trader Talk,” Bob Pisani talks about what’s pressuring the markets today, and argues, in essence, that all such negativity is misplaced. After listing all those criteria, such as reduced consumer spending, falling housing values, problems in the financial service industries, Pisani says that “all is not doom and gloom. The key (says he) is to look at the data the right way.” After all, a weakening economy, less consumer spending (unlike Mark Haines, Pisani believes that “consumer sentiment” is unimportant. Only “consumer spending” matters), declining home prices and downgrades of brokerage stocks all have a silver lining: a more accommodative Fed. Taking that argument to its logical conclusion, of course, would suggest that a depression would be REALLY EXCELLENT for low interest rates!

Later this afternoon, after the market closes, and we hear the closing roundup, we can expect to be treated to the whimsical musings of Larry Kudlow, whose insipid mantra “I’m for a strong America” calls for an analysis, to quote Cher Horowitz in the film Clueless, akin to “searching for meaning in a Pauly Shore movie.” Until a few weeks ago, Kudlow shut down every guest who dared express a negative point of view, by inanely going on about our Goldilocks Economy (not too hot, not too cold, but just right!). I haven’t heard that expression recently, but I’m not fretting, because no matter what, Kudlow, for one, is for a strong America!

Follow that up with an hour of “B-B-B-Booyah, Cramer!” and, well, you get the point. At one time, I thought Jim Cramer was an insightful and brilliant trader. According to the most recent Barrons, however, Cramer’s record, based on his stock picking in recent days, was worse than an indexed mutual fund. That’s not so important, though, because one’s stock picking record should be measured over many years, and Cramer’s is fine. The problem is that his persona has become a caricature, and what with his sound effects, and ranting manner, it’s hard to take him seriously.

A fundamental part of the problem may be found in CNBC’s selection of guest commentators on its news segments. The vast majority of those commentators derive their (very high) incomes, either directly or indirectly, from the sale of securities. Although most financial services companies are careful to separate the sales/investment and research aspects of their operations, the financial gurus trotted out by these companies are paid in salaries plus bonuses. Their bonuses, of course, are, in large measure, determined by the profitability of their sale/research divisions. These folks are anything but stupid and they realize this. Hence, I believe that nearly all the guest commentators have, to a greater or lesser extent, an axe to grind. Over the past few weeks, for the first time, business news outlets broke their tacit vows of silence, to discuss, openly, the horrifying prospect that Manhattan residential prices, after years of incredible speculative frenzy, might be due for a correction. And who did they trot out to discuss this? Barbara Corcoran, the dean of high-end Manhattan residential brokerage, who has made a fortune in this ever-increasing wonderland of multimillion dollar condominiums built, it appears, mostly for hedge fund wunderkinds. Barbara Corcoran is to Manhattan real estate, what Abby Joseph Cohen is to the stock market. It’s ALWAYS the right time to buy, and everything will ALWAYS increase in value. This type of “reporting” might be likened to a news outlet which wanted to report on dentistry, but rather than book a dentist, it interviewed only the Tooth Fairy. “Yes, sure the teeth fall out (I imagine the guest saying), but its really good news, not bad news, because they were going to fall out anyway, they fall out gradually, and you get paid every time!”

The result of all this is that much of the business-reporting media has become almost a propaganda mill for Wall Street and for a rising stock market. Its reportage is often little more than spin. This is not its stated mission or its brief, and the point of this piece is to suggest that more attention be paid to objective business news gathering and dissemination.

If the folks at CNBC are fans of undomesticated animals, it might do them well to recall that the bear is one, too. And it has feelings. Anybody remember Winnie the Pooh? The Care Bears? The poor hungry baby bear who was left with no porridge because that nasty Goldilocks took another spoonful every day on Kudlow’s show?

There are people (a minority, to be sure), who are short the markets. Moreover, there are {gasp} benefits to a falling market. Opportunities are presented to buy into equities at more favorable prices. There is a greater impetus for entrenched management to build up businesses through increased sales and product enhancement, instead of spending its spare currency on zero sum game activities such as share buybacks and taking companies private. Declining home prices provides opportunities to more potential homeowners to gain their share of the American Dream.

The gist of this is that it seems to me that a media outlet purporting to report business news ought to do just that. I don’t say that the reportage should be dry and without any entertainment value. After all, ratings are the mothers’ milk of any television media outlet. Ratings for business news are, of course, always better in a frothy and rising market, when every pushcart vendor has a portfolio that he can discuss in detail, but that does not mean that the bad news should be censored or even downplayed. Yet evidence of bias for the bull is omnipresent on CNBC and everywhere on many of its fellow business news outlets. Poor bear! Unloved and unappreciated.

People who know me might well say that I have an axe to grind, too. They are certainly right, but as I am not being paid for writing this, and CNBC is not inviting me to be its guest anytime soon (especially now), I feel quite free to exhibit my prejudices. Oh, and by the way, in my defense, I’m for a strong America!

Warren R. Graham
Copyright 2007

Wednesday, August 15, 2007

It’s the (Sub-Prime) Economy, Stupid!

Some months ago, I wrote an article entitled A Sub-Prime Economy? and I urge anyone reading the following piece to revisit that material, both to see what was wrong about it, and what was right. In it, I predicted that the trigger for financial trouble would come either in the form of an overheating economy, which would drive up interest rates and end the era of easy money, pushing marginal companies over the cliff, or, alternatively, that a weakening economy would tighten up lending standards, starving weak companies by blocking their resource to working capital, and increasing business failures. I was wrong.

While even the chronically optimistic must surely now admit that there is a problem in the capital markets, and that it has, in fact, spilled over into equities, the fuse has been lit not by either of the phenomena described, but rather, by the proverbial “tail wagging the dog.” That is to say that while the fundamentals of the “Global Economy”—more about that hackneyed phrase below—remain strong, they threaten to be compromised by an absence of access to credit, hitherto provided by hedge funds and private equity sources, with seemingly endless pools of easy money looking for a home.

Can it be only a few weeks ago that the indomitable cheerleaders for the markets (who, by some magical coincidence, are, for the most part, individuals engaged in the business of selling securities) were telling us that we need not fear, because the world was “awash in oceans of liquidity?” Now, suddenly, central banks worldwide are finding it necessary to intervene almost around the clock in order to inject "liquidity" into the credit markets.

As for this author, I thought I saw the worm turn about two weeks ago, when, in the face of tremendous (and rather scary) volatility in both directions, the folks at Goldman Sachs trotted out Abby Joseph Cohen to tell us that the bull was alive and well, thank you very much. I had forgotten about Abby Joseph Cohen, and last remember her telling us in March, 2000 (the last hurrah for the internet bubble) that that, well, the bull was alive and well. Ms. Cohen has, to the best of my knowledge, never suggested publicly that the market might {gasp!} go down.

Further evidence of a change in mood can be found by anyone who is a regular watcher of CNBC. Gone are most of the smiles, jokes and general bonhomie that could always be found when the expectations were of an endlessly rising market. Gone is that most annoying "cowbell" signal which rang at CNBC to herald any announcement of note in the business world. And although CNBC is supposed to be a source of business and market news, any regular viewer of its programming can have no doubt about the inherent love for bulls and loathing of bears exhibited by its on-air talent. After all, just as sellers of securities want us to think that the markets will always go up, CNBC’s producers understand well that broad, general interest in the markets (and hence, higher ratings) increase dramatically when the markets are rising. But today, the featured guest of CNBC before the U.S. Markets opened for trading was none other than Wilbur Ross, the unchallenged Dean of Distress. Wilbur is an icon in the bankruptcy/restructuring/turnaround world, and, speaking for myself (I have spent over 25 years in this field), I readily acknowledge that Wilbur has probably forgotten more about this subject than I will ever know.

And yet, his observations on the current turmoil in the markets were succinct and remarkably simple. He noted that: “for the past two years, consumers have spent more than they have earned, and the government has spent more than it has earned (sic).” He pointed out the obvious: that such a situation cannot continue indefinitely. He attributed some of the recent difficulties to what he called the two most dangerous words in the English Language: “Financial Engineering,” which, according to Ross means that “someone has figured out a way to underprice risk.” Ross noted that many people had relied entirely, and to their detriment, on ratings agencies and bought products that were designed to sell a “risk-ignorant rate of return.” According to him, such a practice “always has a bad end.”

Yet, the purveyors of promised profits will, undoubtedly, continue to tell us that this is a mere “blip on the radar screen,” and that the indestructible “Global Economy” will save the day. If one has a memory that reaches back to before yesterday afternoon (not, by any means, a given in an industry marked by twenty-something wunderkinds), one might easily substitute the words “Global Economy” for the words “New Economy” that was so prevalent during the internet bubble. One might also easily realize that the recent and massive spate of private equity deals, in which private equity groups acquire public companies, and fund their acquisitions with either low-cost loans or investor capital financed with assets of the target company are (not-so) strangely reminiscent of the leveraged buy-out boom of the late 1980’s, so well-exhibited in the film Wall Street. Those deals certainly came to a bad end. Show of hands….who remembers the early ‘90’s?

The difference now, the starry-eyed optimists tell us, is that the defaults in these deals are much more difficult to trigger. In fact, some of these private equity deals have provisions in which, if the borrower cannot pay, in cash, it has the option of merely issuing more stock to the lender. That system works fine, until and unless the borrower is in genuine financial difficulty. It may not be in default, because it retains the right to issue more stock (of ever-increasing worthlessness) to its lender. So what has been accomplished? The risk of financial disaster has merely been transferred from the borrower to the investors in the private equity deal. To my knowledge, nobody has, as yet, figured out a mechanism to generate “junk bond” level returns with “treasury instrument” credit quality. And yet, the investors in many of these vehicles have somehow allowed themselves to be bamboozled into thinking that someone had. And they were willing to pay astronomical fees for it. Now, of course, many investors are running for the exits, shocked at having actually lost capital! And the “Financial Engineers” are begging the Federal Reserve to ride in to the rescue and reduce the Fed Funds rate. Who would benefit by such action? Well, the stock market would likely go up, at least for a while. Is the Fed supposed to be in the business of propping up the stock market? On the other hand, there would almost certainly be run on the already battered U.S. Dollar, as foreign investment capital opts for currencies tied to more friendly central bank yields. The Sub-Prime mess would not be solved by any such action, as it represents much more than a problem of less than stellar borrowers. It is mostly a problem of declining housing values in a system where there was precious little equity from the buyers in the first place. Borrowers who could not afford conventional mortgages bought homes, upon which they put little or no money down, and took on mortgages at teaser rates, which are now adjusting to market.

So who are the victims? Not the lenders. They got their fees and their points. And they got paid yet again when they “securitized” their loan holdings and sold them on a market newly created and packaged by other “Financial Engineers.” Not really the borrowers, either, who got houses without having put up any equity, and paid (for awhile) low-interest mortgages instead of rent, for a place to live which they could not otherwise have afforded.

But if the Fed plays the role of the cavalry, or the Government embarks upon yet another bail-out plan (anyone remember the Savings and Loan crisis?), we KNOW who the victims will be: the taxpayers. We will be called upon to save the banks and the hedge funds from the consequences of their “Financial Engineering.”

The “Global Economy” may well be strong, but the U.S. Economy is two-thirds driven by the true American vice: rabid consumerism. Once the credit cards are nearly all maxed out (and accruing interest at, in some cases, over 30%), and the middle class is no longer able to access its non-existent home equity (whether because of declining values or tightening credit standards), consumer spending MUST suffer. The first hints of this are even now coming from profit warnings from Wal-Mart, Home Depot and Macy’s.

I am certainly a believer in the resilience and ultimate success of this Country, and we will somehow grow ourselves out of this mess, too, in the long run. But for the shorter term, all the protestations of Government spin doctors and Wall Street salesmen posing as analysts will not change the simple truth, borrowed and paraphrased from the Clintonian: It’s the Sub-Prime Economy, stupid!

Warren R. Graham
Copyright 2007

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