Policy Makers to the Rescue

Rewind

Last year, at this time, the stock market was struggling under the weight of worsening economic news. On August 27^th 2010, Ben Bernanke, Chairman of the Federal Reserve, gave a speech at an annual central bank symposium in Jackson Hole, Wyoming, hinting at his willingness to initiate what we have referred to in this blog as “The Bernanke Playbook”. (Recall that this refers to a paper he wrote as an academic, criticizing the monetary policy of the Japanese during the 1990s and providing his own policy prescriptions.) His speech introduced what became known as QE2 (the second round of quantitative easing) in which the Fed would buy $600 Billion of long-term US Treasury Bonds in an attempt to stimulate the economy.

Three days later the stock market embarked on a furious rally that topped out on April 29^th of this year. The market took the bait and gambled that QE2 would spark a sustainable recovery in the economy.

Last week we found out that the annualized growth rate in the economy for the first 6 months of 2011 was 0.8%. By some economists’ estimates, this is less than half of what is required to simply maintain current employment levels. Other very recent economic reports show that the economy is weaker than many would have expected. Needless to say, QE2 has fallen short of expectations. Today the market closed below where it started the year.

The silver lining here is that corporate profits have remained quite strong, due largely to productivity gains. Of course, productivity means doing more with relatively less (i.e. fewer employees). And there’s the rub. How long can corporate profitability withstand the effects of a weak job market? Given the recent economic data, we may soon find out. Importantly, even with the amount of discord among policy makers in Washington, corporate managers are performing exceedingly well in creating value for shareholders.

As for our portfolio strategy, back when Bernanke embarked on QE2 last fall, we maintained our conservative position (as we wrote in this blog in December). We did not believe that QE2 would really fix what ails the economy and lead to a sustainable recovery. What seemed like a very contrarian position then, appears to be the consensus now, as the market recoils from recent economic news. Our efforts have been to invest in lower risk, high-quality companies, with good dividends that, as always, generate EVA. We have conserved cash to be ready when opportunity arises and protect capital. In a volatile world, we have tried to be stable and consistent.

Another Leap of Faith?

While the Fed may distort asset prices, (like making the stock market go up just by saying they will print money) we are not taking issue with the Fed’s willingness to help; they are using every tool made available to them. Without their initial response in 2008, things would have been far worse. Even Bernanke has learned to sympathize with his own plight. At a recent press conference, a Japanese reporter specifically asked him whether he still agreed with the paper he wrote criticizing Japanese monetary policy, while still a professor at Princeton. Bernanke’s answer: “Well, I’m a bit more sympathetic to central bankers now than I was 10 years ago.”

Add this to President Obama’s recent comments about last year’s stimulus package that “shovel-ready wasn’t as shovel-ready as we expected” and you get the sense that policy makers are disoriented. Washington has lately been caught up in talking points and ideology with complete disregard for the tremendous risks they are adding to the economic recovery. However, this doesn’t come as a complete surprise. The country is divided, as demonstrated by the last election. In a way, they are doing what they were elected to do.

We do, however, take issue with investors blindly assuming that our economic problems can simply be overcome by government policy. Every new policy prescription from Washington appears only to be a red herring, diverting attention from the issues and giving investors hope without justification. Just look at the jubilant response of the stock market after the Fed committed to QE2. Or after the elections when the Bush Tax cuts were extended and payroll taxes were reduced. As if one more round of printing money is the solution. As if tax cuts will suddenly invigorate growth. As if spending cuts will put us on the path to stability. As if more government spending will create jobs. As if raising the debt ceiling will create more certainty. While several policies may be necessary at different times, investors have seemed intent on believing the solution is simply a matter of the next policy fix.

In what feels like a scene from the movie Groundhog Day, traders and investors are again anxiously awaiting Bernanke’s upcoming appearance at Jackson Hole later this month for hints of QE3, as the economy weakens. As if…well you get the picture.

Working Through It

We continue to think the world is upside down for policy makers, making them ineffective in overcoming the historic deleveraging occurring in many developed countries of the world. It takes cooperation, coordination, and communication. We have very little of that right now, which is a startling parallel to the 1930s. In Europe it is even more complicated.

There simply is no easy fix. In their landmark book, “This Time is Different”, Carmen Reinhart and Kenneth Rogoff describe the history of financial panic induced recessions (or depressions). Given history, one could expect a seven year period, or “tail”, after the initial shock, until a sustainable recovery begins. During those years, a multitude of policy risks exist with growth taking place in fits and starts. We are almost halfway there.

The irony of the title, and stated purpose of the book, is that it really is no different now than it ever was. Simply, our lifetime experience in relation to a much longer economic history is different. Rogoff and Reinhart show us that this has been happening for 800 years. We can only accept where we are and work through it.

While our politicians fail to inspire us, corporate managers have been brilliant. Dealing with vast political and economic uncertainties coming from Europe, China, and the U.S., they continue to do their part to create value for shareholders. While some pundits, and even members of Congress, proclaim that the U.S. is bankrupt, they fail to recognize the real value that exists in the private sector, regardless of how broken government has become. There is no doubt that policy risk will remain a drag on economic growth and missteps at the government level could have profound consequences. Business owners and managers are very well aware of these issues, yet they continue to look for ways to grow and prosper. We hear this from the management of companies we invest in and we hear it from our own clients, most of whom are making their own business decisions every day. This is what keeps us optimistic and what generally gives the equity market underlying support. The U.S. economy, built on free-market principles and entrepreneurial aspiration, is very much a going concern.

Repeating Ourselves

For investors it takes patience and a dedicated strategy. We have been consistent in our message for the last several years, avoiding the impulse to anticipate every up or down move in the market based on the next government policy. We are working very hard to remain alert to potential downside risks while prudently investing our clients in the best, low-risk, wealth producing companies we can find. We continue to invest in EVA-producing companies with strong balance sheets and good dividends. We are being extremely careful to protect our client assets and continue to provide thoughtful insight via our fiduciary duty as investment advisors.

Our basic goal during this period of elevated uncertainty is to earn a more consistent and predictable return than the market. We believe this is in the best interest of our clients’ ability to preserve and grow their wealth.

Thank you for your continued trust.

Peter and Jack Falker

August 2, 2011

Deflation and Ham ‘n Eggs

On February 2^nd, Peter Falker, CFA, gave a presentation titled “Debt Deflation and Quantitative Easing” to the Ham ‘n Eggs Club, a business professionals' group that meets weekly at the Edina Country Club.

Peter drew on the writings of Irving Fisher, a 1930s-era economist, who correctly identified the economic symptoms that created the deflationary environment of the Great Depression. He went on to show, by the use of a series of charts and graphs, that those same symptoms exist in the United States economy today.

He quoted Fisher from a 1933 statement that “It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

Peter went on to show that this is precisely what the Federal Reserve is doing today with “Quantitative Easing”, which is the largest inflation of the U.S. money supply in history. Since 2008, the Fed has expanded the monetary base by over $1.25 trillion, with the stated purpose of reflating the price level, i.e., literally creating inflation to offset deflation.

He quoted the “Bernanke Playbook” from a 1999 article written by Ben Bernanke, while he was an economics professor at Princeton, calling for Japan to deal with their own deflationary symptoms in the following way:

1. Maintain a zero level of interest rates and a stated inflation target.
2. Depreciate the currency through large scale open-market sales.
3. Initiate a “helicopter drop” of newly printed money to domestic households.
4. Buy government and corporate bonds, commercial paper, etc.

While Japan has pursued aggressive monetary policy since 1989, incorporating much of what Bernanke advocated, it has not stopped the deflationary tendencies in that economy. Because of its unstable condition, Japan has remained highly sensitive to negative global economic events. While not a perfect comparison to the U.S., it is important to understand the Japanese experience in the context of current monetary policy in the U.S.

Peter concluded his presentation by pointing out that, while the U.S. stock market has appreciated 20 percent since the Fed’s announcement of its latest round of quantitative easing (QE2), the lasting impression left by debt deflation leaves the economy vulnerable to external economic shocks.

To view Peter’s entire presentation click here:

Peter Falker's Ham 'n Eggs Presentation

Too Conservative?

Is it possible to be too conservative in the face of all that is going on in the world right now, both economically and geopolitically? We don’t think so.

During the last year, we have patiently developed a portfolio designed to bring consistent, compounding returns over several years. We have focused on dividend yield and capital preservation, as we carefully invest our cash position. Through the first eight months of 2010, the market was extremely volatile (remember the “flash crash” in May?), while our portfolios held steady, maintaining a sizable advantage in returns. Ironically, right about the time we started seeing widespread value in the stock market, the Federal Reserve hit the panic button in the face of a softening economy, to ward off deflation. The “Bernanke Playbook”, about which we’ve previously written, is in full effect and lifting the stock market. While we benefit from this increase, our conservative strategy (which incorporates both stocks and bonds) is naturally slower to respond than the overall stock market, at least for the moment.

Get With the Program

The Fed’s current, extreme and historic quantitative easing effort (QE2) to buy newly issued, longer-term government bonds is an attempt to raise inflation expectations and lift asset prices, in particular equities (yes, they actually said that). The thinking goes like this: lower the longer-term cost of capital, making current equity valuations look attractive. By bringing investors into the equity markets, companies can access capital on better terms (e.g. the General Motors IPO). That, of course, assumes there is an abundance of viable capital projects that can return in excess of this lowered cost of equity. If so, then you get immediate job creation as capital spending increases.

The question is, when this explicit subsidy to the cost of capital is removed (through future Fed tightening), are those newly formed investments sustainable? Furthermore, the unintended consequences of inadvertently financing subpar “investments” (i.e. housing) can have dramatic consequences. An increase in equity values supports greater amounts of debt. If equity values falter, the debt becomes highly onerous.

The first round of Fed quantitative easing (QE1) in 2009 was probably effective in preventing a liquidity crisis from exacerbating an already deepening insolvency crisis. Now, with an extra $600 Billion promised over the next six months, coupled with a lenient tax policy, you can see that our country’s monetary and fiscal leaders have implemented an all out go-for-growth (go-for-broke?) strategy. While all of this might create growth, we remain skeptical that it will create sustainable value. For now the stock market has taken the bait and gone higher. However, bond yields have also gone higher, giving a confusing signal about expectations for growth, inflation, and future unfunded deficits. To what extent will the Fed tolerate such rate increases before embarking on another round of bond purchases?

That said, there are signs of stability in the economy and we are encouraged to see the productive spirit of the private sector deliver profits. Unemployment is still high and likely to grow, but new jobs are usually seen late in a recovery. The banks appear stabilized, although a persistent decline in real estate prices keeps them in capital preservation mode. Right now the stock, bond, and commodity markets appear certain that the economy will grow unabated, given the aid of massive stimulus.

What Happened to The Road Not Taken?

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads diverged in a wood, and I--

I took the one less traveled by,

And that has made all the difference.

-Robert Frost, The Road Not Taken

Certainty in the market makes us wary. Such confidence emanates from what has become Wall Street’s Golden Rule: “Don’t Fight the Fed”. Oddly enough, for the past 12 years, the exact opposite would have been more rewarding. Perhaps that rule should be rephrased: “Get Rich or Die Trying”. That doesn’t sound quite as appealing. Needless to say, Wall Street is feeling bullish these days. We’ve seen this road before.

The list of headwinds to economic recovery is long. But that is not what primarily concerns us. Most of them are well known to investors already. We are concerned with the risk of government policies preventing the market from functioning efficiently. For example, we are encouraged by the pace of domestic private sector deleveraging (whether through default or pay down) and the concurrent increase in personal savings. Such headwinds to growth will eventually become tailwinds. Our greater concern is whether productive, market-clearing processes are interrupted by potentially false perceptions created by chronic money printing and stimulus spending. Rising asset prices without wealth creation leads to debt/payment obligations with no collateral value. Again, we’ve been down this road before.

Feeling Like a Contrarian

At least for the moment, our year-to-date equity performance trails the market, as investors have ramped up their risk-appetite. Yet, we are very confident in maintaining our conservative position. Even though we wrote about the potential for QE2 this summer, perhaps we mistakenly believed the political fallout over printing money would have short-circuited its occurrence. Or perhaps that story has yet to be told. There’s nothing like a political vacuum, created by an election season, to give the Fed free reign. Either way, since we ourselves cannot print money, we choose to stick with prudent capital management on behalf of our clients. We are moving down the road we want to take, looking for consistent, compounding returns.

We are avoiding market-timing, looking instead to “draw our own line” that wavers less than the markets. We do this by investing only where we see value and value-creation for the long-term, sometimes regardless of the level of the stock market. As frustrating as the past decade has been, that strategy has worked for us and resulted in consistently better returns than the market over time. Making predictions about future stock market values can be eternally futile. We will stick with what we know and pursue our strategy of creating wealth and preserving capital by investing in companies that consistently create value for shareholders.

Hopefully we have been able to clarify what’s going on in the economy and the markets, here at the end of 2010.

Holiday greetings to all,

Peter and Jack Falker

December 20, 2010

Confronting the Boogieman (or Why the U.S. Economy Isn't Growing)

Concern over deflation has started going mainstream. This is not a simple concept to embrace, especially with the backdrop of an easy Fed and massive government spending. But that is the paradox of easy money in an era of over-indebtedness. Identifying why this is happening allows us to formulate a sensible, constructive investment strategy during this very unusual time.

With confidence weak and high levels of debt to income, easy money does not prevent dollar hoarding and debt reduction. People are not induced to take risk or borrow money, even with very low yields on savings. This puts downward pressure on the demand for goods, services, and investment, resulting in an embedded deflationary bias in pricing. That includes both consumer prices and nominal interest rates.

Deflation is the scourge of central bankers, rendering them useless (which they probably are anyway) as society embarks on a rational policy of saving and reducing debt. In previous blog posts I have mentioned Ben Bernanke’s 1999 paper entitled “Japanese Monetary Policy: A Case of Self-Induced Paralysis”, which lobbed hefty criticism at Japanese policy-makers for being too rigid during their decade-long battle with deflation (that’s now two decades and counting). I highly recommend reading the section “How to Get Out of a Liquidity Trap” starting on page 14. Call it the Bernanke Playbook.

Here is a link to the pdf file of that paper if you are interested.

This type of hubris keeps us thinking that simply the “right” monetary policy, or even the right policy-maker can fix our problems. Markets spin with talk of the Fed initiating what is dubbed QE 2 (the first quantitative easing was the $1.25 Trillion purchase of mortgage-backed bonds), a sort of monetary nuclear option to obliterate the threat of deflation. Recently the Fed announced they will use the receipt of interest and principle from their mortgage portfolio to buy U.S. Government bonds to maintain the size of their balance sheet. While not at a full court press as of yet, the Bernanke Playbook is getting more attention. (see it referenced here in Paul Krugman's blog)

The Bernanke Playbook has not been fully initiated yet, likely because it is too politically challenging for the Fed to engage any further in the outright purchase of Treasury bonds or pursue more unconventional asset purchases. They are letting the economy bleed out as many bad credits as possible, while staying very accommodating to prevent a liquidity crisis that could boil over into further insolvency.

But why then is the economy so sluggish, and why is job creation missing? Remember something I mentioned in a previous blog post: Every recession since WWII has been accompanied by growth in private sector credit. If we are confused by the current progress of recovery, it is because we are simply not wired for this environment. It’s very hard to grow when credit is contracting.

All questions regarding tax policy, capital spending, jobs, bank lending, etc. have more or less to do with this largely unprecedented reduction in private sector debt, or deleveraging, in a consumption driven economy.

Interestingly though, the process of saving more and reducing debt is extremely rational and almost too much for us to handle. Strategic default and foreclosure, for example, while ethically disturbing, is very rational behavior, given the structure of housing finance and mortgage contracts in this country.

So what is the endgame here? In truth, the end will justify the means as less leverage and more equity in the economy decrease risk and increase future wealth creation. However, the means carry all the risk and that is our primary concern. At the top of the list is whether private sector credit is simply transferred and concentrated within the government. That will only increase the risk of a systemic breakdown (e.g., a failed Treasury auction) in the future. We need to see total debt levels, i.e., private and public debt, reduced. If that results in sluggish growth and a long trough in this depression-like environment, so be it. Be conservative and patient in your investments.

This is what we are closely watching. Deleveraging is the “boogieman”, striking fear into the hearts of central bankers and policy makers, because it can spiral into deflation, potentially unrestrained by any policy initiative.

Below are some numbers and more pictures to help explain what is happening. I intended to publish this earlier in the summer, when the Fed released the data, but the next set of numbers is not released until September 17^th anyway. That will update us for the 2^nd quarter, but I think these numbers tell the story.

Out of roughly $55 Trillion in total outstanding U.S. debt:

Total U.S. debt reduction in 2009: $201 Billion

Total U.S. debt reduction Q1 2010: $260 Billion (5.1 X the run rate of 2009)

Household sector debt reduction 2009: $240 Billion

Household sector debt reduction Q1 2010: $98 Billion (1.6X the run rate of 2009)

Financial sector debt reduction 2009: $1.5 Trillion

Financial sector debt reduction Q1 2010: $646 Billion (1.7X the run rate of 2009)

State and Federal debt INCREASE 2009: $1.5 Trillion

State and Federal debt INCREASE Q1 2010: $506 Billion (1.3 X the run rate of 2009)

It is also interesting to note that debt reduction in the small business sector since the beginning of 2009 has been entirely offset by increases in debt financing done at the large company level. The banks are not increasing lending to small businesses, but the capital markets are open to companies with access. In other words, easy money is not trickling down to where it needs to go.

It’s also important to highlight that total debt is declining (government borrowing is not keeping pace with the private sector reduction), albeit at a very slow rate. That is a good thing from my point of view and we need to keep a close eye on that. We are also watching the transfer of mortgage debt financing to the balance sheet of GSEs. Here I am talking about the increase in debt levels for Fannie Mae and Freddie Mac since they were placed into the conservatorship of the Federal Housing Finance Agency in 2008. The once assumed guarantee of the Federal Government is now explicit. This is where the risk from consolidating debt at the government level is most concerning.

Now some pictures and notes.

People are simultaneously saving more....

and reducing debt....

In addition to reducing debt, households have gone from being net sellers of Treasuries two years ago, to buying almost 20% of new issuance in the 12 months ending in Q1 2010. Some may argue with the wisdom of buying Treasuries, given current interest rates and deficits, but clearly the household sector is trying to save without adding risk. From the late 1940s to the late 1990s, the household sector owned between 20% and 30% of publicly held Treasury debt. Today it owns about 10%, up from 4% in 2008. Could the household sector be the new marginal buyer, replacing foreign capital? Consider that potential trend, given how low interest rates are today.

Bank credit, the lifeline of small businesses, is shrinking.

As deposit growth is a function of credit expansion, we would expect deposits to start shrinking as bank credit continues to contract. Notice that deposit growth turned negative somewhere between 1992 and 1995. However, it was not preceded by a contraction in credit. What happened is money temporarily moved out of the deposit base into the broader economy, providing fuel for a capital spending boom that resulted in the tech mania of the late 1990s. The chart below, depicting the velocity of money (representing how quickly money is circulating in the economy), clearly shows this.

The other side of this “rainbow” is signaling exactly the opposite effect of the mid-1990s, as money is leaving the wider economy through deleveraging. Money (read credit) that was once flying around the economy is coming home to roost in the form of excess reserves at the Fed. Advocates of hard money expect to find their pot of gold at the end of this rainbow to keep money supply growth under control in the future. While not an advocate of the gold standard or the Federal Reserve for that matter, Milton Friedman said in an August 2006 interview that only a major financial catastrophe could bring about a radical change in how monetary policy is administered, so as to reduce the risk of policy mistakes. He died less than three months after that interview, on the eve of just such a crisis.

And to sum it all up....

That little downturn at the top is what we have to show for our efforts, but at least it’s going in the right direction. Confirmation that we had too much debt lies in the fact that debt levels are starting to fall, seen in the chart above relating total debt to national income. Remember, growth will make this line fall even further. If we reach a point of sustainable debt levels, possibly we will see that growth.

Clearly, deleveraging can explain, in large part, why the current recovery is so weak and ripe for a prolonged recession. But is that something to fear?

As I said before, the process itself carries all the risk, as any shock or further loss of confidence (no jobs, further debt trouble in Europe or Japan, war etc.) could quickly intensify debt reduction, as the private sector could go beyond saving excess income and into asset liquidation. On the other hand, if the so-called “bad” credits (such as credit used for consumption and sour real estate investments) can bleed-off without causing a disorderly unwind of the entire debt structure, the economy and markets will eventually face less risk and a more robust future.

Confronting the Boogieman

So we have a rare, so-called outlier, event taking place right in front of our eyes, i.e., the deleveraging of the U.S. economy. We know from history that events thought to be statistically improbable are by far the most consequential when they occur. The obvious reason for this is that society doesn’t prepare for what is mistakenly thought to be highly unlikely. That makes sense, but financial and social matters tend to ignore probabilities. If you see something coming, but do nothing about it, it is irresponsible. In other words, don’t just lie in fear of the boogieman. Confront him.

Here’s how we are confronting him. We are intensely focused on our EVA strategy, which is vitally important in today’s world (a subject for an upcoming blog). Our equity holdings have been outpacing the market lately while overall returns are somewhat moderated by our sizable bond and cash positions (i.e., we don’t go down as much and we don’t go up as much). We are ahead of the overall market in our model portfolio year-to-date because we are doing more with less by holding cash. We are more protected, taking much less risk by being 50-55% invested in the stock market, but good performance in that select group of EVA-producing equities is driving solid returns overall. The cash position is an intentional allocation aimed at protecting capital, as the risks of deflation and falling asset prices loom large. It is not a permanent condition for us, but we need to see this “once in a century” type event play out. Certainly with the upcoming elections in November, which may prove volatile, this is a good time to stay patient and conservative.

Please let me know if you have any questions or comments by visiting our website at www.FalkerInvestments.com

Peter J. Falker, CFA

8/24/2010

General Motors IPO—A Financial Opinion

General Motors has been making a good recovery and has some great new cars, with the possible exception of the Chevy Volt (see NY Times article below). However, from my financial point of view, it is ridiculous to take the company public right now. This move is political, not financial, and is related to the coming mid-term elections, not the financial viability of General Motors.

For those readers who have not read my previous posts calling for and commenting on the General Motors bankruptcy, over the last several years, please take a look at what I had to say on the subject in March 2006: http://falkerinvestments.blogspot.com/2006/03/generous-motors.html and June 2009: http://falkerinvestments.blogspot.com/2009/06/nationalization-of-general-motors.html .

Of course, when the bankruptcy finally occurred, several constructive things were enabled, including a restructuring (sort of) of the dealer network and pension/healthcare obligations, as well as the renegotiation of union contracts. Of course, no lender could have been expected, under such dire circumstances, to provide debtor in possession (DIP) financing, as is the norm for Chapter 11 bankruptcies, which proceed through the courts to reorganization, with new shareholders etc. Instead, the U.S. Government invested $50 billion and received a 60% equity position and the Canadian government invested $10.5 billion and received 12.5%. We know the U.S. government had a loan outstanding of about $20 billion, before the bankruptcy, and it’s unclear to me what became of that loan. Earlier this year, the company, with an announcement that made it sound like they were repaying the government’s entire investment, repaid $6.7 billion. Perhaps I’m missing something here, but the remainder of that loan does not seem to appear on the company’s most recent balance sheet, so it is presumably part of shareholders’ equity.

What is quite clear, however, is that, after announcing earnings of $2.6 billion and free cash flow of $3.8 billion, for the six months ended June 30, 2010, General Motors’ balance sheet shows total cash and marketable securities of $33 billion and total shareholders’ equity of $23 billion. So, what happened to the other $37.5 billion of the U.S. and Canadian governments’ roughly $60.5 billion in capital investments in the last year? One can only assume that these new capital investments, like all other capital invested in General Motors historically, have been dissipated.

And this company, with its ongoing record of capital destruction says it’s going to launch an IPO to repay the government? Remember, if they repay the government, they will not retain the proceeds from the offering. They will have only the cash they have right now, plus future cash flows, to operate the company going forward.

Indeed, on August 5^th, the New York Times reported GM CEO Ed Whitacre saying: “We want the government out, period….We don’t want to be known as Government Motors.” The Times went on to say, “Through its sponsorship of the automaker’s bankruptcy last summer — including more than $50 billion in loans — the Treasury Department holds about 61 percent of G.M. Analysts have been expecting G.M. to sell part of its shares during the initial offering, but Mr. Whitacre said the company anticipated selling them all at once.”

Really? Do you suppose he is talking about the whole $60.5 billion or just the $23 billion that’s left? Let’s take a look at how that would work. The nation’s big underwriters (at least who’s left) are supposedly vying for the privilege of selling the new GM IPO (read vying for the big underwriting fee to be paid from the proceeds). So, Goldman Sachs, JP Morgan Chase, Morgan Stanley etc. would take GM’s executives on a worldwide road show to hype the company’s terrific products (some really are but not the Chevy Volt yet; see below) and how they are making a big profit, while still being propped up by the US and Canadian governments’ $60.5 billion (or what’s left of it).

Here’s a NY Times article on problems with the Chevy Volt: http://www.nytimes.com/2010/07/30/opinion/30neidermeyer.html?emc=eta1).

If GM succeeds in raising equity capital (and they probably will to some extent), these new investors will be committing capital to equity, which carries the highest risk on the very risky balance sheet of a company that still appears to be destroying capital investments. To clarify my point, consider this: Would these same investors be willing to buy the long-term debt of General Motors, i.e. 20 year bonds with a legal promise to pay and a fixed interest rate? Very unlikely, because these investors are not planning to stick around to find out how GM eventually works out. What will likely happen, assuming the hype is strong enough and the talking heads bob around enough when the IPO occurs, is that the original investors will engage in the “greater fool” syndrome, flipping the stock to the next fool and the next fool, and so on, until someone holds the stock for the long term and takes all the risk of loss. There has been a recent lesson in this regard, with the Tesla Motors IPO, several months ago. The stock initially jumped, allowing the original fools to flip their stock to the greater fools. However, in this instance, the next fools in the series didn’t appear and the stock tanked. Perhaps that will happen here, as well.

Please don’t misunderstand me here. I believe that GM is definitely on the mend, with many good new products and a much-needed cultural change underway. However, in my opinion, it is too soon for the company to be selling stock to the public. For all intents and purposes, the company is technically bankrupt, still relying on the government to prop it up. If it could really stand on its own, the company should be able to access the bond market and borrow substantial amounts of money for its day-to-day operations, with the government’s equity ownership essentially serving as collateral. That is clearly not the case and apparently not what the government wants. They want a political solution, before the mid-term elections. That, unfortunately, could do a great disservice to the taxpayers, the equity markets and the company itself. We have heard, in just the last few days, from a financially astute, potential GM customer, who has decided against buying a new GM product for fear of the company’s failure to survive the government’s current manipulation of their financial situation.

Finally, there has been a very significant announcement, while I was writing this blog post. The Chairman and CEO of GM, Ed Whitacre, has unexpectedly resigned as CEO, effective September 1^{st ,} and from the board effective at year end. He is to be replaced by Daniel Akerson, who has been CEO of one failed company (XO Communications) and one relatively unsuccessful company (Nextel); hardly the credentials necessary to run GM, especially not in the midst of a critical IPO.

Question: Why would Ed Whitacre (or any CEO) suddenly resign right at the beginning of one of the biggest IPOs in history, unless there is something wrong? Answer: There probably is.

Stay tuned.

Jack Falker

August 16th, 2010