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Fishing For Bailouts


Setting the hook in the mortgage meltdown and credit crisis.

Note: In this piece, I would like to share some beautiful moments experienced from my family's annual pilgrimage to Bigfork, Montana while at the same time explaining how I see the economic picture playing out.

Fly Fishing and the Swan River

Have you ever sat down to work and knew you were on to something? In our topsy-turvy world of investing, there is so much information to sort through that it is easy to get distracted from your thought process.

Even on vacation in beautiful Bigfork, Montana, overlooking the truly beautiful Swan River (if you ever want to experience one of the prettiest trout streams in the world, you should take a trip), it's hard to not get wrapped up in all of the financial news thrown at you on a daily basis.

Working on a laptop alone, listening to the sounds of the river, these old eyes still scan Bloomberg, Trade Web, Cyber Trader, Bloomberg Trade book, ten Internet browsers, Minyanville's Buzz & Banter, 20 Instant Message windows - you get the point. Information overload can become a problem, even for those of us used to staring at banks of computer screens for decades.

I have to admit to being a serial list maker-there are just so many things going on simultaneously, (like catching and releasing a beautiful native rainbow trout from the famous 'Green Room' on the Swan) that it is easy to become distracted from the route that I believe we will take over coming months and years in financial markets around the globe.

Everyone's mind works in different ways. Mine likes to work in a 'flow-chart' sort of way, where I begin at Point A and then attempt to get to what I believe will be the 'Final Act'. Once I get a sense of where I think we are going, I then position myself (whether in a hedged or 'long only' manner) in a way that suits my investors' goals and objectives of 'defined risk.'

Fishing and Money

Catching a sly four lb. native rainbow is really no different than managing money when you boil it all down. You have to:

a) Figure out where the trout is likely to be
b) Choose the right fly pattern
c) Get your drag-free drift just right
d) Sneak up on the trout (they don't get large by accident)
e) Then hook the trout and land it.

A flow-chart of sorts, no? It seems so to me, which possibly explains why a trout stream is where I like to spend vacation time with family and friends. It can be the ultimate challenge, just like the financial markets are these days.

Native Rainbow Trout from the Swan River (near Swan Lake, Montana)

The Flow Chart

Overlooking the beautiful Swan, I sat down and drew a flowchart of what I think will occur in the next year or two. I have been negative towards credit and equities for long enough that it is hard to stay that way, but if anything, I feel as cautious as ever.

The move that ends bear markets is usually the most emotional and catches both novices and professionals unprepared for the test that can set you apart from the crowd. While I do not fancy myself as anything but a market participant responsible for OPM (Other People's Money), I am fully aware of the problems that face America and perhaps the world at large. I have a feeling that the next move in risk generally, whether it be credit, equity prices and/or derivatives will be more violent than many expect.

True fear defines the bottoming process, not the seemingly benign mood we're getting from some financial media. While stock markets around the world are mostly in bear market territory (as if declaring a move or -20% after it is over is worth much-I think not), and credit markets are closed as best as I can tell, I sense no panic, no real fear.

The market decline, to date, has been rather orderly in my book, notwithstanding government intervention everywhere I turn. Unruly equity markets usually feature daily imbalances where sellers cannot sell and unruly credit markets are 'offered without a bid.' I have not seen this stage of fear yet and I sense that many with younger eyes and much less grey hair will not know what to do when liquidity dries up - the dreaded 'Liquidity Trap,' otherwise known in Wall Street parlance as 'The Roach Motel,' where you can get in but never get out. Trust me, I've been in that motel and it is a place I wish to never visit again.

I believe the two following flow charts will be a road map to how the credit crisis worsens. I will explain further down how I intend to avoid it and possibly prosper from it.

1) Where we are and where we are likely to go from here: More write-downs.

2) How the finish line might look: Consolidation.

The Finish Line

Congress, the Treasury Department and the Federal Reserve are all trying to prop up the housing market with all sorts of stimulus. With a presidential election coming up, it should come as no surprise that everyone wants to look like the hero that solved the housing mess.

I can't do anything but believe that whatever stimulus is approved will simply prove to be a mistake, throwing good money after bad. In the most recent bill passed this weekend by Congress, we now will raise the debt ceiling by nearly $1 trillion to bail out homeowners who overspent on houses and are getting foreclosed on, give interest free loans to first time home buyers, give states money to buy up foreclosed properties, and stick you and I with the bill.

I do not wish to sound harsh, but when I make a mistake in the markets, or when I have overspent, I have not yet seen a check showing up in my mailbox bailing me out. Where is my check? Allowing states to take my money and buy foreclosed homes seems as un-democratic (socialistic) as I can possibly imagine.

Those houses belong on the balance sheets of the financial institutions that made the loans in the first place. Think of it this way-if the bank makes a bad loan, it should be forced to take the loan, and the asset, back onto its balance sheet. It is akin to me purchasing a low grade corporate bond and watching it get downgraded from AA to D-I took the risk and I will suffer the markdown that occurs with the downgrade. It would be nice if I could just ship the bond off to some governmental agency that rewards risk-takers who took more risk than they should have. But no! I have to mark the bond down, not send it off to Secretary Paulsen or Congressman Dodd, as much as I would like to.

I can only conclude that the government stood by and watched the stock market bubble form and then bust and now it's housing's turn. By forestalling the inevitable, it simply allows banks to take on more risk yet again.

In the flow-charts above, the main takeaway should be that while major financial institutions are saying they do not need more capital at this time, what they should all be doing is cutting dividends (many regional banks have), raising equity capital no matter how dilutive it is to current shareholders (I would take special note that with Bank of America (BAC) preferred and hybrid shares trading in the 9% range, they actually announced a 75 million share buyback on Thursday), and sell whatever debt they can while the window is partially open.

As it is, the borrowing window is all but shut for most regional banks like KeyCorp National City (NCC), Regions (RF), GSE's, Freddie Mac (FRE), Fannie Mae (FNM) and broker dealers like Lehman Brothers (LEH), Merrill Lynch (MER) and Morgan Stanley (MS). I believe that Bank of America, etc. will wish they had raised capital while they could at some point in the not-too-distant future, no matter what the costs. Because when the financing window really shuts, it will shut hard, creating a much larger credit market mess than would have likely occurred without government/political intervention.

There needs to be a business cycle! That is said forcefully, and is meant to imply that there must be boom and bust, not just boom and bailout. Without a business cycle, where the weak fail and the strong survive, it encourages those that have made mistakes in their lending practices and shoddy business practices to continue.

In summary, I remain cautious towards credit and believe that once we get past the presidential election (I am already shivering thinking about the mud-slinging and false promises that will be made as it regards the housing mess), the credit crisis will finally accelerate into what feels like a crisis, not the orderly bear market we have experienced to date.

In my firm's Harbor Pilot Fund, I've hedged all of my interest rate spread increase risk away and will soon be taking an interest rate non-directional position against corporate credit risk in general. For my long only accounts, I continue my defensive position toward credit and are still void of common stocks. I believe that the largest surprise may come in non-financial shares, and instead bleed over into technology and emerging markets, retailers and just about anything else that is economically sensitive and a derivative of the housing correction.
As always, if I'm wrong, I'll have lost opportunity, not capital. As for 2009 and the first half, as it regards credit and to a similar extent, equities, all I can say is buckle your seatbelts!
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