Viacialevitra in Reverse

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania.


Viacialevitra in Reverse
July 14, 2009 David Kotok, Chairman & Chief Investment Officer

Too big to fail has become smaller. CIT was not on the original Geithner-Summers-Bernanke-designed list of 19 organizations deemed to be too large to fail. In the post-Lehman environment, this has become the norm. Failing is not permitted.

Now we see the making of this policy unfolding to a new level. CIT has received $2.3 billion in TARP money. The government has a stake. Therefore the government will now infuse additional money in order to “protect” the taxpayers. They will do this under the guise and umbrella of “helping small business.” That means a million small and independent businesses will not be incented to go to their local banking institutions but will instead be involved with a weakened CIT, operating under duress.

CIT has experienced a “run,” as those who are able withdrew their cash are doing so. We have an insolvency crisis at CIT becoming a liquidity crisis, because the cash is drained. Now, in steps the new industrial policy of the United States, as developed under the Obama administration and designed by the Secretary of the Treasury. Loan more, reconfigure the balance sheet, alter the form, assign the collateral that is workable, and otherwise find ways to pretend to be more secure while pouring more capital into a sinking ship.

I heard the former president of the St. Louis Fed summarize the dilemma well. Bill Poole said, “If you are in a hole and the hole is deep, stop digging!” With CIT they are going another layer deeper. Too big to fail is growing – Washington does not know how to stop digging.

Markets will like this in the short term, because markets like free lunches and bailout money. We as money managers will continue to position advantageously for the purpose of benefitting our clients in this continuing, post-crisis saga. But to policy wonks this is a disaster in the making, and it is getting bigger.

What to do as an investor? You see the result of government bailout money applied to Goldman Sachs. Who won? Goldman, the shareholders, the debt holders, and others who are less transparent like the former NY Fed director who traded Goldman stock for a profit. Who lost? You may argue no one, since GS paid everything back to the TARP and is now free to operate. Maybe. But they made it through the crunch on the back of a federal guarantee by the FDIC, one of the few remaining credible entities in Washington, thanks to Sheila Bair’s vigilance. Was there a price? Yes, but it is called “moral hazard” and it is difficult to measure until there is a failure like Lehman.

Who lost? Maybe no one. Maybe us? There are those of us citizens who understand that there is no free lunch and that a transfer of risk at a subsidy has a cost, even if you can’t see it at first glance.

Investors need to be vigilant. In my dinner conversation tonight with my colleagues Michael Comes and Peter Demirali, we talked about exit strategies, not for the Federal Reserve but for our clients. We have had a good run, going from Treasuries to spread products on the bond side and using our strategies on the ETF side. Now what do we do?

The conclusion tonight, and subject to change at any time is: stay the course with spread positions for now. They are narrowing and there is still value. Stay the course with an ETF strategy that favors emerging markets in the global view and is very selective and focuses on a broadening stock market in the domestic view. Avoid Treasuries and seek Build America Bonds and tax-free Munis.

And lastly, and most importantly, recognize that the US is heading for trouble and that we are in a benign period that will be followed by a troubled period. Right now it is good to be invested. We will keep a watchful eye on the exit. Too soon is not a good option. Too late is not a good outcome. In between is hard to discern. We need to work more and harder than normal. Stay tuned.

Watch the deal outcome for CIT. It is defining the new limit of too big to fail. Our title is a metaphor for getting smaller. Too big to fail is downsized. Now I am going to sleep.

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