Proposal To Eliminate Government Subsidies Hammers Sallie Mae

Shares of student lender Sallie Mae (SLM) are down 42% this morning after the Obama Administration’s newly unveiled budget included a proposal to eliminate government subsidies paid to private banks who make student loans. The subsidies, which cost the government billions each year, would cut government spending by $47.5 billion over the next 10 years. Wall Street is outraged, claiming that getting rid of the subsidies will drown out private student lenders and increase the market for government loans (and therefore government involvement in our economy).

I’m confused. I thought we all want a free market capitalist system? If private student loans are unprofitable (and therefore require government subsidies in order for banks to offer them), wouldn’t the free market dictate that private student lending is not a worthy endeavor for private, profit-seeking banks? Maybe I’m missing the point, but I think reducing any government subsidy, and therefore the budget deficit, would be a good thing, especially for proponents of the free market.

As for the argument that this measure would virtually eliminate private student lending, I guess I’m not convinced. Given how creative and entrepreneurial our private industry is, do we really think they can’t come up with a student lending program that is both attractive to the borrower and also profitable for the lender? I have no doubt that the banks would love to keep getting these subsidies, but the notion that student lending in the private sector can’t be maintained without them seems a bit extreme, and even if that is the case, maybe private lending is a flawed model.

What do you think?

Full Disclosure: No position in Sallie Mae at the time of writing, but positions may change at any time

With Banks Cutting Common Stock Dividends, Look At High Yielding Preferreds

If you’re a bank that took government TARP funds, whether you asked or were forced to take them, you better be very careful about paying for travel or entertainment for any of your employees or clients. Latest example: Northern Trust (NTRS), a custodian bank that had the nerve to send people and entertainment to the Northern Trust Open golf tournament. Of course, now people are irate because NTRS took $1.6 billion in TARP money and is now “using taxpayer dollars to throw parties.”

Don’t be shocked if they give the money back very soon. Northern Trust is not your typical lending institution, but instead focuses on back office services for financial services firms. As a result, the company is actually doing very well and continues to make good profits even in this environment. The company didn’t want or need TARP money, but former Treasury Secretary Henry Paulson didn’t give them a choice, he made them take more than a billion dollars.

We are now hearing that many banks (those that took TARP funds) are cutting the dividend on their common stock to one cent per share per quarter, thanks to the new wave of government involvement in the management of these firms. Since many investors rely on dividends for regular income, and some banks tried to reject the government money and the accompanying scrutiny, these dividend cuts are tough to stomach for the healthier firms and their investors.

There are alternatives though, namely the publicly traded preferred stock of these banks, which pay lofty dividends and aren’t in danger of being cut because the government is getting paid interest in the form of preferred dividends. There is no way Treasury will make banks cut its own dividend payment, so as long as a bank is relatively healthy and is in little danger of being the next victim of the credit crisis, investors can dip their toes into the preferred stocks of the stronger banks.

Not only are these preferred shares trading at large discounts to par value, but the dividend yields range from 10% to 15% in most cases. In order for a bank to stop paying preferred dividends, it really has to be in bad shape, so if you are looking for high dividend yields in the banking industry, look at the preferred stocks of those banks you think will survive the current mess.

Full Disclosure: No position in Northern Trust at the time of writing, but positions may change at any time

No, Canada Isn’t Evil

Did you know that more North American cars are manufactured in Ontario than in Michigan?

Unfortunately, our country’s political tensions are so elevated that anyone who even suggests the possibility that another country may do something better than the U.S. is labeled unpatriotic. Of course, those suggestions are made because the person making them cares deeply about our country’s future, but that point often gets ignored.

Fareed Zakaria of Time Magazine penned an interested piece in the 2/16 issue entitled “The Canadian Solution.” In it he points out several areas in which Canada’s government policies appear to be working better than ours. Maybe if we finally can admit that not everything we do in the U.S. turns out to be perfectly right, we can begin to at least consider other kinds of policies without being labeled un-American.

It became clear from President Obama address last night that healthcare reform will be on his agenda in 2009. A likely focus for such reform will be making sure that every American has health insurance. Such a task will undoubtedly be bad-mouthed by many, labeled as socialism.

“Let the free market work, we can’t be socialists like Canada and France!,” they’ll say. The free market is usually great, but if you have been diagnosed with a disease and lose your job and employer-based insurance plan, you often can’t turn to private health insurance provided by the free market. Either the insurance company will refuse to cover you at all (because they won’t make a profit on someone who is sick), or they’ll charge you a few thousand dollars a month, which obviously you can’t afford. The free market works most of the time, but not all of the time, as the sub-prime bubble has taught us so well.

Zakaria’s article uses evidence from Canada to try and show us that sometimes other countries get things right more often that we do. Simply pointing out facts does not make Zakaria unpatriotic, it simply suggests that he believes we should keep an open mind about certain important issues. After all, if our system isn’t working very well, but we refuse to adopt the ideas of other countries, then how can we ever expect to make improvements?

Below are some excerpts from Zakaria’s article:

“Guess which country, alone in the industrialized world, has not faced a single bank failure, calls for bailouts or government intervention in the financial or mortgage sectors. Yup, it’s Canada. In 2008, the World Economic Forum ranked Canada’s banking system the healthiest in the world. America’s ranked 40th, Britain’s 44th.”

“Canada has also been shielded from the worst aspects of this crisis because its housing prices have not fluctuated as wildly as those in the United States. Home prices are down 25 percent in the United States, but only half as much in Canada. Why? Well, the Canadian tax code does not provide the massive incentive for overconsumption that the U.S. code does: interest on your mortgage isn’t deductible up north. In addition, home loans in the United States are “non-recourse,” which basically means that if you go belly up on a bad mortgage, it’s mostly the bank’s problem. In Canada, it’s yours.”

“Ah, but you’ve heard American politicians wax eloquent on the need for these expensive programs (interest deductibility alone costs the federal government $100 billion a year) because they allow the average Joe to fulfill the American Dream of owning a home. Sixty-eight percent of Americans own their own homes. And the rate of Canadian homeownership? It’s 68.4 percent.”

“Its health-care system is cheaper than America’s by far (accounting for 9.7 percent of GDP, versus 15.2 percent here), and yet does better on all major indexes. Life expectancy in Canada is 81 years, versus 78 in the United States; “healthy life expectancy” is 72 years, versus 69. American car companies have moved so many jobs to Canada to take advantage of lower health-care costs that since 2004, Ontario and not Michigan has been North America’s largest car-producing region.”

Why Letting Citigroup Fail Could Cost Taxpayers Hundreds of Billions of Dollars

Why has the government injected $45 billion into Citigroup (C) rather than simply let it fail? Believe it or not, because of how much it might cost the taxpayer to do so. I know that might sound backwards, but consider the largest bank failure so far, IndyMac.

IndyMac had $32 billion of assets and its failure cost the taxpayer a whopping $9 billion (remember, the government insures customer deposits should a bank fail). Well, Citigroup has more than $2 trillion of assets, which makes it about 64 times larger than IndyMac. While the numbers won’t be exactly proportional, if you multiply 64 by $9 billion you get an estimated cost to the taxpayer, in the event Citigroup fails, of a staggering $570 billion.

Considering the FDIC insurance fund stood at $35 billion at last check, you can see the government doesn’t have the money to let Citigroup fail. That is probably one of the reasons why they might prefer to provide aid to Citigroup in exchange for an ownership stake. It is conceivable that would be far less costly to the taxpayer to keep them afloat than it would be to let them fail.

Full Disclosure: No position in Citigroup at the time of writing, but positions can change at any time

CNBC Documentary by David Faber, “House of Cards,” Is Worth Your Time

One of CNBC’s finest, David Faber, recently completed a two hour documentary about the housing bubble and the credit crisis. I had the chance to watch it on Sunday and it is very well done. For those of you who are interested in how the combination of mortgage brokers, Wall Street, and consumers led to the dire financial predicament we find ourselves in right now. Faber really hits on all of the major culprits and explains them well along with his superb guests.

CNBC replays House of Cards in prime time during the week and over the weekends. According to my Comcast program guide, the next airing is Wednesday from 8-10pm ET but check your local listings and set your VCR or Tivo.

Tax Cuts Alone Won’t Boost Employment

Terry submits an email saying:

“Tax cuts to increase American companies’ ability to compete, lower corporate tax rates, lower capital gains rates and repatriate that $500B plus overseas that companies don’t want to pay 35% confiscatory tax rates on. Stop pandering to the lowest common denominator and grease the skids for what has made this country great, CAPITALISM!”

I agree with one of the three tax ideas Terry supports; the last one. The other two, while certainly fine on their own merits, don’t do anything to boost job growth, which is why our economy is in the tank right now After all, consumers represent 70% of our GDP and when they are losing their jobs, they have less money to spend.

Corporate tax reductions would boost stock prices (which I would obviously be happy about) but they don’t directly create jobs. But if companies have more money, won’t they hire more workers? Not if they don’t need more workers! Corporate America is shedding jobs because they need fewer people now that demand for their products has dropped. The current round of layoffs is being done to “right-size” their organizations for the amount of business they have now, which is less than it was during the loose credit, low unemployment era of 2004-2007.

Without increased demand, there is no need for a larger workforce, and therefore companies won’t hire people. Profits would increase, making share prices more valuable and it easier to pay dividends and buyback stock to boost shareholder value (which is why Wall Street would applaud corporate tax reductions), but without the need for more workers, companies won’t hire just for the heck of it, even if they have more money that is not being sent to the government.

I’m all for corporate tax reductions, but they aren’t getting much traction right now because the focus is on job creation because the unemployment rate is on track to double between 2007 and 2009 (~4.5% to ~9.0%). With consumers representing the bulk of our economy, job loss is truly the thorn in our side.

I have written before about the capital gains tax argument, and I find it even less compelling than corporate tax reductions for two reasons:

1) Nobody has any capital gains

The stock market has fallen 50% and housing prices are down 25%. Most taxpayers who have investments are going to deduct capital losses on their tax returns because very few things are being sold for a profit right now. Now, they should certainly increase the annual maximum capital loss deduction (it has been $3,000 for too long), but reducing the capital gains tax rate actually hurts those of us who are deducting stock market losses on our tax returns because we would get a smaller deduction if the rate was lowered!

2) Investments are not made based on tax rates

The argument against that first point focuses on future investments, not money that has already been allocated. If capital gains tax rates are low, the argument goes, people will have more of an incentive to invest and capital will again flow into the economy.

I love the idea of incentive-based policy, but this idea assumes that investor capital is sitting on the sidelines right now because capital gains taxes are too high. I think that is completely wrong. People stop investing if they think they’ll lose money and they invest more if they think they’ll make money. Nobody is going to forgo an investment they believe they can make a killing on because they have to pay 15% capital gains tax on any profit they make. Incentives are great, but they have to target the things that prompt whatever behavior you are trying to promote.

Obama Housing Plan Details

Lots of people are already complaining about Obama’s housing plan unveiled yesterday based on the presumption that it is bailing out lenders and homeowners who made poor decisions at the expense of those who are paying their mortgages on time each month. Here are the details of the actual plan, which don’t seem as bad as some are claiming with respect to moral hazard.

1) Allow Responsible Homeowners to Refinance their Existing Mortgage (4 to 5 million households)

You may not think the government would need to intervene in order for this to happen, but Fannie Mae and Freddie Mac do not guarantee loans if the loan amount is more than 80% of the home’s value. This is a problem in the current housing environment because with housing prices dropping so rapidly, home owners who are paying their mortgage on time still may not qualify for a refinance, even if they are current and simply want to lower their payments since interest rates have fallen.

The Obama plan lifts the loan-to-value cap for refinances to 105% from 80%. As a result, responsible home owners who want to refinance their mortgage to a lower rate can do so, as long as their loan balance is no more than 105% of their home’s value. This change will reduce monthly payments for many responsible borrowers and therefore help prevent future foreclosures.

2) Offer Incentives to Lenders and Borrowers to Modify At-Risk Mortgages (3 to 4 million households)

Since not all mortgages are guaranteed by Fannie and Freddie, Obama’s plan provides incentives for lenders to work with borrowers who are at-risk of default before they become delinquent. Currently most lenders require you to be a few months behind on your mortgage before they work with you on a loan modification.

This plan offers lenders cash payments for every modification they complete. To prevent lenders from dropping the monthly payment by a very small amount simply to collect the upfront fee, they are offering another incentive payment if the loan remains current for a year after the modification.

As for what amount the monthly payments should be adjusted to, the government is offering incentives for loans that total no more than 38% of the borrowers income. The government will subsidize the mortgage interest by 7% of income, so that the monthly payment will equal 31% of monthly income.

The lender will still decide if it wants to modify a loan or not, so the government is not forcing them to do anything, but merely providing incentives to try and reduce future foreclosures for at-risk mortgages. If you lose your job and are facing foreclosure, adjusting your payment to 31% of income may allow you to keep your home in some cases, but clearly not all of them. Investment properties owned by speculators do not qualify under this program.

Research in Motion Options Scandal Is A Non-Event

Shares of Research in Motion (RIMM), maker of the popular Blackberry line of smart phones have fallen to $44 per share and the latest news is that the SEC has reached a settlement with RIM executives over an options backdating scandal. I thought options backdating was over and done with, but evidently there are still some cases that have yet to be resolved.

A lot was made at the time options backdating came to light, and the practice is certainly unethical, but it really will have no impact on the company’s business. RIM shares are down 70% from their highs and now trade at only 13 times current year earnings estimates. If you think Blackberries are here to stay, the weakness this week, in part due to the options headlines, is giving investors an interesting entry point.

Full Disclosure: No position in RIMM at the time of writing, but positions may change at any time

Will Obama’s Stimulus Plan Work?

As President Obama gets ready to sign the 2009 American Recovery and Reinvestment Act later today, a common question is, will it work? Of course we won’t know for a while, but my honest non-partisan opinion is “a little bit.” There is little doubt that parts of the bill are positive for our country and the employment situation, whereas others are likely to not do us any good. I think that the extreme views on either side, that this bill will either bring us out of recession or make it far worse, are both unfounded.

In particular, there are some people that insist FDR’s New Deal in the 1930’s prolonged the Great Depression, and only when World War II began did the economy rebound. They use this argument to imply that this stimulus bill (a mini New Deal of sorts) will further cripple our economy. I just wanted to share the chart below with everyone in order to debunk this myth.

Arguing that government spending does not create jobs is pretty silly. You can certainly take the position that government should not do anything (let the market work!), or that we are spending too much money when we are already in debt (to the tune of $10 trillion!), but denying that building a road, or upgrading a power grid, or funding medical research grants will require incremental workers is a pretty strange assertion.

The idea that tax cuts are a better means to create jobs is odd too because giving a tax cut to an unemployed person (who isn’t earning any money) doesn’t really help them very much, and it certainly doesn’t get their job back. An extra $13 per week (or whatever the number is) might help people pay their bills, but it can’t boost demand enough to force companies to need to hire more workers to meet that demand.

All in all, I think this bill is far from perfect and I don’t think it will have the same impact as the New Deal did on our economy. That said, there is no reason to think it won’t have some impact. Probably not enough to return to positive economic growth and falling unemployment anytime soon, but before we can grow again we have to halt the decline and hopefully this bill can contribute to that goal. Everyone should hope it works, whether you supported it or not.

Why Fair Value For The S&P 500 Is Not 440

Barry Ritholtz, market veteran and blogger over at The Big Picture postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.

Personally, I expect more from Barry given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don’t know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index’s components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.

Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a business person interested in buying your store. What would your reaction be if this person took your store’s profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits. Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!

The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.

The second issue with Barry’s analysis is the use of “as-reported” GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock’s value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don’t really play a role in fair value estimations.

The interesting thing is that you don’t have to take my word for it on this topic if you don’t want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.