Agora Financial’s Rude Awakening

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Melbourne, Australia

• The future for banks in the hyphenated securities markets,
• Rogue traders vs. rogue capitalists…the real financial hit men,
• A five-step bear market strategy: Closing at end of business today…

Dan Denning, spiritual leader of the Rude Awakening brain trust, reports from Melbourne, Australia…

Hey, did you see that 31-year old Societe General trader Jerome Kerviel lost
his French bank $8 billion on stock futures trades gone wrong? Wall Street
likes to call these incidents “rogue trading,” as if it perpetrated by
renegade madmen, pursing their own nefarious agendas.

Please…The real rogues are in the corner offices.

What about rogue CEO Stan O’Neal who made a market call on subprime mortgages
and cost his shareholders billions of dollars in equity and losses? Kerviel
didn’t even personally profit from his trades, according to wire service
reports. He was either a bad trader, or one who thought he knew how to make
the bank some extra money. “Better to ask forgiveness than permission,” goes
the old saying. If he had been right, he would probably have been given a
raise and several billion euros of the bank’s money to play with.

By contrast, guys like Stan O’Neal and Chuck Prince at Citigroup made
strategic decisions to immerse their company’s balance sheets in risky
financial products at the height of a credit bubble. They shifted operational
focus, dedicated company resources, and committed their companies’ non-risk
capital to extreme risk. Oops! O’Neal and Prince lost their big bets. But
they hardly walked away as losers. O’Neal cashed about US$161 million worth
of severance checks after leading Merrill Lynch to its largest loss in the
firm’s 93-year history. Prince received a $40 million farewell package from
Citigroup. Kerviel will likely receive a jail sentence. Something is very
wrong here.

Let’s not blame the rogue traders or the hedge funds for the mess we’re in,
dear investor. Let’s blame the rogue capitalists – the people who’ve turned
financial companies into vehicles for funneling shareholder capital directly
into their own pockets. These titans of the banking world were supposed to be
the men and women that made Britain and America the best “allocators of
capital” in the world.

Little did we know that these folks would excel at allocating your capital
into their pockets…and would put the entire Western financial system at risk
in the process.

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——————————————–

The Credit Crisis Lives
By Dan Denning

Is the credit crisis over?

Our colleague, Steve Sjuggerud, says part of the crisis is over, at least.
What makes him so sure? He points out that the interest rate banks charge
each other for overnight loans has gone down, and even briefly dipped under
the Fed funds target rate. (This overnight rate is called the LIBOR rate). In
other words, the Western world’s major banks are not scrambling for cash as
desperately as they were a few weeks ago.

Banks in Europe and America have taken substantial losses both in their
proprietary trading departments and in their loan portfolios. They’ve had to
go hat-in-hand to creditors (mostly Sovereign Wealth Funds) in the Middle
East and Far East to recapitalize their balance sheets. So in the short term,
Steve is probably right that there is plenty of liquidity in the financial
sector.

The falling LIBOR rates also suggest that the big banks are not as suspicious
of one another as they were a few weeks ago. Underlying the rise in inter-
bank lending rates last year was a deep suspicion among the lending banks
that the borrowing banks were sitting on tens of billions in unrealized
losses on over-valued assets. Most of those assets, of course, were bundles
of questionable mortgages and mortgage derivatives.

But big banks have been taking their medicine by realizing losses on
mortgage-related assets. Merrill Lynch lost $9.8 billion, Morgan Stanley lost
$7.8 billion, UBS lost $14 billion, and Citigroup famously lost $20 billion
and was forced to issue bonds with junk-like yields to attract more capital
from the Middle East.

So here’s the question…is the credit crisis over? Having reported billions
in losses on subprime mortgages, are the banks in the clear? Is it time to
consider buying the financial sector, even as a trade?

Before you go rushing off to buy call options on a financial ETF, here are a
few things to consider. First, Wall Street banks (and French, German, and
British banks) have shown miserable risk-management policies over the last
five years. (Here we have a French bank claiming a single trader hacked its
systems and managed to lose US$7.2 billion).

Where was the “adult supervision?” Where were the corporate boards charged
with protecting shareholder capital? Where were the masters of the universe
this whole time? Do they all work for hedge funds? And most importantly, why
should we assume that the financial sector’s ability to manage risk has
improved, after fessing up to billions of dollars of losses? Confessions do
not automatically lead to repentance. The sinners might simply find new sins
to commit.

The temptation to buy the banks for a bounce is obvious and…well…tempting. On
a year-over-year basis, 2008’s fourth quarter should look a lot better than
2007’s fourth quarter. The banks should see a big earnings bounce. But you
have to wonder who the banks will be lending to this year. Earnings will look
comparatively better. But will the real-world business of borrowing and
lending money produce lush, pre-crisis profitability? Doubtful.

Money center banks and investment banks simply never had it so good as they
did during the last ten years. We reckon they won’t have it that good again
for a very long time. The market for financial products is going to undergo a
contraction. This means, we think, lower long-term profits for financial
institutions.

Besides, if the banks were so bad at managing risk in the subprime market,
how can we be sure they will manage risk any better in the option-ARM market,
the credit-default swap market, the insured-bond market or in the market for
any other sort of quirky, hyphenated security?

“Bond insurer woes carry major risks for banks as well,” reports
CNNMoney.com. “Last week, American regulators tried to put together a bailout
in which banks recapitalize the bond insurers and prevent a downgrade by the
ratings agencies, which would in turn force the sale of billions in bonds
held by institutions which can only buy AAA rated debt.

“If no new capital is forthcoming for bond insurers,” CNN continues, “lenders
and other policyholders could end up swallowing heavy losses…Citigroup
(NYSE: C), Merrill Lynch (NYSE:MER), Bank of America (NYSE:BAC) and Wachovia
(NYSE:WB) are among the most exposed.”

Sound familiar? It’s already been a memorable month, and it’s not over yet.
The last few days of rebounding stock prices have provided a welcome respite.
But the unwinding of leverage and the deflating of the credit bubble is
likely to continue, whether we like it or not. And not everyone likes it,
that’s for sure.

“Dear Editor,” a reader of the Australian Daily Reckoning writes, “Please–
all you Cassandras out there, get it straight once ‘n for all time that
everythin’s gonna be just fine soon as all the excesses are outta the system
and as long as money just keeps gettin’ pumped into the system!

“Long live the Fed! They know what they’re doing!

“It all works out, and the dominoes aren’t fallin’ like in 1929 at any rate
of speed so just hang in there!…There hasn’t been a single
economic/financial mess we haven’t gotten out of since we became a nation,
and it’ll be no different this time.

“You all just wanna sell us stuff!”

Let’s be clear. We’re not hoping for the end of the world. But we suspect
that the excesses of the credit boom will lead to an economic contraction.
Some might call it a recession. Others think it will be a depression,
accompanied by a severe financial crisis.

Either way, these cyclical events are nothing new. They are common in the
history of Western financial markets. The longer you go without them – or the
more the politicians and bankers try to avoid them with stupid policies – the
worse they tend to get.

As for Cassandra, Apollo granted her the gift of prophecy, after being
smitten by her good looks. She did not return his affections. The scorned
Greek god of reason then cursed her: her prophecies, though accurate, would
never be believed.

Cassandara wasn’t a false prophet, so get your metaphors right before you go
dashing them off. There are plenty of false economic prophets out there. Most
of them work for investment banks and show up on TV telling you everything is
going to be fine.

In the end, everything WILL be fine. The world will operate, more or less, as
it always has. The sun will continue to rise. The sun will continue to set.
And CEOs will continue to parlay massive corporate failures into massive
personal fortunes. Everything will be fine. But that doesn’t mean you should
ignore the financial dangers ahead, or fail to prepare for them if you can.

[Joel's Note: The rising and setting of the sun each day, while fine, is not
usually enough to satisfy most people. They also desire things like food,
water and a few decent trades to make their lives a little more comfortable.
In turbulent times, such as these, it pays to have a strategy for playing
both sides of the market, up and down.

Dan Amoss’ Strategic Short Report has just emerged from beta testing with a
102% average return. We’d suggest adding a short strategy to your arsenal so
you can take advantage of swings both ways. Dan’s “Paddle Strategy” is one of
the better ones out there, but positions close at sunset tonight.

If you’re interested, you’ll want to give this report a quick read and get
back to us by 5pm tonight.

Good Luck!

Cheers,

Joel Bowman
Rude Awakening