Ron Muhlenkamp's review of events that impacted the markets during the past quarter

I’m writing this letter just after the U.S. Senate and House passed the “bailout” bill. The media and the politicians have labeled the Treasury’s Troubled Assets Relief Program (TARP II) as a bailout of Wall Street. But, in reality, it’s a support for the banking system and is designed to keep the problems in the credit markets from overflowing into Main Street. In the past few weeks, this overflow had begun, making it difficult for some firms to get normal funding from their banks. For this reason, I believe the bill was necessary.

In this short letter, I don’t have the time to describe all the drivers that got us to this place. We will do that at our seminar on November 18, 2008. But I do want to mention a couple of the main drivers which reinforced each other and drove us to where we are now.

In 2005, the Financial Accounting Standards Board (FASB) issued FASB #157 which states that banks, insurance companies, and brokers must mark the value of the assets to market prices in their quarterly and annual reports. Regulations for each of these industries limit the amount of business they can do and the liabilities they can carry is a multiple of the assets and/or equity. Thus, FASB #157 allowed firms to expand their business as the market prices of their assets moved up, and forced them to contract their business as market prices moved down. This has become self-feeding.

Had we a similar accounting rule in effect in 1989, nearly every S&L and bank in the country would have been bankrupt. Most of you know that, in the 2005-2007 period, banks and mortgage brokers made mortgages and, therefore, home ownership available to people who could not have afforded a home by prior standards. (You may know that Congress mandated that mortgages be made available to low income people.) As some of these mortgages failed, the market value of the remaining mortgages fell. Any that were owned by financial firms, (banks, insurance companies, or stockbrokers), had to be “marked to market,” forcing the firms to raise capital or sell assets. Most had to sell assets — into a vacuum of no buyers. This caused further mark-down and the spiral began. Some managed to raise capital. Merrill Lynch got $12 billion from Korea, Kuwait, and private investors. Citigroup got $12 billion from Abu Dhabi; Washington Mutual got $7 billion from a hedge fund, TPG, Inc. Within eight months, each of these investors lost over 30% of their purchase price, discouraging other potential investors.

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