Greece, Goldman and gobbledygook (financial regulation)

May 17, 2010
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Investors dislike uncertainty. And they certainly have been greeted by a very large dose of it the past several weeks. Greece, Goldman Sachs and proposed financial regulation have all been in the news on an almost nonstop basis.

In terms of Greece, the country is plagued by a very large budget deficit brought about in part by the deep worldwide recession in 2008 and 2009. In March, leaders of the 16-member European Union backed a plan under which the euro zone countries and the International Monetary Fund would jointly help Greece and any other European nation facing growing debt problems. The plan also laid the groundwork for future rescue packages if they are needed.

The original package was $45 billion. During the last week of April, the government debt of Greece was downgraded to BB+ or "junk" status by Standard & Poor's Corp. On the same day, Portugal was downgraded to A- from A+. The yield on Greek government securities maturing in two years traded up to 20 percent based on fears that the country may default and need to restructure its debt. As a result of the downgrade, many investors are now unable to hold these below investment grade securities and need to sell, while other investors are panicking and just want out. S&P added some "fuel to the fire" by downgrading the debt of Spain from a very strong AA+ rating to a still strong AA rating.

This has created a sense of contagion — that the euro zone's debt crisis is likely to spread from Greece to Portugal and eventually to Spain. The European Union, the International Monetary Fund and Germany, the largest country in the euro zone, have stated very forcefully that a Greek default and/or debt restructuring is not an option and they are working very diligently in seeking a solution to re-instill confidence in investors and provide funding to countries that need it. At this point, we continue to believe that the financial crisis is limited to Greece, and is unlikely to spread throughout the euro zone enough to derail the global economic recovery.

In terms of Goldman Sachs, the Securities and Exchange Commission has brought a civil suit claiming that Goldman deceived clients by selling them mortgage securities that were largely "manufactured" by another group who were betting that the mortgage market was about to collapse. We already know who "won the bet" and could easily devote the rest of this article to the moral and ethical issues involved with Goldman (although if you saw some of the eleven hour Senate

testimony on CNBC, much has already been vetted).

Our key point, though, is the uncertainty it has created with respect to the financial instruments of not only Goldman Sachs but the other investment banks, as well. While Goldman's stock has performed very poorly, the stocks of other investment banks have also been weak due to the perceived fear that they may also be targets of SEC investigations. The likely outcome is that the headline news begins to go away as Goldman exerts damage control to limit further tarnish to its image and settles and/or litigates the legal suits that are likely to be brought. This result appears to be eerily reminiscent of the outcome of the dotcom bubble and the investment banks (remember Merrill Lynch and Henry Blodgett?).

Gobbledygook refers to the pending financial reform legislation that Congress is close to creating. Many of the issues Congress is deciding upon such as derivatives, too big to fail, securitization, and creation of a new consumer protection agency are very important issues that will have a major impact on the financial services industry. For over a year, the financial sector has been operating under a veil of uncertainty. Change is coming that will have an effect on how business is done but the final form of the change is not yet known. As a result, many financial firms have been fearful of undertaking new initiatives, and many investors have avoided the sector.

On one earnings call we listened to, the CEO remarked about financial reform legislation and the fact that investors and Wall Street do not like uncertainty. "We can work around the rules of the legislation, once we know what they are," he said.

It finally appears that Congress is getting close to the new rules. The one thing that has been certain is the strength of the U.S. economy and stock market. The negative news headlines have thus far caused just modest sell offs in the market followed by quick recoveries. Much of the overall strength in the markets has to do with the continued favorable economic news and much better-than-expected corporate earnings. Improved retail sales, strength in manufacturing and signs of an improving job market, combined with still subdued inflation trends, all point to economic strength.

A self-sustaining economy needs to see a growing job market. That now seems to be taking hold due to the recovery in corporate profits and the ability for corporations to resume hiring. First quarter earnings reports are showing very impressive results with solid growth in sales and strong operating leverage further boosting earnings. Even the banks are beginning to report better-than-expected earnings due to lower loan losses. On many of the earnings calls that we have participated in over the last few weeks, several companies have announced that they are now in the position to add employees.

Lest readers think we have a Pollyanna view, there are still a multitude of issues that need to be successfully dealt with by policymakers around the world to assure the continued global economic recovery. In addition, the stock market never goes straight up. We, along with many others, have been looking for a 10 percent or so correction in the market. If that happens, we would actually view this as somewhat healthy as it would clear the market of excesses and provide the opportunity for the long-term investor to put additional money to work at more reasonable prices.

Scott Wagasky is a principal, director of business development, for AMBS Investment Counsel LLC, Grand Rapids.

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