Why Did TARP Change Course?

The twists and turns of TARP have confused and dismayed. From financing "bad" assets to direct capital injections to the myriad applications of its vast resources, TARP is now hardly recognizable from its original incarnation. The question is: Why? Why was the acquisition of troubled assets abandoned? Why was an open checkbook given to banks interested in receiving TARP funds, causing a rush of investment banks, finance companies and insurance companies to either convert to Bank Holding Companies ("BHC") or acquire banks to become BHCs? Why are common shareholders of seemingly bankrupt institutions (AIG, Citigroup, etc.) being bailed out, all with U.S. taxpayer dollars? These are some of the more pressing questions on my mind over the past three months. 

I have long thought that the issue was political, that Mr. Paulson and those in Congress lacked the political will to wipe out common shareholders and restructure both broken balance sheets and the banking industry. But perhaps the issue is logistical as well: do we have the data necessary to restructure broken CDO pools, and if we lack the data, then the will necessary to acquire the data in order that fundamental change can be achieved? And while I've written extensively about the need for transparency, published prices and dynamic collateral management, how we get from here to there is a matter for discussion.

I recently met with Hernando de Soto, a leading thinker, writer and activist in the areas of individual property rights and documentation of ownership as catalysts for social progress. We fixated on the role of the mortgage-backed securities markets in the current financial crisis, and explored the structure of securitized mortgage asset pools as a reason for why Mr. Paulson's original "buy troubled assets" approach was discarded. Having a granular understanding of the composition of these pools - loan by loan, with the ability to analyze and separate the good, the bad and the salvagable - would seemingly have three critical benefits:

1. Gaining a better understanding of the asset quality of large holders of these CDO assets, in order that the markets can incorporate this information into business and investment decisions
2. Being able to identify which mortages should be restructured, as a vehicle for stemming the tide of foreclosures and the spiraling decline in property values; and
3. Reinforcing the necessity of transparency, a concept that has sorely been missed in the asset-backet security explosion of the past 25 years.

Further, this information would better enable Treasury, the FDIC and Congress to determine precisely which banks are insolvent, the magnitude of the insolvency, and to fuel a rational and data-driven purchase of troubled assets and recapitalization of damaged institutions. This, together with providing a basis for restructuring and writing off trillions of ill-conceived mortgage obligations would likely result in a much more efficient and impactful expenditure of U.S. taxpayer dollars.

With all of these benefits at hand, why hasn't this path been pursued? Is it the difficultly in specifically identifying elements of these pools that are ultimately broken up and broadly distributed, such that the data doesn't exist? Is it the dirty and laborious work necessary to obtain this data by building a bureaucracy necessary to obtain it? Or is that on some level our Government leaders don't really want to know the truth, the magnitude of the idiocy has driven us to toss trillions at problems in the absence of hard data? How we, as taxpayer-investors, can be forced to spend these sums without data and without a plan is troubling. It is as if someone came up to me seeking funding for a start-up and initiatied the following conversation:

Start-up guy:  "I've got this start-up. I'd like $10 million to get it going."

Investor: "$10 million for a start-up? That's a lot of money. Can you tell me about it?"

Start-up guy: "No."

(Amused) Investor: "Do you have a business plan?"

Start-up guy: "No."

(Less amused) Investor: "Do you think there is a market for your product?"

Start-up guy: "I have no idea."

(Irked) Investor: "Then why do you think you know enough to succeed?"

Start-up guy: "I don't."

(Irate) Investor: "Do you really think I'll fund you?"

Start-up guy: "Yes."

(Incredulous) Investor: "How could you possibly think that?"

Start-up guy: "Because you already have. Check your bank account."

(Apoplectic) Investor: "#$%@&*>@#"

I am still trying to figure out the answers, because the way the bailout has unfolded just doesn't compute. And I'm guessing that many taxpayers out there feel exactly the same way.

The Seduction of Municipal Derivatives: JUST DON'T DO IT

Bloomberg just ran a story on municipalities entering into derivatives contracts to help finance budget deficits. I've seen this movie before about 15 years ago, and I can tell you how it ends: in tears. As someone who spent much of my career in the realm, I can and have provided examples of the prudent use of derivatives: primarily, as risk management tools for issuers. The problem is, these municipalities are neither hedging anything nor do they truly understand the ramifications of their actions.

Without getting too complicated, counties, cities and states who feel desperate sometimes sell massive amounts of optionality to investment banks, with large embedded spreads for the dealers, and hope and pray that the options they've sold don't move in the money. Problem is, they almost always do. My fervent belief is: hope and prayer should not play a role in municipal finance (or in the White House, for that matter). If there are fundamental problems with balancing the budget, deal with it head on. But there is never a free lunch, and the pains of unwinding disastrous derivatives transactions can burden local governments for a generation.

Back in the ealry 1990s, when municipalities felt the same pressure they feel today, they sold massive amounts of "index amortizing swaps," swaptions, range accrual swaps and other leveraged structures in order to take in premium income to finance near-term cash needs. This was done in a low rate environment, when the Fed pushed down short-term rates to 3% (which was considered low back then) to spur economic growth and volatility was also low. Essentially the worst time to be selling optionality based on rates staying low or within a prescribed range. In the event that rates (either short or term rates, depending on the structure) rose, either the municipality would be sitting with a large notional, low received-fixed swap rate (where they are left with the prospect of paying rising short-term rates in excess of the fixed rate received) or the need to make a large cash payment in the future. So what happened? The Fed cranked up rates by 300 bps over an 18 month period, volatility spiked, the yield curve flattened and counterparties that were short optionality, like the municipalities and corporations such as P&G, Gibson Greetings and Air Products,  got crushed. There was no hedge. There was only desperation (municipalities) and greed (corporations).

After everything we've been through as a society, and will be going through over the ensuing years as we extricate ourselves from the current crisis, haven't we seen enough of the misuse and abuse of financial instruments? I certainly think so. While I am generally not a believer in saving people from themselves, when fiduciaries impacting thousands and millions of people use poor judgment with long-term implications, legislators need to intercede with sensible regulation. And fast.

Twitter: I Can See Clearly Now

Though a fan and a user of Twitter, I have had my doubts as to true value of the platform. However, a recent release by one of my companies has made me see more clearly how Twitter can be a powerful enabler and unleash a rash of innovation for the betterment of its community.

The latest StockTwits release, which through a Firefox extension provides a hot-link from stock-related messages delineated by a $ sign on Twitter to the StockTwits ticker page, highlights the power of the Twitter platform and the value that can be layered atop the community. Fred's post touches on other companies that might build their own extensions to extract greater intelligence from Twitter. VentureBeat has been focusing on Twitter's potential to link to other websites. These are both really good points, and the AVC discussion thread has other good perspectives as well. In short, Soren and Howard are making it happen.

What it all comes down to, IMHO, is the ability of Twitter users to find and build relevant communities both on and off the Twitter platform. In the case of StockTwits, the community is a bunch of people - professionals, skilled amateurs and voyeurs - who are interested in sharing views on stocks and the economy. If StockTwits didn't exist, it would be much harder to find people with similar interests where one could easily be inserted into the dialogue. This was my big knock on Twitter in the beginning. But as more apps are built that help people identify Twitters of like interests whom they might want to follow, and that facilitate the creation of communities that interact on Twitter but can dig in deeper elsewhere (like StockTwits), Twitter's power as an enabling platform is rapidly coming into view.

Just as the iPhone unleashed a wave of rapid, creative innovation that brought real value to its users, I expect a similar phenomenon with Twitter. Without a doubt, the best is yet to come.

Citigroup Bailout: Not Far Enough

After reviewing the "Term Sheet" and the write-ups in the press I am not happy. The U.S. Government didn't go far enough. I'm not convinced that we won't be exactly in the same position I was worrying about with direct cash injections and no Good Bank/Bad Bank structure. Liabilities could well exceed Citigroup's losses plus the second and third loss guarantees. The deal is exceptionally complicated, without full transparency for either the Government or the U.S. taxpayer. The fact that equity holders are getting bailed out - at least temporarily - offends me, given that the U.S. taxpayer is bearing the lion's share of the risk. This looks and feels like AIG redux - except perhaps worse. Transparency. Simplicity. Avoidance of moral hazard. Will we ever learn?

We, the People: Good Bank, Bad Bank, OUR BANK

With the news that the U.S. Government is on the cusp of striking a Good Bank/Bad Bank restructuring deal with Citigroup, I am left with the following question: what took so long? And notwithstanding my brainy friend Paul Kedrosky's contention that one couldn't have known whether direct bank injections and/or Good Bank/Bad Bank restructurings would work, and that likely both were needed, I say: we should have known. The key to the puzzle is that of understanding complex financial exposures - how they work, how they impact other constituencies and how investor confidence is rebuilt and won. It is in this regard, I'm afraid, that most within both public and private sectors missed the boat, that in the absence of clarity around these complex exposures investors would wait on the sidelines, and bank managements' would hoard any and all liquidity provided them until they got a grip on how their complex asset portfolios would ultimately perform.

Alas, we've shelled out $125 billion with nary a thing to show for it, except a handful of banks with billions in stranded liquidity and a bunch of uneducated writers and politicos spouting "We should have compelled the banks to lend." Sure, just like Congress compelled Fannie Mae and Freddie Mac to lend. That was an egregious error and exactly the wrong thing to do. The way to get banks to lend is to provide them with good lending opportunities. And good lending opportunities come from clean banks, a stable banking sector and attractive risk-adjusted opportunities to invest in the real economy. As of now we have precious few clean banks, a fundamentally unstable banking sector and a real economy in tatters. And we can't get clean banks that are able to lend without Good Bank/Bad Bank restructurings, which require transparency in on and off-balance sheet exposures and a commitment to offloading bad assets and recapitalizing the healthy assets that remain.

Banks given the opportunity to claim TARP funds are doing exactly what rational bank managements should do for their shareholders: take the money and sit on it. The strings many wanted attached to TARP funds - the requirement to lend - are the wrong strings. The right strings are: if you want TARP funds you need to agree to a Good Bank/Bad Bank restructuring, with troubled assets marked down and sold at market value to a Government-sponsored "liquidation trust," after which the gap between hard book capital and BIS regulatory-mandated capital is made up by either public or private investment. What then emerges is a healthy, well-capitalized bank without the legacy burden of toxic, illiquid assets. Private capital will be attracted to such a bank, and this bank has the ability to lend without the fear that it is spending capital on new business when it should be stockpiling it to deal with legacy problems.

Lehman should have been handled in such a way: Good Bank/Bad Bank would have meted out pain to those who deserved it, common shareholders and unsecured bondholders, while adding stability in how the hundreds of billions in complex exposures were wound down. AIG should have been handled this way from the outset; how many tens of billions more have taxpayers borne that was necessary had this approach been used? Hard to calculate, but you can bet the number is quite large. The first $25 billion that was injected into Citigroup? Let's just call that the cost of education. As long as we do it right now, it will be a small price to pay compared to a rolling series of injections into a still-troubled bank that continues to be laden with tens of billions of toxic assets both on and off-balance sheet. We as taxpayers and as rational investors have a right to know what we are investing in, and as of now the picture couldn't be more opaque. This is not ok.

• We, the people, are the owners of the Treasury, the Fed and the full faith and credit of the U.S. Government;
  

• We, the people, should benefit from the monies spent to reclaim our financial sector, that is merely a precursor to reclaiming the health of our economy;

• We, the people, need to know that our representative in Washington, D.C., are thinking clearly about this issue, free from lobbyists, conflicts of interests and other distractions;

• We, the people, need transparency from our Government, our financial institutions, and the process for restoring the health of our financial sector;

• We, the people, cannot see any more of our money squandered on short-term, patchwork solutions to painful and seemingly intractable problems that require radical thinking and even more radical actions; and
  

• We, the people, showed our desire for change at the polls and want to begin seeing these changes among our elected representatives, RIGHT NOW.

NB: For those interested in reading more on my views concerning the Good Bank/Bad Bank concept, I've written many posts dating back more than year. This link provides the output of a Good Bank/Bad Bank keyword search on my blog.

Understanding and Identifying the Winners of Tomorrow

My friends Fred and Howard each penned "Lost Decade" posts that offered valuable perspectives on who the winners of tomorrow might be. Fred points to companies like Google and Apple, two winners of the past 10 years whose futures are likely to be bright. Howard emphasizes the importance of entrepreneurship, yet believes a strong core of under-invested in winners will emerge that will offer historic opportunities for capital appreciation. Both posts are worth a read; please do check them out.

However, there is an important facet of the discussion I'd like to explore more fully: the business dynamics of future winners. This is particularly relevant given the rapid changes in technology and restructuring of the global business landscape through outsourcing, cloud computing and other variable-cost solutions. One thing is for sure: the winners of tomorrow will look quite different than the winners of yesterday. But why?

I'd suggest that Return on Equity (ROE) is a good proxy for financial success. It is a very rich measure that embodies three critical elements of performance: Profitability (Net Margin), Efficiency (Asset Turnover) and Leverage. This decomposition of ROE is commonly called The Dupont Formula:

               Net Income     x       Sales     x      Assets

ROE =     ----------------           ----------           ----------    =  Margin x Efficiency x Leverage

                    Sales                  Assets             Equity

Consider the winners of yesterday, the manufacturing and materials companies that long dominated the Dow. In the early and mid-1900s, these businesses had attractive margins, poor efficiency and substantial leverage. This is because the businesses were neither global nor commoditized (so high margins were still available), but were also very asset intensive and, therefore, not very efficient. They did enjoy high leverage, but due to good margins were less risky than their leverage might indicate. As the 1900s came to an end and the 2000s began, these businesses came under significant pressure. Think autos, steel, and a host of other asset-intensive businesses that either became commoditized (e.g., chemicals, steel, bank lending) or were disrupted by cheap substitutes from abroad (e.g., toys, shoes). This had the result of depressing both margins and efficiency, while leverage remained high. In short, a formula for dying businesses and industries. Shrinking margins. Asset intensive. Reliant on leverage to generate even marginally acceptable returns. But with poor operating performance these businesses lack the cushion necessary to deal with sharp turns of the business cycle, as we've seen in the recent crisis. Banking is a prime example. ROE was artificially inflated by excessive leverage, masking problems in both margins and efficiency. And when the cycle turned and asset quality deteriorated, many have had life-threatening problems with little hope of extricating themselves through operating performance.

The winners of tomorrow will necessarily look different. Businesses that are not yet commoditized and, therefore, have high margins. Companies that heavily leverage technology and don't require as much infrastructure as leaders of the prior century. Lower asset levels result in less leverage, making businesses less vulnerable to business cycles and liquidity shortages. Google and Apple, two companies mentioned in Fred's earlier post, fit the bill. Companies whose principal asset is IP will necessarily perform well in the tomorrow's economy. Those who leverage open source software, distributed computing and center their investments on people and products will have attractive operating characteristics. Manufacturing is and will always be necessary, but it is unlikely that these companies drive value creation in the next century.  

High margins. Low asset intensity. Low required leverage. These are the hallmarks of tomorrow's winners. Technology will be a key enabler in both identifying and making these winners, which is why investments in science and math education and progressive tax policy to spur innovation and entrepreneurship are absolutely vital. The template for success is here. All we need to do now is execute.

NB: Check out my earlier post on optimal cash balances. I profiled Apple in my discussion back in March 2007.

Bulging Side Pockets: Turning Hedge Funds into Private Equity Funds?

Many hedge funds are in trouble. Whether due to bad security selection, issues that were once considered liquid that now "trade by appointment" or by jittery LPs, managers are having to generate cash to meet a flood of redemption requests. This has placed tremendous pressure on managers who are not only depressed to see management fees drop while high-water marks remain far out-of-reach, but who have hard decisions to make about which assets should be converted into cash.

One way managers can delay the inevitable: putting less-liquid assets into "side pockets" and shifting them from main funds into long-term liquidation vehicles. These assets generally attract management fees but not performance fees until sold. The more assets that are classified in this manner the less cash that is available to meet investor requests, and the longer investors are locked-in to the managers whom they've decided they no longer want to be in business with. Hedge fund investors have unwittingly been turned into private equity investors, forced to stay invested for an indeterminate period of time. Certainly not what they thought they were signing up for.

This concept was briefly touched on in a recent Wall Street Journal article, but it is an issue that requires far more consideration and analysis.

"I don't think people are selling their less-liquid holdings to meet redemptions, they're just telling investors they can't have that portion of their money or that it's in a liquidating class," (emphasis mine) says Brett Barth, who helps run BBR Partners, a firm that manages money for wealthy families.

The hedge fund manager argument for side pockets: "Being forced to sell illiquid assets in a "fire sale" damages all investors." While this is surely true, what about those investors who want to fully cash out, regardless? What about investors who got cash prior to the re-classification of certain assets as "illiquid," getting a better deal than those who unfortunately delivered their redemption notices a little later? The first issue can be dealt with by creating a vibrant secondary market in side-pocket investments, just like the market in LP interests for hedge, private equity and venture capital funds. The second issue is more complicated, and will invariably result in a spate of lawsuits by LPs saying they were treated unfairly relative to other investors by the GP.  And this doesn't take into account the "side letters" that frequently exist between large LPs and GPs, often providing preferential liquidation terms and fee concessions. This isn't a terrible time to be a hedge fund attorney: it's just that the business mix has changed from new fund formation to litigation.

Conceptually, however, does the "side pocket" concept make sense? Did LPs really think that GPs would fully use those illiquid asset allocations provided for in their fund documents? Think about the percentage of illiquids relative to total fund assets now - likely way beyond the amount stipulated in fund documents as the mostly liquid assets are being sold to meet redemptions while the remainder is left behind as a long-term liquidating stub. This stub, as noted earlier, has private equity-like characteristics, yet LP allocations did not take this shift in liquidity profile into account. My guess is that new hedge funds, when they emerge, will likely have much tighter documents than those cut in this decade, with greater restrictions concerning illiquid asset percentages and rules for shifting assets from the main fund into side pockets. But the issue of current side pockets will continue to loom large, as many of their holdings will be worked out over many years. 

One of the first posts I ever penned discussed the convergence of hedge and private equity funds, where hedge funds were becoming greater participants in buyouts, venture capital and structured investments. I keyed on the issues of valuation, compensation and disclosure as being three vital elements for hedge funds successfully making this transition. But this was in the context of all assets being held in the main fund, not in side pockets. Today's situation is far more complex, especially as hedge funds did not take my advice back in Summer 2006. LPs are getting upset and will only get more so in the coming months. But given the latitude offered most of their GPs, they've got no one to blame but themselves.

Playing Chicken with Citigroup

What does "too big to fail" mean anymore? Bailing out equity-holders? Debt-holders? Depositors? Entrenched managements? Sovereign wealth funds and other large offshore investors? We need to define our terms and our goals and we need to get it right. And one of the most stunning case studies for what this means in a post-AIG bailout world may well be Citigroup.

Citigroup touches every part of the U.S. economy and many parts of foreign economies as well. An out-and-out failure of Citigroup would invariably cause ripple effects across the global financial landscape due to its labyrinthine counterparty risks, collateral held on behalf of others, worldwide branch network and panicked depositors. Rightly or wrongly, I assign a zero probability to Citigroup being forced to file Chapter 11, so then the question becomes: what does happen if it hits the wall a la Bear Stearns or Lehman Brothers?

Option 1: TARP-style bail-out

This would involve writing $25 billion checks on a quarterly basis for the foreseeable future.  There would be no end in sight since the amount of toxic waste residing on Citigroup's balance sheet (see Assets, Level 3) is in the tens of billions and currently unknown. Transparency is not yet at hand. This plan would protect equity-holders and debt-holders at the expense of the U.S. taxpayer and better-run competitors. It would also protect the investments of sovereign wealth funds and Prince al Waleed, two constituencies who would likely go ballistic if Citigroup's stock price went to zero. The political ramifications of such a move shouldn't be underestimated, yet the impact of irritating offshore investors now pales in comparison to best dealing with the global financial crisis. Sure, they hold a lot of U.S. Government debt, but right now that is perceived as the safest paper in town. That said, this plan reeks of moral hazard and burns the very people who have the most skin in the game: the average U.S. citizen.

Option 2: Good Bank/Bad Bank restructuring

This would entail a multi-step process that wipes out common stockholders, and potentially some preferred stockholders and debt holders as well:

1. Separate Citigroup's Level 3 and other illiquid financial assets ("Bad Assets") from the others ("Good Assets") ;
2. Sell the Bad Assets to a Treasury-controlled special-purpose vehicle ("SPV") at market value. The SPV would be owned by the U.S. taxpayers;
3. After receiving the cash proceeds of the sale, take the book loss and mark down the capital account. Use free cash to pay off creditors beginning at the top of the capital structure. Some creditors will be paid and other's won't. That is part and parcel of the risks of investing; and
4. Compute the amount of capital necessary to bring the Good Assets - now the Good Bank - into regulatory compliance under the BIS standards. Capital can be provided by either public or private sources. The Good Bank, now freed from balance sheet uncertainty and with an attractive global asset base, may be an appealing candidate for private equity investment. If not, the U.S. taxpayer - through the U.S Treasury - will make the necessary capital injection. It will get a good deal.

This solution avoids moral hazard, penalizes those who took risk with the hope of great reward, and provides the U.S. taxpayer with a fighting chance to earn a fair return on its investment. Further, the Good Bank will not be motivated to hoard capital, since its clean and transparent book will be adequately capitalized and without the embedded mega-disasters causing most banks on the planet to apply for TARP funds. Will common and preferred equity holders be irked? Yes. Big deal. They are at the bottom of the capital structure for a reason: trying to capture the benefits of a levered return. Sometimes leverage works against you, as it has across many large financial firms. And in those cases, you lose. This is one of those times.

Conclusion

The time has come to drop the arguments over mark-to-market accounting, FAS 157 and fairness. If you can't finance your book, you are dead. Period. This isn't about accounting; it's about survival. This is a plan U.S. citizens, Congress and global financial leaders should be able to get behind. And they should apply the same solution to their problems. Because once we have financial firms with transparent, clean, well-capitalized balance sheets, the motive to stockpile capital is gone. Then we can turn our attention to the real economy where things are just beginning to get bad. But one step at a time; we need to lay the foundation for capital formation as the real economy starts to heal, and it all begins with a healthy banking system.

Why Can't We Admit That...

...Citigroup, parent of the once-proud Citibank and Salomon Brothers, is bankrupt?

...larger venture firms are fair-weather friends and lack the staying power that their prodigious committed capital balances would indicate?

...venture capital and private equity Limited Partners got burned by the old maxims of the ratio of funded commitments to committed capital?

...venture capital is a cyclical business, and that a dedicated focus on any one stage will leave a firm exposed when the cycle shifts?

...the stock market will continue to go down, regardless of perceptions that "this quality stock is cheap" or "this is the buying opportunity of a lifetime?"

...Berkshire Hathaway is genuinely threatened by a potential run on its credit, due to contractual provisions in its derivatives agreements that could compel it to post more collateral at exactly the worst time?

...if we are even talking about Berkshire Hathaway being at risk, then ANY company is at risk of a run on its credit?

...as well-intentioned as those in our Government might be, that most have no idea of how to address the issues that threaten our national prosperity and well-being?

...any institution for which buying a bank is even remotely logical will do so to gain access to TARP funds, whether necessary or not?

...spending on infrastructure to get people back to work while re-building and upgrading essential services is a useful expenditure of taxpayer funds?

...everyone is scared, from the top 1% of the wealth pyramid down to those doing everything in their power simply to get by?

...there is a difference between being pragmatic and being pessimistic, and that what seems overly depressing and negative in most environments is merely pragmatic in today's historic down-cycle?

...there will always be trading strategies that outperform in a given market, and that while CTAs, trend-followers and long volatility strategies look terrific now they often look like crap in market upturns?

...B of A buying Merrill Lynch is beyond inane and that BAC shareholders should rebel and vote "no" on what will surely be a value-killer for their holdings?

...derivatives need to move to exchanges to ensure transparency, liquidity and collateral adequacy?

...financial company balance sheets need to be marked-to-market unless assets can be financed on a long-term basis?

...Jerry Yang killed his own company, having shifted from his appropriate role of Chief Yahoo to CEO and blowing firm strategy in the process?

...good seed stage investors need to do what they do best, assess and take risk, and put money to work at sick prices for businesses that can weather the economic storm for the next 18-24 months?

...we are all in this thing together, as cratering Asian and European economies decline in sympathy with the embattled U.S. markets?

...as long as we've got our health and love in our lives that the Sun will rise tomorrow and bring new opportunities and challanges that make us feel alive and vital?

Scanning the News: Tough Times Require Decisive Action

Though I get most of my in-depth commentary on business and technology from blogs, I augment that with mainstream news headlines and alerts. I often extract the implied sentiment of headlines to get a tone of the markets and the economy, and this becomes part of the prism through which I view news, events and my activities. Lately the headlines have been pretty grim, and increasingly so as the global financial crisis bleeds into the real economy. Normally I associate depressing headlines with a contrarian opportunity to act, but at this point I believe the headlines do not yet discount the difficulties we will encounter both economically and militarily over the next 12-24 months.

Consider the top Breaking News headlines from Bloomberg.com, 2:30pm Eastern yesterday afternoon:

Breaking News

•Paulson Clashes With Congress, Warns Against Using Bailout as a `Panacea'
•U.S. Producer Prices Plunge 2.8%, Most on Record, as Global Demand Shrinks
•Home Prices Tumble in 80% of U.S. Cities as Foreclosures Drive Down Values
•Stocks in U.S. Retreat; S&P 500 Index Falls Below Lowest Close Since 2003
•Berkshire Credit Risk on AAA-Rated Debt Soars in Sign of Investor Anxiety
•Falcone's Harbinger Capital Faces Potential $200 Million Loss on Navistar
•Bank of America's Lewis Says Merrill Takeover Is `On Track' as Shares Fall
•Senate's McConnell Calls for Expediting $25 Billion of Loans to Automakers
•Hijacked Saudi Tanker Anchored Off Somalia Coast; Rescue Attempt Unlikely

This is what I take away from these headlines:

Seeing the chinks in "Teflon Hank's" armor. Hank has made big mistakes with TARP. He had the wrong plan, communicated it poorly and, as a result, sharply undermined his own credibility with Congress and the American people. That said, he was in a difficult position, made decisions that I believe were done with the best of intentions and changed course when he realized he was wrong. And for this he deserves credit. However, now that he is no longer Teflon Hank, he has to work extra hard to educate Congress on how and when TARP funds should be used. He is being bombarded on all sides by special interests and getting pressure from every faction in Congress. Had he done a better job of planning and communication upfront it would be much easier to manage the current situation, but this not the way it played out. What should have been a surgical strike of deploying massive funds into key areas (e.g., cleaning up busted bank balance sheets a la Good Bank/Bad Bank and developing a sensible mortgage restructuring solution, NOT opening the U.S. taxpayer's checkbook to virtually any bank that wants a capital cushion, money that will sit idle and not be used for capital formation) will invariably turn into a free-for-all. I can feel my wallet getting lighter by the minute, which would be ok if I felt the funds were being spent in a prudent manner. Which I don't.

The real economy shouts "No Mas." Just as Roberto Duran uttered those fateful words, the massive drop in U.S. producer prices is saying the same thing. Cratering commodity prices - metals, oil, etc. - are simply an outgrowth of the global economic slow-down. While lower prices are good, the speed and depth of the drop only exacerbated current problems: all that new production capacity that came onstream to take advantage of high prices are being mothballed only months later. Higher cost structures in the face of a precipitous drop in demand equals producer losses for a long time. And the drops were are talking about are of historic proportions, meaning that the adjustment period for demand to catch up to production capacity is likely to take years, not months.

Falling real estate prices aren't limited to the "go-go" markets. With 80% of U.S. cities showing price declines, the real estate bust is far more pervasive than one might have imagined. And, of course, falling prices beget falling prices: vacant houses in foreclosure drive down the values of adjacent housing stock, which in turn places those houses at greater risk of foreclosure, and so on. Further, these problems are worsened by rising unemployment, falling wages and ever-rising healthcare costs. We are likely in the midst of a downward spiral that can only be braked by fixes in the real economy; restructuring mortgages is a drop in the bucket if unemployment approaches 10% and people can't make even reduced monthly payments. We've just seen the beginning of the story; how the rest plays out is a function of how our new President, in conjunction with other global leaders and Congress, work to get our economic engines running again.

The equity markets have created zero value over the past five years. Sure, there have been some IPOs (value in), secondary stock issuances (value in), stock buybacks (value out), dividends (value out) and compensation paid (value out), but the bottom line is that we have basically been treading water. And if you look back, you can make the argument that we've made little headway over the past decade. In addition to the adverse effects on people's savings and retirement accounts, it is very poor for consumer sentiment and people's attitudes in general. Why did I work so hard only to be back where I started? While the issue is certainly more complex, the headline is very corrosive to peoples' sense of worth, accomplishment and safety.

Even Warren Buffett isn't immune from the market's harsh judgment. First, it was his deeply-underwater preferred stock investments, most notably in Goldman Sachs. Now, the cost of protecting against Berkshire's credit has skyrocketed to a level more in line with BBB-rated companies, not the vaunted AAA that it currently holds. Fears are centered around the long-dated equity index put options it wrote beginning in 2005, on a notional amount of around $40 billion. In Warren's eyes he has secured almost $5 billion in option premium that he can use for acquisitions, stock buybacks, etc. In the market's eyes some believe Berkshire is going to have to come up with collateral for the decline in the short option position. Reality is, the only way Berkshire has to post is if its credit rating falls below a pre-determined level. As unlikely as this may seem, those in the credit derivatives markets are looking at Berkshire credit risk with a wary eye. Sentiment in this market is as volatile as the VIX: if the market continues to push against Berkshire's credit will a downgrade become a self-fulfilling prophecy?

Even the "do no wrong" hedge funds are getting crushed. Phil Falcone's Harbinger has been on a roll for several years, making him among the richest and most feared activist hedge fund managers on the planet. But lately things haven't been working out so well for Harbinger, with the Navistar loss only the latest among a sea of bad news. To be fair, Harbinger is doing better than many and long-term, Mr. Falcone's fund has been a super-performer. But like many things, people often get too much credit in good times and too much blame in bad, but hedge fund managers and their compensation models make it hard to feel bad for them when times get tough. This is the time to fix the compensation models such that payment horizon and investment horizon match. Medium and long-term investors like Mr. Falcone should secure long-term lock-up money in line with their strategies, but should only collect performance fees that match holding periods. Having activist and longer-term thematic investors getting paid quarterly makes no sense. The best-in-class like Harbinger should lead the way on a new compensation model to better align GPs and LPs. Now.

B of A and Merrill - the market says no. What once seemed like a steal now looks both pricey and risky. Mega-mergers almost ever work, especially when the cultures of the firms in question are so different. The equity markets have been properly cynical about the merger going through, even in the face of Ken Lewis's insistence that he is committed to the deal. The market is offering him an out - he should take it. The value destruction facing BAC shareholders is monumental: bad culture fit, fleeing brokers, significant potential losses looming in its mortgage and derivative books, etc.. This is the time to protect your shareholders and to focus on execution of the core business plan. Bolting Merrill Lynch onto B of A cannot be seen as core to B of A's business plan. It was a grasp at what seemed like a compelling opportunity. Only the equity markets didn't believe it made sense. And I don't, either.

Bail out the automakers - or else... This partially has to do with Mr. Paulson's loss of control over TARP. The lobbyists and spin-masters are out in force, and all eyes are focused on the auto industry. Yes, it's in turmoil. But the proposals on the table are perhaps worse than Mr. Paulson's injection of $25 billion into Citigroup before they cleaned up their on- and off-balance sheet liabilities. A campaign of fear is being spread by entrenched interests, who want to see the sector bailed out and for its life to be prolonged until - who knows. The U.S. auto industry as we know it is dead. It has to die. The issue of legacy retirement and health care costs absolutely has to be dealt with before putting in dime one. That said, the industry can be restructured and the productive capacity used for other pursuits. Large chunks of the auto parts industry can be sold to more efficient foreign automakers who are already big customers. Certain factories may be able to be sold as well. Other plants can be retro-fitted for other activities, perhaps relating to core infrastructure projects to create attractive jobs, many of which can go to current auto workers. It would be far cheaper to pay workers a living wage and to give them training while plants are being re-tooled for other activities than pouring $25 billion into a sector that will need similarly-sized injections every quarter until the U.S. Treasury is bankrupt. We need radical change and creative thinking, not the same linear, predictable, pork-barrel line of thought that is the norm for legacy unionized industries.

Global instability on the rise. The recent spate of hijackings is indicative of an already unstable world in need of cooperation and order. Somalia, Yemen, Pakistan and Afghanistan will continue to be threats to the U.S. and our allies without a multilateral effort to ferret out terrorists and break their lines of funding. This will require information and intelligence sharing, jointly funded and staffed, that illustrates an unprecedented level of multilateral support that eventually serves as a deterrent to bad actors. Hopefully our new Administration can move this initiative forward - and fast.

Times are difficult and are likely to get tougher, and there is a lot of work to do. But much of the work isn't a mystery - it just need to get done by people with brains, heart, courage and vision. This isn't a popularity contest; it's about serving our country. If today's global turmoil isn't enough of a call to action, then I don't know what it will take.