Hank Paulson appeared before the House committee on (Lack of) Oversight and (Prevention of) Government Reform last week to defend his actions in the Bank of America/Merrill Lynch deal. For those of you who haven’t been following along, Bank of America CEO Ken Lewis has accused Ben Bernanke and Hank Paulson of pressuring him to complete the Merill acquisition even after discovering that the losses at Merrill were several orders of magnitude higher than what he thought when the deal was struck. Bernanke and Paulson allegedly told Lewis that he and the entire board would be replaced if he didn’t conceal the losses until the deal was approved by shareholders.

I didn’t think Hammerin’ Hank’s reputation could fall any further but after listening to his arrogant testimony this week, I think I have to revise that. Paulson cast himself as the hero in his testimony:

“Many more Americans would be without their homes, their jobs, their businesses, their savings and their way of life,” he said in written testimony prepared for a hearing Thursday.

While losses have been staggering, “that suffering would have been far more profound and disturbing” had the government not intervened, he will tell the House Oversight and Government Reform Committee.

“Our responses were not perfect … But, having had the benefit of some time to reflect, and to consider views expressed by others, I am confident that our responses were substantially correct and they saved this nation from great peril,” Paulson wrote.

Well, gee, thanks Hank. There is no way to know how things would have turned out if you hadn’t bailed out every firm that acted as a counterparty to your net worth (Goldman Sachs), but it’s nice to know it hasn’t affected your self esteem.  

While Bernanke prudently fell back on the “I don’t recall” defense, Paulson, believe it or not, defended his threat to Lewis:

Paulson said he told Lewis that reneging on the promise to purchase Merrill would show “a colossal lack of judgment.” He then pointed out to Lewis that the Fed could remove management at the bank if it saw fit, he said.

“By referring to the Federal Reserve’s supervisory powers, I intended to deliver a strong message reinforcing the view that had been consistently expressed by the Federal Reserve, as Bank of America’s regulator, and shared by the Treasury, that it would be unthinkable for Bank of America to take this destructive action for which there was no reasonable legal basis and which would show a lack of judgment,” Paulson said.

Paulson said he believed his remarks to Lewis were “appropriate.”

Faced with being forced out with only a golden parachute to cushion his fall, Lewis decided that maybe those Merrill losses weren’t really so important that they needed to be disclosed to BAC shareholders prior to voting on the merger. Based on the performance of BAC’s stock price since then, shareholders might disagree, but hey that’s a small price to pay for saving the “system”, right?

The charge that the failure of large financial institutions represents a systemic risk is one that suffers from a lack of evidence. Is the system really better off maintaining Citigroup on life support rather than letting it die a natural death? Is the system really better off by expanding the allegedly already too large to fail Bank of America? Is the system really better off when poorly managed companies are rescued at the expense of those who acted more prudently? Is the system really better off when losses are spread far and wide rather than concentrated with those who took the risks? What message does it send to prudent managers when their imprudent competitors are bailed out? Will they be so prudent next time?

The economic success of the US is not dependent on maintaining the status quo. Capitalism is a system which requires failure to advance. The failure of a few companies is not evidence that capitalism has failed but evidence that it is working. Failure sends a message to other market participants that the practices that caused the failure should be avoided. That message applies not only to private companies but to the government institutions that also failed us in this crisis. Attempting to return to the status quo rather than allowing private company failures and reforming failed government institutions does not advance us as a society. It mires us in mediocrity.

It is Paulson, Bernanke and Bush who showed a colossal lack of judgment. It is the management of Bear Stearns, AIG, Lehman, Merrill Lynch, Fannie Mae and Freddie Mac who showed a colossal lack of judgment. It is Alan Greenspan and all the member of the Federal Reserve who showed a colossal lack of judgment. It is most of Congress that showed a colossal lack of judgment. It is Tim Geithner and President Obama who continue to show a colossal lack of judgment. And it is the American taxpayer who will have to pay the tab for the colossal lack of judgment shown by all of them.

The long term consequences of government actions over the last two years will become evident to investors in the coming years, but for now, attention is focused on the immediate situation. And the immediate situation is still improving. The stock market rallied 7% last week as earnings season kicked off with some highly visible positive surprises. Goldman Sachs, JP Morgan, Bank of America and Citigroup all reported better than expected earnings (thanks in large part to the implicit guarantee of the government) and the remainder of the financial sector seems likely to follow suit in the coming weeks. Intel and IBM got the tech sector off to a good start. Next week will see a flood of companies reporting their second quarter results and while there will be a few disappointments such as Google last week, I believe the aggregate numbers will continue to be better than the market expects.

The better than expected earnings are being driven by improved margins as companies are reducing costs faster than sales are falling. Both Intel and IBM reported revenues below last year, but gross margins improved dramatically at both firms. This rise in productivity is good for the bottom line of individual companies but also underscores the need to encourage new business formation. These companies will not be eager to hire new workers until they have wrung every bit of productivity out of their surviving work forces. New business formation needs to be encouraged so that the unemployed have opportunities to re-enter the workforce. As I said above, returning to the status quo is not a recipe for long term success. During the campaign last year, President Obama proposed a policy of much reduced capital gains on newly formed businesses. Unfortunately, that proposal doesn’t seem to have made the cut, but it is one that should be revived asap.

The economic reports last week continued to show improvement. June retail sales were up 0.6% and while down signficantly from last year, seem to be stabilizing. Many focused on the rise in gas station sales that was driven by higher prices, but auto sales also improved and that is genuinely good news. Producer and consumer prices rose more than expected in June. Prices were down year over year, but sustained deflation seems highly unlikely. Mortgage applications rose for the second straight week as homeowners rushed to refinance. Applications for purchases fell though so I’d call the report mixed. Jobless claims also fell, but a lot of the recent improvement in claims has to do with seasonal adjustments related to auto production, so I’m a little skeptical of real improvement. The claims data should become more clear over the next few weeks. Housing starts and permits rose more than expected. While it will take more time for prices to start rising, the drag on GDP from reduced residential investment is coming to an end. Two indicators which tend to lag recovery, industrial production and inventories, continued to show weakness.

The earnings season kicks into high gear next week with well over 100 S&P 500 companies reporting. I expect the general tone to be positive, but with the rally last week, it will be interesting to see if the market can get through the 940-950 resistance level that has proved a signficant barrier for the cyclical bull market that started in March:

Looking at a longer term chart, the 950 level also corresponds to a downtrend line that starts from last May:

I don’t put a lot of emphasis on long term trend lines like this though since most traders who use technical analysis don’t have a long term focus. Nevertheless, in a secular bear market, the burden of proof has to fall on the bulls. I suspect though that this downtrend line will give way to higher prices for a couple of reasons. First, sentiment is still very negative; this rally has not suffered from a lack of skeptics. Second, money managers who have stayed steadfastly negative through this rally, will soon start to feel pressure to show they are participating. If we get through 950, I would expect to see a lot of bears throw in the towel. That includes those who are short and those who are long only and have been hiding in cash.

Joe Calhoun

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Significant earnings this week:

Monday - Merck, Texas Instruments

Tuesday - AK Steel, Apple Computer, Caterpillar, Dupont, Freeport McMoran, State Street Bank, United Technologies, Yahoo

Wednesday - Bank of New York Mellon, Ebay, Eli Lilly, Glaxo Smithkline, Morgan Stanley, Pepsi, Pfizer, Qualcomm, Suntrust, Boeing, US Bancorp, Wells Fargo

Thursday - 3M, Amazon, American Express, AT&T, Bristol Myers, Broadcom, Burlington Northern, Credit Suisse, Ford, Juniper Networks, Kimberly Clark, McDonald’s, Microsoft, Phillip Morris Int’l, Potash, UPS

Friday - Schlumberger

Selected charts:

Commodities corrected harder than stocks, but with the dollar looking weak again, I expect a fast recovery:

The dollar was down last week and is nearing major support:

International Real Estate continues to outperform US Real Estate:

As I mentioned last week, Asian real estate offered a good entry point. I think there is more upside:

One area of US reits that looks interesting is the mortgage reit sector:

Long term Treaury bonds took a beating last week. As I mentioned on the blog, demand for long Treasuries by foreign central banks has dried up:

Foreign bonds continue to outperform: