Friday, January 02, 2009

The Coming Economic Mess

Last weekend's Wall Street Journal carried a brief but potent piece by Peter Schiff, President of Euro Pacific Capital, entitled "There's No Pain-Free Cure for Recession."

Schiff, a self-identified member of the Austrian school of economics, casts new doubt on the vaunted coming $1T stimulus package later this month. Reminding us of the common sense of cutting spending and cleaning out weak businesses in the periodic recession that grips all economies, he begins his editorial,

"As recession fears cause the nation to embrace greater state control of the economy and unimaginable federal deficits, one searches in vain for debate worthy of the moment. Where there should be an historic clash of ideas, there is only blind resignation and an amorphous queasiness that we are simply sweeping the slouching beast under the rug.

With faith in the free markets now taking a back seat to fear and expediency, nearly the entire political spectrum agrees that the federal government must spend whatever amount is necessary to stabilize the housing market, bail out financial firms, liquefy the credit markets, create jobs and make the recession as shallow and brief as possible. The few who maintain free-market views have been largely marginalized.

Taking the theories of economist John Maynard Keynes as gospel, our most highly respected contemporary economists imagine a complex world in which economics at the personal, corporate and municipal levels are governed by laws far different from those in effect at the national level.

Individuals, companies or cities with heavy debt and shrinking revenues instinctively know that they must reduce spending, tighten their belts, pay down debt and live within their means. But it is axiomatic in Keynesianism that national governments can create and sustain economic activity by injecting printed money into the financial system. In their view, absent the stimuli of the New Deal and World War II, the Depression would never have ended.

On a gut level, we have a hard time with this concept. There is a vague sense of smoke and mirrors, of something being magically created out of nothing. But economics, we are told, is complicated."

Allowing for Schiff's sarcasm, he has a valid point. It's interesting to see Keynesian economics brought back to reality by exposing its central flaws so directly.

Schiff continues,

"It would be irresponsible in the extreme for an individual to forestall a personal recession by taking out newer, bigger loans when the old loans can't be repaid. However, this is precisely what we are planning on a national level.

I believe these ideas hold sway largely because they promise happy, pain-free solutions. They are the economic equivalent of miracle weight-loss programs that require no dieting or exercise. The theories permit economists to claim mystic wisdom, governments to pretend that they have the power to dispel hardship with the whir of a printing press, and voters to believe that they can have recovery without sacrifice.

Governments cannot create but merely redirect. When the government spends, the money has to come from somewhere. If the government doesn't have a surplus, then it must come from taxes. If taxes don't go up, then it must come from increased borrowing. If lenders won't lend, then it must come from the printing press, which is where all these bailouts are headed. But each additional dollar printed diminishes the value those already in circulation. Something cannot be effortlessly created from nothing."

This is really the crux of the matter in the modern global economy. Individuals must borrow capital they do not have, in order to use it. Nations either borrow, tax, or devalue their currency and create inflation. There is no other 'out.' Congress can't simply create a new way of financing the coming huge spending programs. It must choose one of these three, two of which require national belt-tightening elsewhere, in time or sector, if the spending is to go forward.

Schiff concludes by observing,

"By borrowing more than it can ever pay back, the government will guarantee higher inflation for years to come, thereby diminishing the value of all that Americans have saved and acquired. For now the inflationary tide is being held back by the countervailing pressures of bursting asset bubbles in real estate and stocks, forced liquidations in commodities, and troubled retailers slashing prices to unload excess inventory. But when the dust settles, trillions of new dollars will remain, chasing a diminished supply of goods. We will be left with 1970s-style stagflation, only with a much sharper contraction and significantly higher inflation.

The good news is that economics is not all that complicated. The bad news is that our economy is broken and there is nothing the government can do to fix it. However, the free market does have a cure: it's called a recession, and it's not fun, easy or quick. But if we put our faith in the power of government to make the pain go away, we will live with the consequences for generations."

I agree wholeheartedly with Schiff. As I noted in the linked post above to my last piece on Samuelson's accelerator-multiplier theory, all economies must cycle through recessions. It's a mathematical certainty stemming from the natural consequences of varying economic growth rates.

Instead of letting a normal recession clean out bad business models, reallocate resources to their most efficient usage, and let risk be taken sensibly, we are, instead, embarking on the lunacy of Federal investment by fiat of printed money.

Reading Schiff's piece, I think my experiences with the Nixon-Carter era stagflation is, sadly, going to be useful soon.

Thursday, January 01, 2009

Dangerous Advice From The WSJ's James Stewart

The Wall Street Journal employs a particularly inept and whiny investments writer named James B. Stewart, author of its "Common Sense" column.

I last wrote of Stewart's dubious credentials here, in August, in regard to his having fallen victim to the auction rate securities mess. In that post, I observed,

"Which brings me to a hilarious companion piece in the same WSJ edition.
It seems that James B. Stewart, a regular investment columnist who writes "Common Sense," lost his. He spent yesterday's column bitching about his lack of satisfaction as a 'victim' of the ARS mess.

But, back to Mr. Stewart. For someone so lofty as to write a column in the WSJ on investing, wouldn't you think he would know better than to offer an excuse like the above for purchasing ARS notes? Really- something for nothing, James?

Free extra returns, just for 'valuable clients?'

I have to laugh, because I've never bought any structured finance instrument in my life. The market-making assurances on these instruments are simply not to be believed.

Anyone with any experience in securities markets would know this.

Should James B. Stewart even be writing a weekly investing column for the WSJ, if he was taken in by such a simple ruse as the ARS game, and went for the old 'something for nothing' con?"

In yesterday's edition of the Journal, Stewart weighs in on those conned by Bernie Madoff. Here are some priceless gems from Stewart's attempt to excuse all those victims of any personal responsibility in the matter,

"Now that some of the dust is settling around the Bernard Madoff scandal, there has been a growing tendency in some quarters to blame the victims, at least in part. According to these theories, they should have recognized that annual returns of around 10% in both good times and bad were too good to be true. They should have been suspicious of Mr. Madoff's vague explanations of how he arrived at those results. And to the extent he described his strategy, which involved the simultaneous purchase of stock and sale of option contracts, they should have noticed that there wasn't sufficient volume in those options trades to account for the reported gains.

The lesson from such criticisms, I suppose, is that we should all turn ourselves into forensic accountants. I find that preposterous, not to mention distasteful, given that some of these people have lost their life savings. After all, consistent returns in good and bad markets are the selling point for nearly every hedge fund. There are plenty that have reported much larger annual returns without raising eyebrows. Indeed, Mr. Madoff's returns were good, but not so spectacular as to raise undue suspicion. As for his vague explanations, they were no vaguer than those of many other hedge-fund managers and even mutual-fund managers."

For someone writing a column entitled 'Common Sense,' it seems Stewart has decided that investors really shouldn't have to bring any to the table. Madoff's return weren't just consistent- they were practically constant and uniform! Big difference!

It's not forensic accounting to observe that returns are too steady in markets that fluctuate, and you can't get a straight, understandable and believable answer regarding how a manager is able to achieve such unwavering results for years on end.

What Stewart does recommend, later in his piece, are basically four things:

-a well-known manager should have a well-known accountant
-diversify your investments among different managers
-remember that above-average returns have above-average risk
-don't use middlemen to find a manager

The second and third points are basic investment truisms. The first is probably a good idea, but might cause you to avoid a credible manager. Everybody starts somewhere, and every accountant has to have a first client. That doesn't make him/her a criminal.

As to using middlemen, that's a tougher call. Some managers can't really be accessed any other way. Most retail investors don't have the time or knowledge to contact individual managers who will give them the time of day. That's why we have mutual funds. For most investors, either a private bank or pension fund offer a pre-screened selection of managers, i.e., they behave as middlemen.

Stewart's final recommendations are, for the most part, either harmless or obvious.

But his worst offense is in the opening paragraphs of his article, in which he effectively absolves investors from having to take responsibility for using common sense to assess the likelihood that an investment manager is engaging in real, verifiable, extraordinary investment strategies.

The Wall Street Journal shouldn't be publishing this dangerous nonsense, or, in my opinion, anything by James Stewart.

The Coming Cost of Mortgage "Cram-Downs"

Yesterday's Wall Street Journal reported that, thanks to the severe credit crunch, current recession, and imminent control of both Houses of Congress and the Oval Office by Democrats, even mortgage lenders are bracing for some sort of "cram-down" legislation in the coming months.

The TARP bill originally had such a provision, but it was struck on the threat of veto.

In the past, all bankruptcy law modifications have carefully avoided violating residential mortgages on primary residences, since it was understood that introducing such risk into mortgage finance would lead to higher rates and probably downpayments, as well.

Welcome to the new world of mortgage finance. What investor will want to own mortgage-backed securities which are vulnerable to any small-town bankruptcy court judge's whims? It may not be a matter of higher rates or larger downpayments. Much of the mortgage-backed securities market might just vanish if such legislation passes.

Like it or not, the issue boils down to people being responsible for the obligations under contracts into which they freely entered.

Using cram-downs now, of course, rewards those people who engaged in excessive borrowing. And those who can now claim to have been coerced.

But the signal this sends for future contracts is very disturbing. Essentially, we are slowly evolving contract law into a scheme in which, if you don't get your desired result from the contract, somebody in a bankruptcy court will let you void the contract.

How can we, as a society, continue to function economically amidst such a legal vagueness in the most basic of all advanced economic systems?

Wednesday, December 31, 2008

Dell's Failing Turnaround

Today's Wall Street Journal featured an article about the Dell 'turnaround' in the Marketplace section.

Almost a year ago, in January, I commented on a Journal piece about returning CEOs reviving their companies. I wrote about Dell,

"Why do you suppose that these CEOs, as a group, mostly failed to move their firms to consistently superior total return performance?

In Dell's and Starbuck's cases, I question if they ever will. I believe, for reasons I've discussed in labeled posts on both CEOs and their companies, that competition, growth and simple Schumpeterian dynamics have worked to end their time of consistent outperformance."

It won't matter what sort of shuffling of deck chairs on his personal Titanic that Michael Dell does now. He can change executives, shuffle one to another post, but it won't change the business. Or customer behavior.

As this nearby, one-year price chart for Dell and the S&P500 Index clearly demonstrates, the company still struggles relative to the market.
Dell is down for the count. Nothing Michael Dell does is going to change this Schumpeterian fact.

Tuesday, December 30, 2008

UPB & Madoff: Custody Again

Today's Wall Street Journal featured an article in the Money & Investing section detailing Union Bancaire Privee's attempts to explain how it became entangled with Bernie Madoff. According to the piece, half of the bank's 22 funds were invested, to varying degrees, with Madoff.

To me, the most revealing passage was this one,

"..UBP said it had reservations about the way Mr. Madoff ran his investment firm, particularly the lack of an outside administrator and custodian (my bold), which would have provided an added degree of certainty that the investments Mr. Madoff claimed to have made were real. But UBP said it overcame those concerns because of Mr. Madoff's firm's status as a "reputable" broker-dealer that was registered with the Securities and Exchange Commission (my bold), as well as Mr. Madoff's longstanding reputation in building Wall Street's financial markets infrastructure."

As I wrote here last week,

"As I reviewed the mechanics of Madoff's scheme of undisclosed numbers of individual accounts, rather than a single, explicitly-spotlighted fund, with my partner, my belief that Madoff had long ago discovered loopholes that I, too, observed earlier this decade grew significantly.

The most important element of his fraud, without question, was the lack of independent custodial inventory reports of financial assets held in accounts for clients. I can't emphasize enough that this alone left every one of Madoff's clients vulnerable."

So, it seems that even a veteran, experienced private bank looked the other way and simply through prudence and common sense to the wind. They let an unrelated aspect of Madoff's investment business- his separate, registered broker-dealer- color their choice of him as an investment manager.

Anyone in the business knows that just because business A is regulated and supervised by the SEC means nothing about a business B, which is not registered.

But, apparently, UBP's staff knew better. Or so it thought.

These are called "con" games for a reason. Short for "confidence," the schemes always work by getting the mark, er, investor, to trust the fraudster, and give him their confidence.

Surprisingly, that's how easy it was for Madoff to accomplish his fraud. Whether he ever had an investment approach that made money is actually immaterial. And always was.

We now see that he managed to dupe the most experienced banks in the business, simply due to gaining their trust on bases other than his investment performance, a thorough review of his methodology, or any other typical object of due diligence.

Leading me, once more, to state that everyone who lost money with Madoff deserved to, because they were motivated by sheer greed. Greed that overwhelmed diversification and common sense investigations that any other investment manager would have had to undergo.

Monday, December 29, 2008

Sheila Bair's Mixed Signals

Friday's Wall Street Journal's Money & Investing Section carried a lead article entitled "Banks Told: Lend More, Save More." With a picture of FDIC's Chairman, Sheila Bair, accompanying it, the piece explored the mixed, opposite signals now being given to US banks- lend what the Federal government has invested in them, but, at the same time, build capital cushions.

As Brian Wesbury pointed out recently, about which I wrote in this post,

"In a related argument, Wesbury noted something genuinely novel and elegant. He opined that, with the Fed pushing rates to nearly zero, there was no way bank lending could expand.

He pointed out that, at a time when risk in the economy, among borrowers, is still so high, and rates are now so low, there is absolutely no way lending can be cost-justified. The risk-adjusted returns to ultra-low interest loans are negative. Wesbury thus observed that the problem isn't a lack of borrowers, but a lack of lenders willing to effectively take a loss on new loans.

He then pointed out how ludicrous was the situation in which banks have been placed by Treasury and the Fed. They are pilloried if they don't lend out the new, unwanted TARP-based 'capital' bestowed upon them by Hank Paulson.

But, if they do make loans at market rates in this environment, those loans will surely go bad, too, resulting in even more balance sheet damage and reprimands from regulators."

It's never fun to have to note a situation of governmental incongruity and wrong-headedness. In this case, Wesbury called this a full two weeks ago.

This is why, in my opinion, if we're going to nationalize the banking sector, we should do it correctly. Lending standards should be articulated from Washington, with clear, quantitative guidelines. If Federal money is going to back the banking system, let's not have loose, prone-to-misinterpretation signals.

If Treasury, the Fed and FDIC all want more bank lending, they should clearly express that in a formal regulatory message, complete with guidelines and a statement of responsibility for subsequent loan performance.

This is why it's not a great idea to mix Federal funding with private funding of banks. Now we have Federal directives to private shareholders that their bank employees should be doing more lending, though, as Wesbury notes, the chances of getting rates to compensate the risks are nil.

Gee, didn't we just spend about a dozen years doing this in the housing sector, via Fannie, Freddie, Barney Frank and two Presidents?

We could be in for a long, long learning period under the new, quasi-nationalized banking system the US now possesses.