Friday, April 10, 2009

The Pulte-Centex Merger

The big news a few days ago, before the ephemeral runup in the major equity indices due to Wells Fargo's one-quarter earnings announcement, was the combination of homebuilders Pulte and Centex.

Notionally a purchase of weaker Centex by Pulte, the Wall Street Journal article assessing the move claimed that this means Pulte thinks the bottom of the housing market has been reached.

Personally, I don't believe this is true. If anything, I think it signals that Pulte's management- and that of Centex, for that matter- are girding for a longer dry spell.

Typical of industries undergoing a decline in sales and uncertain long term prospects is consolidation. It's a Schumpeterian thing. As well as basic industrial dynamics. When heavily-leveraged balance sheets and slow sales combine, so do companies. Cost savings become paramount for survival.

As I noted in yesterday's post about the life insurers, what is happening in the homebuilding sector is normal. The life insurance bailouts are not, and actually confound and delay the reckoning of markets on poor performers.

By the way, the homebuilders' combination will most certainly result in job loss. Oh my God!

Somebody shovel some TARP money or a special program in there to preserve the two companies!

Sounds silly, doesn't it? And it is. For both the homebuilders and life insurers. And any other company, the management of which has run it up on the rocks.

Stepping back from the details, it's easy to see the sensibility in the Pulte-Centex merger. Homes were vastly overbought and overbuilt for at least the last two years. Therefore, there's less need for resources in the homebuilding sector. It's logical that it should shrink, with firms combining, employees being shed, as well as assets and expenses, where possible.

Perhaps if the national scale of homebuilding had proceeded somewhat less frenetically, both companies could have survived. But it didn't. So they didn't, either.

The same should be true of any sector. Government meddling only delays the point at which incompetent management and an oversupply of resources are finally removed by market forces.

In the meantime, we all pay, with tax dollars, for our government's wrongheaded subsidization of some companies, but not others.

All must be left to weather Schumpeter's storm of creative destruction without taxpayer "help."

Thursday, April 09, 2009

Another Mistake: Bailing Out Life Insurers

I read with horror earlier this week that the federal government has decided to bail out at least three large life insurers- Hartford, Lincoln and Genworth. All three had quickly acquired small S&Ls or banks last fall, in order to get their snouts into the federal TARP trough.

Reading the Wall Street Journal piece announcing this development, I was sickened to learn,

"The news will come as a relief to a number of iconic American companies that have suffered big losses made worse by generous promises to buyers of some investment products. Shares of life insurers have fallen more than 40% this year. Their troubles led to a string of rating-agency downgrades that, in a vicious cycle, made it more difficult for some insurers to raise funds.

Life insurers had for a time seemed to be somewhat immune from the credit crisis, since they tend to invest in relatively safe assets in order to match their liabilities. These companies got into trouble for two main reasons, both tied to the weak financial markets.

First, many of the roughly two dozen insurers that dominate the variable-annuity business made aggressive promises on these popular retirement-income products, guaranteeing minimum returns, no matter what happened to the stock market. With the market's decline, the issuers are on the hook for big payouts, though most of the payments won't come due for 10 or more years. Second, the insurers also have lost money on the investments in bonds and real estate that back their policies.

Many life insurers also hold large portfolios of residential mortgage and commercial real-estate assets. While most of the assets are highly rated, further downgrades of those assets could put considerable pressure on insurers, forcing them to take additional write-downs."

So, basically, life insurers, as they seem to do once every few decades, sold products which promised returns they cannot deliver. And consumers were stupid enough to buy these.

Further, the insurance executives then invested premiums in assets of questionable value, which have now plummeted.

Such incompetence ordinarily leads to bankruptcy, sale of assets to a competitor, and the exit of the worst-managed firms.

Now, our government is rewarding these morons by bailing them out. Better-managed firms will be burdened by having to compete with insurers with access to cheap government capital.

And consumers won't learn to be more judicious in their purchase of investment products.

This bailout is troubling all the way around. Just a disastrous development.

The article further declared, as if to justify this government intervention,

"The life-insurance industry is an important piece of the U.S. financial system."

That's really rich. Does anyone think our financial system would have unimportant pieces just sitting around, operating for no good purpose? I don't think any existing financial players aren't "an important piece of the U.S. financial system," do you?

Frankly, I'm disappointed in the lack of critical reporting in the Journal on this rather important story. Why do I have to rely on my own memory to remind me that life insurers go through this cycle every 10-20 years?

Shoddy reporting of a mistaken financial rescue.

For a more uplifting story, consider the Pulte-Centex merger in the home building sector. That's an example of what should happen to struggling firms. I'll write about that tomorrow.

Wednesday, April 08, 2009

CNBC's Irresponsible Commentary

I've noted with some disappointment the continuing trend on CNBC of its anchors and reporters to present themselves as experts, rather than the talking heads they, in fact, are.

It's become so bad that I found myself describing it to a friend yesterday like listening to the radio. I have the channel on for news, and the occasional interesting guest. But with the menu of clunkers who are the on-air co-anchors, and too many irrelevant guests, like this morning's Howard Dean, it's getting tougher by the week.

Take morning co-anchor Mark Hanes, for example. A lawyer by training, he has recently been trumpeting his personal call of the equity market bottom. Nevermind that we have no idea if this is yet true, nor for how long.

NYSE floor reporter Bob Pisani focuses less on news, and more on cheerleading equities as if the market has a personality.

The market, she be happy.

Rather than attempt to accept and understand reality, he is prone to statements like,

'What we need is for some buyers to step up and provide broad volume.'

By far the most foolish, inane and pompous of the group, though, is senior economic idiot Steve Liesman. This irresponsible goof ball has now become a replacement for Larry Kudlow on the latter's evening program, causing me to wonder if Kudlow is back on cocaine or some other addicting, controlled substance.

Here's why.

I have an interest in science. Suppose I report on physics, and read about the subject, in order to be able to ask sensible interview questions, with the objective of providing viewers with interesting information from leading physicists.

One day, I begin to follow my interviews with my own thoughts on the views of the physicist whom I've just interviewed, criticizing his remarks, and adding my own opinions. Over time, I begin to appear personally to talk about physics theories and discoveries, their credibility, and detailed technical analyses.

That's how Liesman has morphed. Rather than have someone with credentials, like Brian Wesbury, or a Nobel Laureate like Joseph Stiglitz, remark on some piece of economic news, Liesman now personally inserts his own uncredentialed, uneducated interpretations and opinions.

It's become so prevalent and sickening that I am heading for the "mute" button on my television controller when I hear the idiot's voice.

I truly cannot understand why Kudlow, a degreed economist, would pay the slightest attention to Liesman. To make the guy Kudlow's replacement when the latter is away is just incomprehensible. Maybe CNBC forced Kudlow into that "choice."

Although a leading business cable channel, CNBC has a remarkably small audience when compared to Fox's News Channel. So I guess the silver lining is that not that many people actually listen to the CNBC anchors' and reporters' drivel. On the other hand, enough do that the occasional interview will move markets.

I can only hope that, like me, most viewers ignore the CNBC employees and focus on the news and occasional decent guests.

GM's Pathetic Latest Development- The PUMA

In one of the more comical and idiotic developments at ineptly-run, nearly-bankrupt GM, the nearby "vehicle" represents the firm's latest attempt to please its newest stakeholder, i.e., Treasury.
As a Wall Street Journal article reported,
"General Motors Corp. is teaming with Segway Inc., maker of the upright, self-balancing scooters, to build a new type of two-wheeled vehicle designed to move easily through congested urban streets.

The machine, which GM says it aims to develop by 2012, would run on batteries and use wireless technology to avoid traffic backups and navigate cities.

The struggling auto maker, surviving on a government lifeline, is looking to generate enthusiasm for its increasingly uncertain future ahead of the New York auto show this week.
GM has slashed product-development programs, advertising and spending on auto-show events. But it will take to the streets of Manhattan on Tuesday to show off a prototype of the vehicle, called PUMA, for Personal Urban Mobility and Accessibility."
Unfortunately, April Fool's day was last week. So we can't dismiss this as a joke. The Journal piece further noted,
"GM didn't say how much the machines would cost, but research chief Larry Burns said owners would spend one-third to one-fourth of the cost of a traditional vehicle.

PUMA would have a range of about 35 miles. GM said it aims to use so-called vehicle-to-vehicle technology to avoid traffic problems and potentially have it navigate itself through city streets."
What's next, bicycled from the former auto-making titan? Maybe those plastic, foot-powered toy cars for your toddler? Because that, too, would be: green, non-carbon-emitting, personal and downsized.
But let's be realistic and serious for a moment. If the PUMA is truly going to cost only a quarter of a normal car, how in the world does this address the financial problems of GM?
They don't even hold the basic patents or rights for the Segway. So their margin on this thing will probably even less than on a small car. Of course, with federal government aid, GM will be forced to assemble it with UAW labor.
Does anyone think the PUMA will be profitable? And at what volumes? Most New Yorker's don't even own cars. Commuters couldn't really drive these things into Manhattan, because they'd be out of juice by the end of the commute.
How about accidents? What happens when the PUMA runs over a pedestrian? Or is creamed by a taxi running an amber light? How would you lock this thing up, or store anything in it? It looks like thieves could just pull a pickup truck next to it, get out and lift the thing into the back of the pickup. Goodbye PUMA.
I don't even want to imagine the insurance rates for owning and driving it in a major US city.
It's a joke. Only not the funny kind. More like the continuingly pathetic sort.

Tuesday, April 07, 2009

Volcker's Temperance on Regulation

The Wall Street Journal ran a special section on March 30th resulting from its recent conference on financial regulation. Frankly, I found most of it to be either a rehash of ideas already put forth by others, including myself. There were a few highlights of note. One was Peter Fisher's remarks. Another were some quotes from a discussion including noted hedge fund short James Chanos.

And Paul Volcker's observations on changes in regulation. It is on this topic I wish to write today.

For me, the headline is that, despite being associated with an administration that is rushing about demanding excessive regulation, punitive actions toward private sector executives, and generally attempting to morph our capitalistic system into a fascist one, Volcker enunciates a great deal of common sense.

His remarks begin by focusing on potential changes in the regulatory approach to financial services,

"But beneath the seeming consensus on the broad elements of reform, there is a lot of disagreement. There's a lot of disagreement in principle and even more disagreement in detail. So there is a great kind of political pressure to get things done in a hurry, strike while the iron's hot.

I guess my principal feeling is: Not too fast, because any specific reform raises questions about how it fits into the whole system. And unless you have some idea of the direction in which you want the system to go, it's a little premature to be taking too much specific action.

The other way to look at it, which I favor, is no, there are distinctions that legitimately can and should be made, not only on institutional grounds but on historic grounds and given the present framework we have. And the one is a commercial bank-centered approach, accepting that commercial banks are going to be the core of any system. They've been regulated, they're going to continue to be regulated. We can improve that regulation. Those institutions have a fiduciary responsibility to serve the public, to serve their individual clients, to serve business, to serve governments. That's their job, and they also underlie the infrastructure.

The rest of the system I call a capital-market system. I would not consider them at the core of the system. They might be important, they innovate, they're flexible, but the implication is they don't need to be regulated to the extent of the banking system. Transparency is important. If one of those institutions gets so big they're in some sense systemically important, maybe we have to regulate them with capital requirements. Otherwise, I don't think there should be any presumption that the government is going to rescue them."

I find this astonishing and comforting. Volcker is essentially arguing that we retain our focus on banks, and reinforce with investors that non-bank participants in finance bear risk that will not, despite current federal government actions, be rescued. In this, I think Volcker is correct, and, if influential in the current administration, a tremendous force for slow, sensible changes, if necessary, in regulation.

Volcker then comments on this new notion of a 'systemic risk regulator.' His comments include these,

"Everybody wants a systemic-risk regulator. What is that supposed to do? And what do you mean by systemic risk? Are we talking about a regulator that's going to regulate in detail those institutions? They're going to send in examiners? If so, what do the other banking regulators do? Do they follow the same policies, different policies?

Or do we mean by systemic-risk regulator they're looking for overriding trends in the system that will over time be destructive? Should they have been sensitive to the subprime-mortgage problem and the enormous growth in mortgages, not by looking at individual institutions but by looking at what the market as a whole was producing. Should they have been concerned about an undercapitalization of the banking system generally? That's a different approach than looking at individual institutions.

And what is that systemic-risk regulator supposed to do? What is his charge? Let's not invent the role before we know what the charge should be.

Again, I think Volcker is incredibly astute in calling a spade a spade. Having been involved in my share of risk-related matters while research director at Oliver, Wyman & Co., now the financial services consulting unit of Mercer Management Consulting, I can vouch for Volcker's reticence in tackling this issue.

Whenever I hear government officials begin to babble about 'systemic risk,' I immediately want to ask him/her to define, with equations and variables, precisely what they mean.

Of course they could not. I'm quite sure that even risk management practitioners in most of today's commercial banks and asset management firms could not, either. Or at least not in anything approaching a univocal view of the subject.

Volcker correctly notes this, and even some of the potential conceptual definitions. In this, I think he helps put the brakes on any rush to invent this type of risk, and then regulate it. We are very, very far from such a point, and Volcker wisely says so.

The Journal article which contains Volcker's remarks ends with his thoughts on a few related topics,

Fair-value accounting: That's a big subject that I don't think we're going to solve in the midst of all this turmoil, but it needs careful discussion and determination.

You have this enormous issue of compensation. Well, there is a great urge politically to do something. Most of what the political system would produce is probably destructive, yet there is a real problem of how to deal with compensation policies.

So I hope we take our time to have a kind of consensus on what the general framework of the system ought to be, and what makes sense in individual instances to put into that framework."

Overall, I found Volcker's comments surprising, given his association with the current federal government administration. He seems to be the Volcker of old, who slew the inflation dragon in the late 1970s and early 1980s, speaking clearly, even against prevailing political winds.

I'm pleased to see him providing counsel to government at such a perilous time.

Monday, April 06, 2009

The Recent S&P Rally

The recent 25% upward move in the S&P500 from early March to last Friday is the subject of much debate. Unlike the similar gains in the index from mid-November to early January, this recent rally comes amid allegations that the economic news has stopped getting worse.

Using the aphorism that equity markets turn prior to the economy, many investors choose to believe that, if the pace of economic deterioration has lessened, that's good enough to justify piling into equities again.

Not so fast.

Several things about the current financial markets and economic situation cause my business partner and me to be unconvinced that there will be a sustained upsurge in the S&P that, upon being viewed in six months or so, will prove to be the beginning of a long run, healthy bull market in equities.

First, the contextual news regarding the consequences of deleveraging, as opposed to the recession, about which I wrote here in January, continues to be grim. Consumer revolving credit is becoming either more expensive, less available, or both.

Commercial real estate defaults are heralded to be worsening. Job losses continue apace.

We believe that much of this is deleveraging-related, not purely or merely caused by the recession and, thus, will not be revived anytime soon, federal leverage notwithstanding.

Second, the speed of the recent index recovery, absent strong fundamental corporate earnings data, or, for that matter, much of any other private-sector economic news of a positive nature, suggests a trading frenzy based on hope, rather than a longer term investment opportunity based upon early signs of a genuine economic revival.

Finally, the volatility of the equity markets remains distressingly high. Rather than decay in a 'normal' fashion, as equity volatility did after the crashes of 1929 and 1987, the most recent equity market crash has resulted in a uniquely sustained, high level of volatility. In fact, it has risen this year, both through the late-January decline, and the recent rally.

From our research, we believe it is very unlikely that this volatility will be associated with a healthy, sustained rise in equity market prices. Since we don't try to time the market, missing the 55% rise in the value of our March call options portfolio is acceptable.

In fact, the situation is reminiscent of a year ago. In 2008, there were three months in which call options had significantly positive returns for a long enough period to have been realized - February, March and April. May had briefer and lower levels of call returns.

Ironically, the put portfolio in May reached triple-digit returns, but much later, i.e., after the September equity market carnage. April's puts attained near-triple-digit returns near the end of their lives.

The moral of this story is that, occasionally, one side of the derivatives positions of our portfolios will peak very early, while the other achieves much higher returns much later. In a turbulent market, this is not unheard of.

We think that's what we are seeing again in the current equity markets. Near term hope driving modest equity and call returns, while longer term puts will likely have higher returns later this summer.