Friday, December 04, 2009

David Malpass On Near-Zero Interest Rates

I like David Malpass' clear, simple economic thinking and analysis.

In today's Wall Street Journal, he points out the damaging effect of Ben Bernanke's Fed's continued maintenance of near-zero interest rates.

Simply put, we know that high interest rates attract investment capital. So the Fed's current insistence on low rates drives capital overseas, starves non-financial US uses of capital, and actually helps delay the onset of any economic recovery.

With all of the Congressional debate over Fed independence and Bernanke's reconfirmation as Fed chairman, we're seeing him choose unwisely for the US economy's long term health.

Too-low US interest rates distort capital allocations, promote funding of projects which won't be profitable in normal interest rate environments, and when they exist at the same time that other countries' rates are higher, facilitate capital migration out of the US.

Malpass is correct in calling for the Fed to ignore Wall Street and raise rates. It's not like current low rates are creating jobs or producing a healthy economic recovery.

Maybe trying something more sensible would work?

The New Economy Circa 1990

I've argued in several posts, most notable here and, just this past September, here, that current employment expectations are based upon econometric models built upon data from an economic era prior to 1980 which no longer accurately describes the US economy. In the linked July post, I wrote,

"Prior to the 1991-92 recession and recovery, you are looking back to 1982-83, the early Reagan years, now very nearly thirty years ago. For perspective, was the 1960 economy different from that of 1930? Very much so. And the 1980 economy was so radically different from that of 1950, thanks to electronics and technological advances in communications as to make forecasting the former with models of the latter seem laughable.I suspect that's what is happening now. Those analysts and economists harking back to the early 1980s and using conventional models with estimates of consumer spending and labor growth have missed some important transformations in the US economy of 2009."

In September's post, I contended that, in addition to outdated economic models, other changes in communications and financial markets have had unaccounted-for impacts,

"It's safe to say that business communications and information movement has changed more dramatically and functionally from 1980-2010 than from 1930-1960, or from 1960-1990.

Specifically, the recent period has smoothed supply chain management between companies, so that the holy grail of goods-producing companies, inventory management that is as synchronous with retail sales as possible, has come a lot closer to reality.

Now add to this the rise of outsourcing, both onshore and offshore, and you have corporate employment becoming less sensitive to production volumes. Employment at suppliers becomes more volatile, but those jobs tend to be lower-compensated than the ones they replaced at the larger corporations.

Now add to this mix the public consuming business and markets information via free cable networks, such as CNBC or CNN. Today's consumer can view the reaction of institutional investment managers to some obscure report, previously unknown to consumers, such as durable goods orders, or employment reports, in real time.

Thus, consumer spending and confidence are able to be affected nearly immediately by financial market reactions, which affect the wealth of consumers via asset prices in their various investment accounts.

We probably have a tighter-, faster-linked series of economic phenomena which affect each other as inputs and outputs of information, goods and money flow, than ever before. Certainly far more than thirty years ago."

In Mark Gongloff's "Ahead of the Tape" column in this morning's Wall Street Journal, I read some rather significant reinforcement for my views.

Bear in mind that just an hour ago, the monthly employment report sent the S&P futures soaring nearly 12 points, or almost 1%, when initial job losses for November were announced as only about 12,000. The official initial unemployment rate for November edged down slightly, from 10.2% to 10%.

Never the less, Gongloff wrote, in part,

"The job market is getting less bad, but a full recovery remains a distant hope.

But fast-snapback hopes are countered by a mountain of data suggesting the recovery from this recession will be just as jobless as the prior two.

A record 9.3 million are working part-time because there's nothing else available.

New claims are falling, but the number of people drawing regular or extended unemployment benefits is holding steady at nearly 10 million.

Since May, more than a million workers have left the labor froce, which has essentially stagnated since November 2007, notes Miller Tabak economic strategist Dan Greenhaus. If and when people look for work again, they could push unemployment, which is a percentage of the labor force, much higher."

Gongloff reminds us that, while unemployment can't worsen forever, what we are left with currently is a lot of unemployed people who aren't going back to work. A lessening of new unemployed does nothing to affect this. Despite this morning's manic investor reaction to the jobless numbers, it's all about loss rates, not growth in jobs.

There is still no new net growth in jobs on the horizon, and, as one economist noted last week, it would take four years of 200K jobs/month growth to asborb all of the idled workers.

But what I found particularly satisfying were these closing passages in his piece,

"It is likely no accident that this and the prior two recoveries have been more or less jobless, with globalization and technology making it increasingly easy for companies to sharply cut labor costs.

"With the third jobless recovery, you have to say we shouldn't have expected companies to behave as they did in the 1960s or the 1970s," said Stl Louis Fed President James Bullard.

"We should expect this as the normal state of affairs." "

I've highlighted Bullard's remarks in red to emphasize his, and my, point.

It's not your father's economy anymore. It's an entirely new ballgame.

Those who cheer the slowing of joblessness, as equity investors did within seconds of the 8:30AM jobs data this morning, evidently don't comprehend our current situation.

As Gongloff detailed in just unemployment numbers, the US economy is far from healthy. And he's not even focusing on the financial sector's continuing weaknesses and dysfunctionalities.

I'm not a huge fan of pattern-fitting curves from one decade on those of decades long past. That said, without resorting to exact pattern-matching, let's recall that the Great Depression's equity markets featured several bull markets amidst the decade-long slump in those markets.

Living in the present, immediately post-September 2008, it's easy to understand why the equities market rally from March to now seems like a natural reaction, and the return of healthy US economic and financial markets.

Instead, for so many reasons, not the least of which the enormous amounts and different manners of federal government intervention in financial markets and the economy, I suspect we have only seen a brief bull rally amidst a continuing weak equity market which reflects a still-troubled, non-job-creating weak US economy.

Thursday, December 03, 2009

A Story About The Reach of Dubai's Troubles

Dubai World's recent debt servicing problems, mentioned in this post, gave US investors quite a scare for a day or so.

But, that was then. Now, we've had two days of so-called 'Dubai relief rallies.'

I'm still wondering why.

As I understand the situation, described by a guest on CNBC a few days ago, the UAE came in and guaranteed the local banks from failing due to either having made unrecoverable loans to the project, or holding the project's bonds as assets. The commentator was quite specific in noting that the project debt wasn't being backed by the UAE. Nor investors at large.

No, apparently in an attempt to reassure global investors of Dubai's continued efforts to join the list of the world's financial centers, the UAE would guarantee that Dubai's banks didn't touch off a global bank run or panic.

So, I'm wondering why this rather limited support for the gigantic fun city resulted in such massive US equity rallies.

Then I got my own, small version of the apocryphal JP Morgan story which I related in that linked post.

Yesterday, while getting a haircut, I discovered that my barber is Jordanian born.

She and I were talking about various topics and the Mideast came up. She opined on how extravagant Dubai is, with, she alleged, the world's only seven star hotel property.

She then confided that her boyfriend invested both his and her funds in the project, by way of a fund which bought condominiums. The amount of money wasn't small, given that she is a hairstylist. It was in significant six figures.

I asked if she had heard about last week's little hiccup. She had not, but her amiable chatter changed to a more worried series of questions.

She then admitted that her boyfriend had been worried about their investment, but "was afraid to call" the people managing the fund in which they had invested.

I quoted a guest on CNBC yesterday morning, who contended that Dubai bonds which were priced at 110 last week were selling for 56 today. The woman's face went dark and worried.

When I heard about the Dubai debt default being imminent, and then the restructuring, I naturally assumed that the affected investors would be mostly large, sophisticated banks, hedge funds, insurance companies, etc.

Not a local hairstylist and her boyfriend.

Kind of brings it all home, doesn't it? A bit like 1929, wherein a personal service vendor whom you normally tip tells you of her investment in an overseas luxury resort development.

Let's hope Dubai's problems end better than Wall Street's in '29.

Wednesday, December 02, 2009

BankAmerica & GM: Old & New CEOs

It was quite a day for CEOs of major US companies yesterday.

GM's former CFO, then CEO, Fritz Henderson, became a GM ex-CEO. Meanwhile, in yesterday's edition of the Wall Street Journal, it was reported that BofA's board is having trouble finding a replacement for outgoing CEO Ken Lewis, because several candidates advise shedding some businesses, in order to make the unwieldy bank easier to manage and perhaps, one day, even lead to outperform equity markets.

Of course, as the Journal article related, the board is vehemently agains any such action.
Nevermind the reality of the nearby, five-year price chart for Chase, Wells Fargo, BofA and Citigroup, and the S&P500 Index.
Three of the four banks couldn't beat the index, and Chase only barely manged to outperform in the final months of the 60-month period.
Which means, of course, that the quote in the Journal article ascribed to BofA spokesman Robert Stickler, is completely wrongheaded and misinformed,
"Part of the point of diversity is when a certain part of your engine is not going at full speed you have another part that is."
Either Stickler needs to be fired, or the board member(s) holding this misguided view need to be replaced.
That chart, though seemingly anecdotal, actually supports and reinforces the conclusions of my research into this matter when I was Director of Research at Oliver, Wyman & Co., now the financial services consulting unit of Mercer Management Consulting.
After quantitatively analyzing the total return performance of several hundred financial service institutions over several decades, I discovered that, with perhaps one lone exception, no diversified financial entity was ever able to exhibit consistently superior total return performance to an index of financial service firms.
Rather than have one business take up the slack for others in a diversified financial company's portfolio, in fact, such a company hits every single credit and trading disaster pothole that comes along. Some business is always dragging down the rest, resulting in continual subpar total return performance.
It's unfortunate that BofA's board is so delusional in how to move forward and reward shareholders for the risk of owning the firm's equity.
Then we come to GM.
As bad as Henderson was, how much worse will Ed Whitacre be as the custodial CEO?
Henderson was the CFO of the long-ailing auto maker, and, as such, I think clearly shared in the failure that ex-CEO Rick Wagoner had wrought.
But at least Henderson actually was acquainted with the business.
Ed Whitacre was a phone guy. He ran a regional phone company whose major business influence was government regulation. I worked for ATT back when it was a monolithic communications giant, so I know something about this topic.
Whitacre's SBC never really had the customer as its major focus. It was, during the past few decades, government regulation. Especially in the aftermath of the Bell System breakup, whereby, after many years of uncertain competition, under shifting rules, the old ATT finally succumbed to bad management and an outdated culture, selling what was left of itself to a regional offspring, SBC.
What Whitacre would know about competing in the auto industry ought to scare everyone, both private shareholders and all of the rest of us taxpayers, as public shareholders.
Sure, Whitacre is supposed to be an interim CEO. There's supposed to be a search for a new one.
What qualified candidate for the job would want it now? They're going to have the federal government and Whitacre looking over their shoulder, while they are handed the worst US auto maker of the bunch.
Good luck with that.
Instead, we're all saddled with a badly-run remnant of a car company now being run by a guy whose lifelong business experience is in the old telephone industry.
If this weren't about so much taxpayer money, this tragedy would be comical.

Tuesday, December 01, 2009

GE After Shedding NBC/Universal

There's been a lot of news in the past few days regarding the GE deal to sell its NBC/Universal unit to Comcast. I last wrote about the deal's implications for GE here, early last month.

What interested me about CNBC's coverage of the GE deal in the last few days have been the nature of comments by guests on Squawkbox, the morning program, as distinct from those of the program's co-anchors.

AWithin the last few days, New York Times business columnist Andrew Ross Sorkin called GE after the deal 'another Tyco,' or some phrase very close to that. One of this morning's guests noted that GE ran with way too much short term debt and got caught last year in a refunding squeeze.

From that crisis, he asserted, came the idea to lighten the conglomerate's debt load by jettisoning the media unit. He then lamented that they did it at a time of such a low price for the unit. Finally, he noted, perhaps this would help remove "the conglomerate discount" in GE's price.

I've been writing about this for years. Immelt foolishly maintained the necessity of a value-destroying corporate structure decades after it has become obsolete.

Remember that only months before his people began to explore the sale of GE's media business, Immelt was publicly insisting it was a core business of the needlessly-diversified conglomerate.

Of course, CNBC staffers aren't going near these remarks because, well, they work for Immelt. In fact, co-anchor Joe Kernen regularly jokes about this, to the annoyance of the other on-air staffers.

Yesterday and today, the program brought in ex-anchor and resident CNBC egghead, David Faber, to 'analyze' the GE-Comcast deal situation.

As a news reporter, Faber seems quite proficient. With an apparently large contact list, he has broken some past stories on mergers and acquisitions. But the network overrates his analytic skills. Much as I like Faber, I don't believe I've ever learned anything from his insights that I hadn't already figured out on my own first.

It's the same in this case. People like Sorkin, the other guest this morning, or Holman Jenkins at the Wall Street Journal have all come up with more penetrating insights than Faber. In Faber's defense, on this subject, though, he seems limited, as all CNBC on-air staffers do, by the fact that they (still) work for Immelt's GE.

The interviews they do with their CEO are all puff-ball questions. The interviewer looks appropriately doting and thankful for Jeff's pearls of obfuscation. No tough followup questions to obvious lies or dodges are ever asked.

Thus, on the NBC/Universal deal, you have to look to the guests on CNBC for honest assessments. And their universal opinion, pun intended, is that GE got itself into a mess by mismanaging the duration and size of its debt, had to dump a large unit at the bottom of the market, but, if anything, will be on the way to becoming a more sensible, if still overly-diversified conglomerate in the wake of this sale.

Of course, GE still has the financial services unit to distract its management from the industrial units. And, despite Joe Kernen's quip about becoming like United Technologies, GE probably will never become that well-designed, as I noted in this post.

For me, Sorkin's remarks about this deal's effect on GE have been the most on target. However, he stopped short of simply asking why GE should even exist anymore, in the modern financial environment. The closest he came was to compare it to Tyco, leaving it to viewers to understand that he meant it to be a pointless aggregation of business units having no discernible connection.

Well, in the business media of the past few years, I guess that represents some progress. Analysts and observers are finally beginning to voice opinions about the lack of sense in GE's business composition, and the 'conglomerate discount' its shareholders suffer because of Immelt's ineptitude.

Monday, November 30, 2009

The Next "Tipping Point"

Back in January of this year, I wrote this post concerning the issues of capital creation and private versus public money used as leverage in the economy. I referred to it recently when I wrote this post about Doug Dachille's recent confirmation of my observations.

The question of how excessive leverage enters an economic system was of interest to me. It seems to be something that everyone takes for granted, but few probably can explain.

After tracing the evolution of economics from barter to modern global finance using a multiplicity of fiat currencies, I wrote,

"Somehow, through the centuries, capital creation became increasingly dependent not upon hard assets or saved money, but some analyst's or banker's estimation of the forward earnings power of an entity issuing debt or offering equity subscriptions.

Culminating in events including the famed technology equity 'bubble' of the late 1990s and the recent real estate bubble of the late 2000s, the financial community's allowance of increased leverage, via lending on ever-smaller equity bases, resulted in economic expansion which has to have been secularly due to that higher leverage."

It's no secret that a government's printing of money or issuing of debt creates money which can be used as capital. If that monetary base creation isn't related to some sort of tangible value, then that is a source of excess leverage. In effect, a government's creation of money out of nothing has the same effect as bringing forward years, perhaps decades of value not yet created, and putting it into circulation as if it were already in existence.

There is a secondary manner in which newly-created or existing money can be the basis for excessive capital creation. That would be a market demand for some asset, usually equities or "hard" assets, which simply spirals upwards as a function of bidding on the assets.

A capital-creating phenomenon which occurs here which is so insidious because of the nature of open markets. When you or I bid up the price of the marginal share of a company's equity, we only have to pay for the accepted, higher value of those few shares. But everyone owning those shares feels wealthier by the amount per share which we have bid up the price.

If, in that instant, all those other shareholders borrowed against the new, higher value, then capital is magically created, less the 50% margin withheld by brokers, in an amount directly related to the price rise from just our trade for a fraction of the company's equity.

My point is, markets for privately-held assets can, by generally positive sentiment, cause rises in apparent value which can also serve as bases for capital base expansion.

Thus, we have to take as a given that, at times, the global sum of capital available may vastly exceed the actual, tangible savings.

From such events are financial bubbles born. Today, we have the Dubai World debt problem. A decade ago, the US technology equity bubble was about to burst. After September, 2001, Fed chairman Alan Greenspan touched off a decade-long real estate finance bubble by holding benchmark US interest rates too low for far too long, effectively creating too much capital in advance of its actual, tangible realization.

As I discussed these topics with a business colleagues yesterday morning, I was struck by how, somewhere in the past forty years, from about the time of Reagan's election to the Presidency, we moved from a largely prudent capital creation environment to one which could be more aptly described as 'borrow it forward.'

In a bi-partisan manner, US presidential administrations and the Congress joined the party, running continual deficits. The so-called "peace dividend" of the Clinton years was spent. Congress went further, simply borrowing from the world via Treasury-issued debt, rather than ever even attempt to balance the total federal budget, both on- and off-balance sheet, including Medicare and Social Security.

Since FDR began his first term in 1932, the US lost a sense of fiscal rectitude, and became comfortable with, then addicted to, running deficits, both in wartime and peacetime. It seems to me that this unbridled borrowing binge by the US for the past 80 years is about to come to an end.

Until perhaps 20 years ago, when no other major country had substantial economic power, and the dollar was the undisputed reserve currency in a world which included the hostile, communist Soviet Union and China, such deficits were disguised as Western world capital seeking safety in the greenback.

Now, with other major countries having evolved economically to the point of having substantial trade surpluses, and a lack of such imminent danger from communistic countries, other asset classes are seen as viable, and the excess dollars now have resulted in deprecation of the currency.

It seems to me that, with this background, the US is very near to an economic "tipping point."

Most uses of the phrase these days are political. They refer to the point at which poor voters in the US will use their numbers to vote in lush, perpetual welfare-state programs, overwhelming the votes of productive, working taxpayers.

However, I believe that this latter phenomenon won't actually occur, because the former, economic tipping point, will be reached first. And that will preclude the latter one.

How? Why?

Somewhere in the midst of my colleague's and my discussion on Sunday morning, I remembered a little vignette from a television program I happened to see for about 5 minutes while channel surfing on Saturday.

One of those "Real Housewives of" programs happened to be on, and I saw a recap of a prior episode, and the trailer for the one about to air. What I recall was this Orange County couple sitting with a realtor and agreeing to list their OC McMansion for something like $1.4MM. The husband bemoaned having "seen this coming" two years earlier, when the market-fueled mania priced the same home at around $2.1MM. The wife sobbed as they confessed that the proposed sale price would put them underwater when paying off the mortgage on the home in question.

For some reason, my first reaction was to recall the apocryphal story from 1929 involving JP Morgan and his shoeshine man. The story goes that when Morgan- or perhaps a Vanderbilt or some other wealthy financial luminary- heard his lowly shoeshiner presuming to give him stock tips, the market was dangerously overbought. According to the tale, the financier went to his office and immediately sold all of his equities, putting the proceeds into cash.

The Orange County McMansion tale calls that apocryphal tale to mind, I suppose, because it suggests that excessive leverage has become so woven into the fabric of the US society that some who appear to be wealthy have, in fact, been living on 'borrowed forward' money after all.

From unfunded federal Social Security promises to proposed, bloated health care bills, to essentially bankrupt states such as California, Michigan and, soon, Illinois and New Jersey, our government has become a profligate spender of other people's money in a manner that just got Bernard Madoff a life sentence in prison.

The only times in recent memory that the US dollar has risen in value relative to other currencies has been when global economic doom seemed imminent. If that's what it takes to save the dollar, I doubt those will be economic conditions conducive to the US enjoying healthy growth in the private sector.

No, I suspect that, though the exact timing is unknown, the US dollar and the debt obligations of its government will soon experience significant shunning. I discussed some of the implications of Lawrence Kadish's recent Wall Street Journal editorial on the size of the current interest expense of the federal government in this post, writing,

"You can see the awful mathematical conclusion, can't you? If rates move up, as they most certainly will as liquidity is drained globally, and too many dollars require ever-higher rates on US Treasuries, the current nearly $400B interest tab could easily swell by a factor of at least 5- twice for the larger debt level, and 2.5 times for the interest rate effect.

Imagine explaining to the average taxpayer that his annual tax liability is nearly half-consumed for just interest on our borrowing to pay for our lush social programs. And we're adding more, by the way.

And that, in a few more years, that figure will be easily more than half. So Washington will continue to try to borrow abroad to pay for promises it is increasingly unlikely to be able to keep to all parties- citizens, investors, and other countries."

For the record, the current administration's budget assumes an interest rate on US debt of half of the average of the past decade! That's simply not credible.

This is all simply unsustainable. Too much imaginary capital has been borrowed forward from decades in the future, and much of it has been invested in depreciating dollars or Treasuries denominated in the same depreciating currency.

My partner and I manage proprietary equity options investments, so we must be sensitive to actual, ongoing timing issues between calls and puts. It's not sufficient, for investment management purposes, to see a massive credit crunch returning sometime in the next two or three years.

But I do think that will happen. I don't think the Democrats in Congress and the administration will successfully remain in power for more than three more years if even one of the proposed deficit-increasing, budget-busting bills is passed into law. It is simply not believable that savers around the globe will willingly hand over their tangible, hard-earned capital to the US in order to see it spent on environmentally-popular programs in a currency that will continue to lose value.