About Dell's Purchase of Perot Systems

Yesterday morning's big corporate news was Michael Dell's computer making company buying Perot Systems. For a hefty $30/share, a hefty premium to the $17 or so Perot closed at on Friday. A price the consultant/system integrator hasn't seen in ten years!

I'm sure Dell shareholders are thanking Michael profusely for squandering their money so unwisely.

I happened to have lunch with my friend and former/sometimes business partner, B. He noted that all of Ross Perot's companies had now been purchased, i.e., EDS by HP, and Perot Systems by Dell.

I added that a third, GM, was now owned by the US government. We both laughed. For those too young to recall, GM once purchased EDS, making Ross Perot the largest single shareholder, and a gigantic thorn in the side of then-CEO Roger Smith. Eventually, they paid Ross to go away. And spun off EDS, as well.

But, back to Dell.

The nearby 5-year price chart for Dell, Perot Systems and the S&P500 Index clearly displays the folly of Michael Dell's move. For the past five years, Dell has been on a long, slow decline. My many posts discussing the firm's fall from its prime, and Michael Dell's inability to recover its lost ability to generate consistently superior total returns, provide background on this.

With a loss of 50% of its value over the past half-decade, Dell is headed toward the graveyard of Schumpeterian dynamics. There's just not that much juice left in manufacturing, selling and distributing computers the Dell way.

Compared to Dell, Perot Systems have performed spectacularly well. It's managed to remain even, and even slightly outperform the S&P over the whole period, though not consistently.

For Dell to buy Perot is essentially a bid to diversify into a different business, using spare cash. It's a classic example of the financial theory argument that investors can more cheaply diversify for themselves. At a premium exceeding 50%, that's certainly true in this case!

In fact, the nearly $4B acquisition begs the question of what Dell is doing with some $10B in liquid assets on its balance sheet while its value decays?

The Wall Street Journal opinion piece lauded Dell for diversifying. Personally, I don't see it that way. Instead, Michael Dell, like so many other CEOs, can't let go. He should just sell or merge Dell to create a larger PC manufacturer. Let his shareholders buy a pure systems integrator play, or HP, if that's what they desire.

Michael Dell is using his shareholder's money to continue having a company to run. How he is going to make Perot something it can't be on its own should worry Dell shareholders. Perot could have borrowed money, were its business opportunities sufficiently attractive. If Michael Dell better knows how to run a systems integrator than do the senior management of Perot Systems, Dell could have grown its own unit, for much less money.

Finally, as usually occurs in these situations, Dell seems to be buying the weakest of the breed of remaining systems integrators. The better ones, such as EDS, were already picked off.

There's nothing about this deal that makes sense, except prolonging Michael Dell's personal joyride running a Fortune 500 company.

Much as I suggested for Kodak's shareholders, Dell's should be bringing a lawsuit over this egregious use of their money. Or, better yet, just sell Dell immediately and take the recent loss as a lesson in being more judicious investors when the company is run by the guy it's named for, but the firm is over the hill.

James Grant on An Economic Recovery

This past weekend's Wall Street Journal edition carried a prominent, long piece by respected market observer James Grant.

The Grant piece, which comprises the very long lead in the last section of the edition, is surprisingly positive. Given Grant's recent scepticism, he is unfailingly optimistic about an imminent economic recovery of monumental proportions.


In a way, it's too bad that Grant spent so much ink on something that, to sane, informed business professionals with any economics education, is so obvious. I don't disagree with him that really deep recessions produce really strong recoveries.

The question is when.

On that, I don't see Grant providing compelling evidence, despite his assertion that said recovery will be much sharper and sooner than many pundits now believe and forecast.

Grant omits any evidence as to why recent political changes are not different than prior ones, or, if the same, why. The truth is, today's more powerful government interventions are built upon FDR's original interventions, not instead of them. And the exit of the US from the Great Depression had more to do with rearming for WWII than it did with a magical, sudden change in consumer spending and subsequent employment.

Personally, from my reading of many economists and related pundits, I simply feel that Grant is, in a word, wrong. Too optimistic about the timing of a recovery.

What if one had been similarly optimistic at Carter's election in 1976? One would have been waiting a long time for the Reagan recovery, strong as it ultimately was.

Instead, I found this morning's article by E. S. Browning in the Money & Investing section of the Journal more useful and credible.

Browning is much more convincing, in my opinion, in his/her detailed assessment of the risks of this period of "economic instability."

Absent a major war, it's unclear what consistent, steady demand will arise very soon in the US economy to fuel all the economic recovery currently forecast by Grant and others.

About The Kodak-KKR Financing Deal

I read of the Kodak-KKR financing deal yesterday with mixed feelings. It wasn't until today, reading another, more analytical piece in the Wall Street Journal, that I settled on a final opinion of the matter.

It seems to me that Kodak's CEO and senior management are probably guilty of some poor corporate governance behavior.

In retrospect, the Journal's Thursday edition headline, "Kodak Gets Financial Lifesaver from KKR," should have immediately tipped me off. Yet another management team of a publicly-held company enriches lenders at the expense of its own shareholders.

The way the deal is structured, KKR comes out much like Warren Buffett in his GE financing deal. KKR gets a 10% rate on its loan of up to $700MM, warrants that are already in the money, and senior status to all other Kodak debt.

The article, and this morning's analysis, note that KKR has, predictably, feathered its nest on both the upside and downside. They get a hard 10% income stream and the best protection available on the balance sheet. If Kodak miraculously improves its condition, KKR then gets to convert warrants to own up to 20% of the company.

You have to ask, as I did this morning, reading that second piece, out of whose hide do these generous terms come?

Why, the Kodak shareholders', of course. And I didn't notice any changes in management compensation. You know, like tying bonuses or large parts of salaries to Kodak's total return.

No, the management is basically rolling the dice with their owners' money, after having pissed away so much of it over the past five years, as I noted in this recent post.

Schumpeterian dynamics, as I noted in that post, have gutted this company's ability to function in a manner that would deliver its shareholders consistently superior total returns.

What does management do? Does it explore avenues to reap gains on sale of assets to those who could more profitably use them? Or at least stem the losses? No.

Instead, they are doubling down with borrowed money. Expensively-borrowed money, at that. Paying 10% in an era of 0% Fed funds.

Am I the only person who wonders why those choosing to remain as shareholders in this hapless has-been aren't suing to block the KKR deal?

As for me, I simply don't own this pig.

Michael Porter Is Over The Hill

I regretfully sat through too much of Harvard professor Michael Porter's visit on CNBC this morning.

If Porter isn't emeritus yet, he should be. If that.

I have never actually held Porter in very high regard. The 'competitive strategy' books for which he became known in the late 1970s were, in fact, merely rehashed microeconomics, with generous dashes of findings from the Strategic Planning Institute's PIMS database. Friends of mine from that organization related that Porter had spent months over at their shop, due to its historic tie to Harvard Business School, using their then-current and copious business-unit level database.

Now, with time and thinning hair, Porter is introduced as a 'competitive strategy expert.'

On what basis, I still ask? His books provided no new information. To my knowledge, no one ever hired Mike as a VP of competitive strategy, and then announced some heretofore unachieved total returns over time. Or share gains. Profit. Etc.

You get the idea.

This morning, Mike launched into now-typical accusations against and descriptions of the US medical/health insurance sector, with nary a statistic nor fact within sight.

He began by declaring various European countries to have 'superior' health care systems, and ours to be of inferior 'quality.' Then he held forth on the inadequacy of US health care distribution and lack of universal coverage, declaring those to be worth rating US medical care as subpar.

Apparently, I wasn't the only viewer who had misgivings about Mike's rather loose and cavalier manner of evaluating the US health care sector.

About fifteen minutes later, co-anchor Joe Kernen, in response to many emails which had flooded the program in that time period, asked Porter to clarify his earlier comments.

At which point Porter backtracked, suddenly declaring that, for serious illness, US medicine was, and is, in fact, on a par with, if not superior to that of other countries. He then sharpened his criticism to that of 'delivery' and 'coverage.'

Well, that's fair. But he's not known as a medical care delivery and coverage expert. And Mike provided not a shred of comprehensive, non-anecdotal evidence to support any of his statements this morning. And his little intellectual two-step made him look old, doddering and unable to communicate his thoughts. If he even clearly understood them himself, in the first place.

They may as well have had him on to opine about financial regulation or energy policy. Neither of which is he known for having studied, either.

In fact, it was extremely disappointing to see the program's anchors completely avoid asking Mike some questions that would have taxed his supposed expertise.

For example:

-Given your years studying industry structure, Mike, what do you think is the most likely competitive structure of the health care sector, consistent with sustainable profitability and competitive total returns?

-How do you think some of the proposed new regulations will alter what would be, in their absence, an optimal, terminal competitive industry structure in this sector?

-What do you think of current expense and profitability levels in the health care sector, as compared with; other US economic sectors, long run sustainable profit levels, global comparables.

-How would eliminating or relaxing policy mandates, and allowing inter-state health insurance competition, affect competitive structure, profits, total returns, and overall performance in the sector?

-If the government eviscerates profit in this sector, either through regulation, and/or a government-owned competitor, how do you envision that type of 'competition' comparing with competition from relaxing interstate marketing and policy mandates?

I'd have really appreciated hearing Porter's thoughts on those topics. Sadly, nobody thought to have prepared such a list to ask him. What a waste.

The guy has one alleged speciality, competitive structure analysis, and the CNBC co-anchors and staff couldn't even be bothered to tap it in an intelligent fashion while Porter spent about half an hour on the set.

Two Contrasting Views of The Impact of Lehman's Failure

Today's Wall Street Journal presented two starkly differing anniversary reviews of the failure of Lehman Brothers.

Two finance professors from the University of Chicago, John Cochrane and Luigi Zingales, argued, with hard, credible quantitative evidence, that it wasn't Lehman's demise, but Hank Paulson's and Ben Bernanke's panicked testimony to Congress a few days later, that caused financial markets to begin to fail, too.

On the other side of the argument, with little but hearsay and a few top-line numbers sizing the mutual fund market, is the Journal's own financial columnist, James B. Stewart. Augmenting Stewart's piece in the paper was an afternoon appearance on CNBC, wherein he went beyond his Journal article, contending that Lehman's failure was a financial system near-death event, and that no firm like Lehman should, or could, now, ever be safely allowed to fail.

Whom to believe?

Well, first, let's review the academics' piece. Cochrane and Zingales present a graph showing clearly that shortly after Lehman's bankruptcy, spreads of instruments like Libor-OIS rose only 18 points, whereas it rose more than three times that within two days after the Treasury Secretary and Fed Chairman sounded the general financial alarm and demanded that the TARP legislation be passed.

Since the TARP was never actually used as described, it wasn't even the source of any significant calming of the financial markets.

As to the importance of the Lehman failure, or its rescue, they wrote,

"Would a Lehman bailout have averted a panic? The news would still be that Lehman failed, and markets knew bailouts would not last forever. After all, the Bear Stearns rescue in February had just postponed worse trouble."

Cochrane and Zingales go on to contend that the real lesson in Lehman's bankruptcy "cannot be that the government must always bail out every large financial institution."

They cite the 1984 Continental Bank rescue, and others that followed, including LTCM, to demonstrate that none of these rescues have positively or constructively affected financial firms' appetite for risk. They write, near the end of their piece,

"The blame-it-on Lehman story leads to a dangerous complacency. If we can persuade ourselves that the fault was just one policy mistake, forced on the feds by silly legal restrictions and not enough bailout power, everything can go back the cozy way it was before.

This is a convenient story for large banks that dominate the lobbying and communication effort. And it absolves the Fed and Treasury of facing up to their long string of policy mistakes."

The two Chicago professors conclude that, while they don't claim to have the perfect answer, they would trust markets before trusting an overly-powerful government which has serially increased the stakes of each financial crisis which it has spawned through 25 years of bailouts.

In contrast to Cochrane's and Zingales' use of actual data to demonstrate that Lehman's failure did not panic markets, Journal writer James Stewart continues his usual misunderstanding of financial markets by claiming that Lehman's debt obligations, stuffed into so many mutual funds, required the government to guarantee those assets. Thus, by Stewart's reasoning, allowing Lehman to fail was a huge mistake which necessitated the assumption by the government of $4 trillion of mutual fund value.

On CNBC this afternoon, however, Stewart babbled on incessantly about how necessary it was that Lehman had been saved. That no similarly-sized financial firm can ever be allowed to fail again, because, although markets would have eventually corrected, Stewart solemnly judged that such correction would have taken us 'back to the iron age.'

Really?

That's precisely what the two professors convincingly demonstrate would not have happened. And did not happen.

The fact is that mutual fund investors take risks for extra return. Holding those assets meant investors chose to bet on the managements of those funds.

Have those funds now been cleansed of inept managers? No. The federal safety net saw to that. Just as Ken Lewis and Vik Pandit still run BofA and Citigroup, their incompetence notwithstanding.

I don't know if anyone else happened to notice this bizarre coincidence in today's Journal. It makes for an interesting comparison between savvy, analytical observers of last year's financial crisis, and a fear-mongering, large-government and -bank supporting financial beat flack with little in the way of evidence to sustain his contentions.

BofA, Merrill Lynch, Ken Lewis, Bernanke, Paulson et. al.- Redux

The big news out of always-litigious New York state is that gubernatorial hopeful AG Andrew Cuomo is expected to file charges against BofA CEO Ken Lewis and perhaps his CFO, Joe Price, over the tortured purchase by the ailing bank of Merrill Lynch late last year.

I wrote these two posts, here and here, earlier this year, regarding the conflicting stories emanating from former Treasury Secretary Hank Paulson, Fed Chairman Ben Bernanke, and BofA CEO Lewis.

As I reread the first post, I found myself ironically delighted that a suit may actually be brought over this issue. Reviewing my impressions of Lewis' testimony before Congress, as well as recalling Paulson's and Bernanke's later remarks, also in on Capitol Hill, I'm looking forward to seeing this whole mess hashed out in a courtroom.

Serendipitously, Judge Jed Rakoff rejected the SEC's settlement in the case, pointing out that it is patently unfair to require injured shareholders of BofA to pay a fine for said injury.

Somehow, it seems appropriate that this entire affair is barrelling toward a more formal legal event.

The nearby 2-year price chart for BofA, Chase, Wells Fargo, Citigroup and the S&P500 Index shows that the entire sector hasn't done any favors for investors lately.

As you'd expect, the worst of this sorry bunch are Citi and BofA.

BofA is off more than 50% in the past two years, which hardly constitutes effective stewardship of shareholder assets. It's too simplistic to associate all of the loss in shareholder value in late 2008 with BofA's agreement to acquire the nearly-failed brokerage firm, Merrill Lynch. Still, the bank's equity price dropped an additional 20 or so percentage points through early 2009.

Having heard Lewis, Paulson and Bernanke tiptoe around the issue of whether, and how strongly the two federal officials intimidated and coerced the bank CEO, I, for one, welcome seeing them retell their stories under oath in a courtroom.

I'm not a lawyer, so I can't cite specific laws of which any of the three may be guilty. That said, as I alluded to in my prior posts, I think it's just possible that Lewis could be found guilty of violating Sarbane-Oxley and some other SEC rules. Bernanke and Paulson could potentially be charged with perjury and conspiracy to lead Lewis to violate federal laws.

While reading Amity Schlaes' "The Forgotten Man," it has occurred to me that, just as FDR's NRA was brought low by a seemingly-minor lawsuit in New York court, so, too, could recent, bipartisan federal overreaching into the affairs of financial service companies be brought to a halt by some convictions in the BofA-Merrill matter.

Lehman's Dick Fuld's State of Denial

This past weekend's Wall Street Journal carried a front-page article regarding the recent activity of now-defunct Lehman Brothers' last CEO, Richard Fuld.

It's a lengthy article, carrying over from the middle of the front page to half of an inside page. There are a host of details concerning how Fuld is, appropriately, still treated as a pariah by most senior executives in the financial services sector.

Despite that, Fuld has already filed the paperwork to start his new shell of a firm, Matrix Advisors LLC.

One thing the Journal article stresses through numerous anecdotes is that nobody is paying Fuld for anything. He has "given hours of free advice to a firm run by a former Lehman employee," the piece states, and then goes on to remark similarly on other Fuld efforts to stay busy.

Somewhere among the details of his helping to wind down the smoldering ruins of his old firm, this passage appears,

"Yet in these same months, Mr. Fuld would walk down the hall and park himself in Mr. Marsal's office, sometimes asking his new boss: "Is there anything I could have done differently?" "

Gee, let me think.

Take less risk? Try not to intimidate anyone inside Lehman who disagreed with you?

Maybe wake up by late 2007, watch the commercial banks booking hundreds of millions of dollars in mortgage securities write-offs, and figure that debt markets were going to be getting chary? Maybe lengthen your own firm's average funding duration and prepare to shrink your balance sheet, so you would not get hit with an age-old risk of brokerages, which is having your funding commercial banks pull your credit lines?

You see, when the balance sheets of banks that fund your short-term credit needs, out of their aptly-named broker-loan divisions, begin to shrink like balloon suddenly thrust into a deep-freeze, you can pretty much guess that you, as a brokerage and/or investment bank, will be next in line for credit access troubles.

But, I guess, not if you're Dick Fuld.

No, Dick just merrily played Russian roulette with the regulators, lenders, and investors. Never one to look on the gloomy side, or prudently plan for less-than-desirable scenarios, Fuld rammed his firm's operating throttles to the wall as 2008 moved into summer.

In a telling, candid interview nearly exactly one year ago today, described in this post, former Salomon Brothers' CEO John Gutfreund addressed Fuld's actions at Lehman.

I wrote of Gutfreund's remarks,

"Gutfreund was asked how Lehman's demise came about, and he said something to the effect,
"By the over-optimistic actions of the firm's CEO and his senior managers."

Pressed further, he allowed as how the firm was unrealistic, in this era and environment, to believe it could remain independent while grappling with its writedown problems. Gutfreund never used Fuld's name, but pointed out that Lehman had had months in which to gracefully sell itself before coming to Chapter 11."

Maybe Dick Fuld should have asked Gutfreund, rather than a rather innocuous financial rag merchant, how he managed to run Lehman into the ground, and what he could have "done differently."

The Journal article also replays Fuld's now-famous comment before a House committee that he will never understand, until he is buried, why no government rescue was organized to save Lehman.

I find, and have always found, this to be the epitome of chutzpah on Fuld's part. Ever the swaggering, intimidating brute of an investment bank CEO, cutting an image of a swashbuckling, fearless leader, he now asks us to sympathize with his expectation that, having ruined Lehman, someone should have saved him, and his investors, from his own bad judgment.

I'm a bit surprised the Journal even wasted half a page on this treacle. Then, again, as a friend and I observed over the weekend, the paper has morphed heavily toward tabloid business journalism since Murdoch's purchase.

Human interest stories of fallen Wall Street titans probably sells a lot of newspaper subscriptions.

Financial Regulatory Reform One Year Later

One year on from the month of the most severe equity market collapse in twenty years, financial regulatory reform seems to have hit a brick wall.


I wrote quite a few posts concerning financial regulatory reform over the past year. This one, among them, stands out as being concise and pretty exhaustive in its prescriptions. Of course, that post doesn't deal with federal government-initiated problems such as Fannie Mae and Freddie Mac being directed by Congress to securitize too-thinly capitalized, unseasoned adjustable rate mortgages. But, rereading it a year later, I'm still okay with it as a useful set of regulatory solutions.


The recent action has moved from industry competitors to the regulators. With the new administration, much hot air has been spewed arguing for, or against, empowering the Fed to be the single, omnipotent regulator.


Isn't it odd that none of these financial sector regulations have managed to be enacted in the past year? About all we have is income caps on the CEOs of bailed-out banks. Those which have repaid the forced 'loans,' such as Goldman Sachs, are back to paying large bonuses again.

But what of the development of exchanges for derivatives, so that a Bear Stearns of Lehman bankruptcy would no longer imperil long daisy chains of derivatives executions?

What of the packaging of questionable debt into collateralized obligations?

What of the GSE's pumping too-green, too-leveraged mortgage loans into their own securitized issuances?

How about the fact that the FDIC, Fed and OCC all missed what appear, in retrospect, to have been obvious inadequate mortgage loan documentation and/or improper lending to unqualified borrowers?

None of this has been resolved.

It's very curious and disturbing. Some of these regulatory steps would be very helpful in lowering the risk of a rerun of the mortgage lending bubble that did so much financial damage to the US financial sector and economy.

Why has nothing been done in the past year?

Evidence On Government Spending & Recession Severity

Back on August 21st, the Wall Street Journal published an excellent economic editorial by Alan Reynolds entitled, "Big Government, Big Recession."



As is the case with quite a few of our less partisan economists, Reynolds directly contradicts liberal apologist Paul Krugman. He begins by providing the impetus for his research and resulting editorial,

‘So it seems that we aren’t going to have a second Great Depression after all,” wrote New York Times columnist Paul Krugman last week. “What saved us? The answer, basically, is Big Government. . . . [W]e appear to have averted the worst: utter catastrophe no longer seems likely. And Big Government, run by people who understand its virtues, is the reason why.”

In rebuttal, Reynolds writes,

"This is certainly a novel theory of the business cycle. To be taken seriously, however, any such explanation of recessions and recoveries must be tested against the facts. It is not enough to assert the U.S. economy would have experienced a "second Great Depression" were it not for the Obama stimulus plan.

Proponents of Big Government can't say we avoided the next Great Depression due to hypothetical stimulus money that is mostly unspent. So they argue it's more important that the federal government merely continued spending and didn't "slash" spending as in the early 1930s. But the federal government didn't slash spending in the early '30s. Federal spending rose by 6.2% in 1930, 7.7% in 1931 and 30.2% in 1932. Since prices were falling, real increases in federal spending were huge during the Hoover years.

President Obama clearly believes Big Government is the antidote to this and perhaps all recessions. At his first news conference in February, the president said, "The federal government is the only entity left with the resources to jolt our economy back to life." Yet that raises a key question: If the U.S. economy could not recover without a big "jolt" of deficit spending, then how did the economy recover from recessions in the distant past, when the federal government was very small?

A 1999 study in The Journal of Economic Perspectives by Christina Romer (now head of the Council of Economic Advisers) found that "real macroeconomic indicators have not become dramatically more stable between the pre-World War I and post-World War II eras, and recessions have become only slightly less severe." Ms. Romer also noted that "recessions have not become noticeably shorter" in the era of Big Government. In fact, she found the average length of recessions from 1887 to 1929 was 10.3 months. If the current recession ended in August, then the average postwar recession lasted one month longer—11.3 months. The longest recession from 1887 to 1929 lasted 16 months. But there have been three recessions since 1973 that lasted at least that long."

That's a pretty interesting nugget about Christine Romer, isn't it? Her own academic work concludes that the administration's so-called stimulus plan won't actually alleviate the current recession in any meaningful manner.

But Reynolds goes further,

"In the late 19th and early 20th centuries, nobody thought the government could or should do anything except stand aside and let the mistakes of business and banking be fixed by those who made them. There were no Keynesian plans to borrow and spend our way out of recessions. And bankers had no Federal Reserve to bail them out until 1913. Yet recessions after the Fed was created soon turned out to be much deeper than before (1920-21, 1929-33, 1937-38) and often more persistent.

It's clear that U.S. history does not support the theory that Big Government means shorter and milder recessions. In reality, recessions always ended without government prodding, long before anyone heard of Keynes and long before the Fed existed. What's more, recessions ended more quickly before the New Deal's push for Big Government than they have in the past three decades. The economy's natural recuperative powers before the 1930s proved superior to recent tinkering by Big Government economists, politicians and central bankers."

It's hard to argue with Reynolds, since he bases his conclusions on facts. But Reynolds, again, goes further, looking abroad,

"The chart nearby lists 13 major economies by the size of government spending relative to GDP using OECD figures for 2007 (the U.S. is well above 40% by 2009). Europe's big spenders are at the top, the U.S. and Japan are in the middle, and fiscally frugal countries like China and India are at the bottom.

The last column shows the change in real GDP over the most recent four quarters—ending in the second quarter for the U.S., U.K., Germany, Japan, France, Italy, Sweden and China, but the first for the rest. Four of the five deepest contractions happened in countries with the biggest governments—Sweden, Italy, Germany and the U.K. Japan's government spending in 2007 was about like ours, but Japan's tax rates are far more punitive and the economy has suffered endless "fiscal stimulus" packages. China's central government spent 22% of GDP, but 30%-plus with local government included.

To believe Big Government explains why this extremely long recession was not even longer, we need to find some connection between the size of government and the depth and duration of recessions. There is no such connection in U.S. history, or in recent cyclical experience of other countries."

Again, it's difficult to refute Reynolds' rebuttal of Krugman's emotional contention that only Big Government has saved us this year.

Reynolds then concludes his editorial,

"On the contrary, recessions have become longer as the U.S. government (and the Fed) became larger, more expensive, and more involved in the economy. Foreign countries in which government spending accounts for about half of the economy have also suffered the deepest recessions lately, while economic recovery is well established in countries where government spending is a smaller share of GDP than in the U.S.

In short, bigger government appears to produce only bigger and longer recessions."

Why do you suppose this is true? What is it about large-scale government intervention that causes recessions to be longer and deeper?

I would guess it is two factors.

The first is the distorting effect of government, which is to say, political meddling with price, demand and supply signals in an otherwise-free market for goods and services. Reading Amity Schlaes' excellent history of FDR's economic failure, "The Forgotten Man," brings home how destabilizing and distorting massive government economic intervention is. Investors hold back, worried about the shifting rules governing the context of their investments. Which industries will government punish or radically regulate next?

The second is the nature of recession-based government legislation. Typically, it involves two things- printing or borrowing large amounts of money on the citizens' behalf, and creating or enriching transfer payment schemes.

The first action leads to higher taxes, crowding-out of private investment, and higher interest rates down the road. None of which are necessarily healthy for the private sector, or a country, as a whole.

The second action slowly, inexorably overlays a drag on economic activity, as new claims on behalf of non-producers are made and collected by big government. This saps savings in order to transfer wealth to those who consume without creating value in the economy. This additional marginal tax, in the form of items like FICA, predictably depress marginal economic activity across many income levels.

These transfer payment schemes are rarely reduced or eliminated, so, over time, you probably have an accretion of this economic drag on productive private sector activity.

Seeing as how our federal government, in just a few months of this year, actually doubled US indebtedness from the time of our country's founding to December of last year, it's hard to see how this biggest of all governments can possibly be consistent with an imminent and robust economy recovery in the US.

The Evolution of the US Economy 1980-2010

Back in late July, I wrote this post contrasting the economic punditry and outlooks of several well-known observers, i.e., Alan Blinder, Dick Hoey and Mortimer Zuckerman. My own conclusion was expressed as follows,

"Who's right?

Personally, I'd put my money on Zuckerman. Leaving aside that Dick Hoey was a fixed income manager back in the day, and his BONY/Mellon/Dreyfus bio doesn't exactly laud him as an economic Nobel Laureate, I don't think Hoey is sufficiently observant of the real differences in the effects of the recent recession on the US labor force from those of recessions prior to 1992."

I continued with this observation,

"That so-called 'jobless recovery' may well have marked a turning point for the US economy which has not yet been captured in various models and adequately observed by pundits-cum-economists like Hoey. Or even Alan Blinder.

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."

These passages were what I was referring to in this post of last Friday, when I wrote,

"I personally believe, as I've written in a prior post, that many economists are using inappropriate models and assumptions from over 25 years ago. Models and assumptions which are tied to a different type of economy and workforce than we now have. As such, I don't think they are correctly accounting for today's business IT allowing for previously-unimagined control of overheads and inventories.

If economic recovery is based upon expectations of inventory rebuilds, I just think that's overly optimistic for the next few quarters."

Apparently I thought about this topic a great deal more than wrote about it. Thus, this post.

Though not an economist, as a trained marketing professional, I have been involved with quantitative behavioral modeling and analysis for decades. And, thanks to my business degrees, I've had more economics than most business students, in addition to which, I continually stay abreast of economic thought and opinion in the major business media.

Currently, I believe that what macroeconomic modelling still exists, after the approach lost so much credibility in its early applications forty years ago, remains out of step with our modern US economy.

For starters, the SIC codes were, and are, the underpinnings of most sector-based forecasting. These are now hopelessly outdated.

Employment statistics are warped, thanks to the rise of subchapter-S and LLC entities. This has also served to obscure incomes, as business income for many entrepreneurs now appears on 1040s, rather than corporate returns.

Finally, the entire nature of business operations, being now so heavily dependent upon, and benefiting from computer-based management tools, has changed from 30 years ago.

As an observer who understands economics and business, I find myself wondering just how we can accept economists' references to the jobless recovery from the 1991-92 recession, without explanations as to how this phenomenon has been incorporated into current models.

It's important to know whether economists consider the 1991-92 recession an aberration, or a new paradigm.

A reader commented on my post of last Friday, taking a shorter term, more narrow view of individual recent IT spending by companies. What I meant by my comments in that post was that business has been improving operational information availability for nearly 30 years, with the arrival of the personal computer in 1980. When I was with Andersen Consulting in the mid-1990s, client/server projects were booming, and a sort of internal internet, LotusNotes, was being applied at individual firms.

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.

Is it any wonder that you see employment levels less responsive to economic recoveries in recent decades? Or spending and saving rates affected by generally-available unemployment information?

It is simply stunning to me to read yesterday's Wall Street Journal piece wherein a number of financial pundits were opining on how fast and robust the deep "V-shaped" recovery is going to be.

How do they account for the lack of re-employment of so many recently-unemployed? The defaulting and delinquent home loans? The coming commercial mortgage loan delinquencies and defaults?

Yes, any, or even several of these, in moderation, can be accommodated by a vibrant, recovering economy. But this last recession was, is, different. The scale and breadth of its effects have left conventional financing sources weak and unable to profitably lend at current rates.

There is so much about this recent economic recession, in concert with a financial collapse, that is different from anything the US has experienced in the past 30 years that it's simply difficult for me to trust pundits who rely on conventional econometric models to forecast that the 'usual' recovery has begun, and will surprise us all.

Terry McGraw's New Problems At S&P

A little over a year ago, amidst the then-year-old unraveling of mortgage-backed securities which decimated the US banking industry, I wrote this post concerning Terry McGraw's push for growth at his Standard & Poors, McGraw-Hill's rating agency unit.

Now a case is moving through US courts that could spell the beginning of the payback by S&P and McGraw-Hill for its cavalier approach to ratings over the past few years. The Wall Street Journal covered it last week, and I noted to myself, upon reading the article, that it could spell disaster for the firm.

This morning, CNBC had McGraw-Hill CEO Terry McGraw on to defend the company's position. And Terry didn't disappoint. He claimed that the judge had tossed several charges on first amendment bases, and that only one remained, so the company was in great shape.

Ah, not so fast, Terry.

In a move calculated to boost ratings, which is understandable, the program then aired a telephone interview with occasional guest host and periodic guest, Greenlight Capital hedge fund manager David Einhorn.

Einhorn, though far from perfect, is noted for having correctly shorted Lehman last year, publicly dueling with its CFO and questioning the now-defunct firm's valuation of various real estate assets on its balance sheet.

Einhorn confirmed on the air this morning that his fund has shorted McGraw Hill's stock. He went on to give a very detailed explanation of how, in his opinion, Terry McGraw's prior defense was incorrect and overly-optimistic.

Basically, the case boils down to this. Publicly-available ratings by agencies are deemed 'protected speech' under the first amendment. You can't sue S&P for their public rating of a bond or CMO issue. Even if it was obviously, in retrospect, flawed and poorly-determined.

However, the case in question involves S&P providing ratings opinions on securities to a non-public investing group. This, the court found, is not protected speech. Thus, possible charges could involve fraud.

Einhorn stressed that S&P has never, in the past, had to worry about being sued for its opinion. The fact that this is now about to happen is a watershed event for it, and its competitors, Moody's and Fitch. He opined that other suits will likely now follow, especially if S&P loses this case.

Then there is the question of damages. Einhorn noted that none of the ratings agencies, similar to what occurred with MBIA's under-reserved financial situation, have the financial depth to actually pay damages on fraudulently-rated securities.

As the 5-year price chart for MHP and the S&P500 Index reveals, Terry McGraw's company has struggled for most of the past five years simply to remain comparable to the index. For the past two years, since late 2007, when the ratings mess began to become public, it's basically been underperforming the index.

It's a decent bet that any serious legal problems at S&P are going to really put pressure on the firm's performance, and maybe, in time, Terry's job. After all, per my post of last August, he was running S&P on a pretty thin funding stream while pushing for massively greater profits and volumes from the unit.

It looks like that strategy is now coming home to roost at the firm, in the form of the investor lawsuit based on the private securitized bonds ratings.

Today's Employment Report

This morning's employment report information provided the headline news that unemployment has now risen to 9.7%.

A little over a month ago, I wrote this piece, comparing the economic outlooks of several well-known pundits. In particular, I focused on Mort Zuckerman's views, which I happen to share,

"Then we have a very detailed, persuasive editorial in last Tuesday's Journal, written by Mort Zuckerman. In his piece, the chairman of US News & World Report, and head of Boston Properties, dwells almost exclusively on the under-representative current unemployment rate of 9.5%.

Zuckerman lists 10 separate, but related points, all of which provide evidence that the demand side of the economy, via consumer spending, will almost certainly be much lower in the next few years than most pundits, analysts and economists realize.

Among his points, Zuckerman cites: underemployed, those no longer even looking for work, workers 'employed' but on unpaid leave, part-time workers who were once full-time, shorter work weeks among the employed, a 65% capacity utilization at US factories, and, finally, the longest average length of official unemployment- 24.5 weeks- since this data item has been tracked back in 1948.

For good measure, Zuckerman adds that low consumer confidence and high debt levels have increased the savings rate which will, of course, dampen any subsequent recovery, as the consumer's 'marginal propensity to consume' will be much lower than in recent years. He laments that now, when a truly job-creating, infrastructure-building federal spending bill would help, it's too late. That's because $787B was allocated for what has been, to date, largely increases in Medicare and other state-based transfer payment programs.

In effect, Zuckerman would conclude that people like Bank of New York's Hoey mistakenly believe that there will be sufficient consumer demand to justify rebuilding inventories, building new cars and houses."

This morning, with the release of the unemployment numbers, CNBC had a brief 'discussion' among some pundits and their usual non-pundit, senior economic idiot Steve Liesman.

Bob Barberra was actually bullish, believing that some rather innocuous elements of the data indicated a recovery was already well underway. Mark Zandi, an economist with S&P, disagreed, but in a manner so subtle that one really had to pay close attention to catch it.

Zandi closed his remarks by noting that, with such high unemployment, some of the hopeful signs others noted, such as hours worked or weekly income, weren't all that significant. Instead, Zandi expressed the view that the still-increasing unemployment rate was going to overwhelm those modest signs of some added consumer spending power.

Rick Santelli closed his own comments by noting that the 9.7% topline unemployment rate would be the headline news for the day and weekend.

I went back to my post concerning Zuckerman's piece to remind myself of something I've only seen him illuminate. That is, much of the continuing unemployment data simply defines away, or omits, the fact that the report's perspective excludes certain classes of the unemployed who no longer look for work, and miscounts or under-represents those effectively now on part-time schedules.

One thing is sure, though. The immensely expensive "stimulus" bill passed early this year has done nothing to mitigate the continued rise in unemployment. We don't yet know for certain whether an economic recovery is underway, but there are collateral signs that it is not.

For example, in today's Wall Street Journal, there is an article detailing the unexpected deterioration of the financial condition of consumer borrowers once rated as prime. Their mortgage and credit card debt is growing delinquent at a faster pace now than subprime loans are continuing to deteriorate.

It doesn't take much logic to see this hitting bank earnings and capital, causing another round of private-sector financial shrinkage. Not to mention dampening consumer demand and affecting consumer sentiment.

I personally believe, as I've written in a prior post, that many economists are using inappropriate models and assumptions from over 25 years ago. Models and assumptions which are tied to a different type of economy and workforce than we now have. As such, I don't think they are correctly accounting for today's business IT allowing for previously-unimagined control of overheads and inventories.

If economic recovery is based upon expectations of inventory rebuilds, I just think that's overly optimistic for the next few quarters.

What Does The FDIC's Need For Backstopping Imply For America's Financial Power?

Dennis Berman wrote an interesting piece in Tuesday's Wall Street Journal concerning the current cries abroad- yet again- for an end to the role of the US dollar as the international reserve currency.

I've read these pieces for over 20 years now, and, until now, I have always considered them wishful thinking on the part of foreign economic wannabes.

Berman even included the comments of one academic who continues to label this desire wishful thinking.

But there are developments in the US domestic economic and financial situation which could well herald the final coming to feasibility of these calls for an end to US 'economic hegemony.'

For me, they became more thought-provoking and sobering with the recent spate of articles calling attention to, of all things, the FDIC insurance fund's near depletion.

Of all the FDR-era New Deal programs, the FDIC may well be the first to officially crater. And this marks, I believe, a very differential milestone of a very troubling sort for US economic power.

Why? Why this one somewhat innocuous program, rather than, say, Medicare, Social Security or Medicaid?

Precisely because, while those latter three are explicit social wealth transfer payment schemes, the FDIC program was designed to be a private business-funded insurance program to prevent a repeat of the 1930's era bank collapses which caused depositors' funds to simply evaporate.

That Sheila Bair may have to call on Treasury to write a check to replenish this bank sector-financed program is deeply worrying to me. It means that federal regulatory ineptitude has caused the bank deposits insurance program obligations to have outrun its resources, making this promise essentially empty.

Since the US has an outstanding deficit, any funds lent to the FDIC from Treasury must, given money's fungibility, be borrowed from the financial markets. Thus, the promise to safeguard consumer bank deposits- and money market balances, too- is being financed with borrowing.

There is nothing "there" anymore. The deposit insurance promise will now simply be dependent upon market funding appetites.

This was always supposed to be a federally-designed and -managed scheme whereby private commercial banks paid insurance premiums to be used to guarantee the consumer deposits of banks which were declared bankrupt and seized.

Now, the premiums and their income have been overwhelmed by bank failures. The program hasn't worked, although it took some 70 years to occur. Whether the rate was too low, or FDIC bank closures too lenient, poor design and/or mismanagement has resulted in this program failing.

If a privately-financed, government-run scheme from the New Deal era has failed, what is one to imagine has occurred with government-financed, government-run schemes? Because government-financed is now just another term for borrowed funding.

I suspect the longer term implications for the looming FDIC fund insolvency is going to be skyrocketing interest rates on US debt and a consequent impoverishment of Americans due to the gradual, practical, if long term aversion to dollar-denominated obligations by the rest of the world.

Everyone understands government borrowing for impractical social schemes. But when a US private sector-funded program is seen to become unaffordable, it has to call into question the soundness, creativity, ingenuity and superiority of the now-crippled American capitalistic system for wealth creation.

What once was the envy of the world as an economic wealth-creation engine has been severely damaged over the past several years. Perhaps, now, we are seeing, sufficiently seriously to make the rest of the world's investors finally doubt the once-accepted truism that America is the best country for wealth creation on the globe.

Daniel Yergin On The Future of Oil

Daniel Yergin, the esteemed oil analyst, wrote a wonderful editorial in Monday's Wall Street Journal. In it, he reminded us why oil, for all its problems, will still be with us as the world's dominant energy source, for some time to come. Meaning decades.

He noted, in his piece,



"Why this debate about the single most important source of energy—and a very convenient one—that provides 40% of the world's total energy? There are the traditional concerns—energy security, diversification, political risk, and the potential for conflict among nations over resources. The huge shifts in global income flows raise anxieties about the possible impact on the global balance of power. Some worry that physical supply will run out, although examination of the world's resource base—including a new analysis of over 800 oil fields—shows ample physical resources below ground. The politics above ground is a separate question.

But two new factors are now fueling the debate. One is the way in which oil has taken on a second identity. It is no longer only a physical commodity. It has also become a financial asset, along with stocks, bonds, currencies and the rest of the world's financial portfolio. The resulting price volatility—from less than $40 in 2004, to as high as $147.27 in July 2008, back down to $32.40 in December 2008, and now back over $70—has enormous consequences, and not only at the gas station and in terms of public anger. It makes it much more difficult to plan future energy investments, whether in oil and gas or in renewable and alternative fuels. And it can have enormous economic impact; Detroit was sent reeling by what happened at the gas pump in 2007 and 2008 even before the credit crisis. Such volatility can fuel future recessions and inflation."

So much for two key reasons why Americans might wish for oil to be less important than it is. But then Yergin goes on to analyze the likelihood of such change,

"But are big cuts in world oil usage possible? Both the U.S. Department of Energy and the International Energy Agency project that global energy use will increase almost 50% between 2006 and 2030—with oil still providing 30% or more of the world's energy.

The reason is something else that is new—the globalization of demand. No longer are the growth markets for petroleum to be found in North America, Western Europe and Japan. The United States has already hit "peak gasoline demand."

The demand growth has now shifted, massively, to the fast-growing emerging markets—China, India and the Middle East. Between 2000 and 2007, 85% of the growth in world oil demand was in the developing world. This shift continues: This year, more new cars have been sold in China than in the United States. When economic recovery takes hold, what happens in emerging countries will be the defining factor in the path for overall consumption.

There are two obvious ways to temper demand growth—either roll back economic growth, or find new technologies. The former is not acceptable. Thus, the answer has to lie in technology. The challenge is to find alternatives to oil that can be economically competitive—and convenient and reliable—at the massive scale required."

Mr. Yergin has basically alerted us to the fact that the marginal uses of oil will now be determined by other countries, not the US. Our own management of demand no longer will determine world prices.

Zeroing in on oil's role in energy even further, Yergin observes,

"For oil, the focus is on transportation. After all, only 2% of America's electricity is generated by oil. Until recently, it appeared that the race between the electric car and the gasoline-powered car had been decided a century ago, with a decisive win by the gasoline-powered car on the basis of cost and performance. But the race is clearly on again.

Yet, whatever the breakthroughs, the actual impact on fuel use for the next 20 years will be incremental due to the time it takes to get large-scale mass production up and running and the massive scale of the global auto industry.

My firm, IHS CERA, projects that with aggressive sales volumes and no major bumps in the road (unusual for new technologies), plug-in hybrids and pure electric vehicles could constitute 25% of new car sales by 2030. But because of the slow turn-over of the overall fleet, gasoline consumption would be reduced only modestly below what it would otherwise be. Thereafter, of course, the impact could grow, perhaps very substantially.

But, in the U.S., at least for the next two decades, greater efficiency in the internal combustion engine, advanced diesels, and regular hybrids, combined with second-generation biofuels and new lighter materials, would have a bigger impact sooner. There is, however, a global twist. If small, low-cost electric vehicles really catch on in the auto growth markets in Asia, that would certainly lower the global growth curve for future oil demand."

Again, Yergin points out that developments in, well, the developing countries, e.g., India and China, will have more impact on oil demand than will what happens onshore in America. Precisely because of our mature demand for automobiles, any new, rapid incursion by electrically-powered vehicles won't likely happen in the US. I am presuming that Yergin believes that any draconian federal action to mandate against new gasoline-powered cars will simply result in Americans holding on to the ones they already have for longer, thus further increasing average vehicle life, and reducing turnover. Especially at current prices for electric vehicles, and the non-existent infrastructure for recharging them.

He closes with this passage,

"As to the next 150 years of petroleum, we can hardly even begin to guess. For the next 20 years at least, the unfolding economic saga in emerging markets will continue to make oil a global growth business."

Daniel Yergin doesn't write in the Journal very often, but he never disappoints with the quality and focus of his insights. In this editorial, he reminds us, with factual support, why oil will be powering American vehicles for the next several decades. And why, regardless of our energy policies for the next few years, other countries will have greater impact on the larger issues of vehicular power sources than will Americans for the future.

It puts the current federal government preoccupation with energy policy, cap-and-tax, and other related matters in a whole new light, doesn't it?

If you thought those initiatives were misguided and pointless before, you probably are even more convinced of that position after reading Yergin's thoughts.

Earnings vs. Revenues

Sometimes I have difficulty believing how simple and shallow business writers can be. Even at the Wall Street Journal.

Monday's edition carried a Money & Investing Section lead article seriously discussing whether the recent equity market rally, founded upon the belief of an economic recovery, can be sustained on profit increases without concomitant revenue growth.

Duh.

There's no discussion here. The answer is a resounding, absolute "NO."

In my proprietary research on large-cap equities over several decades, I discovered that there is a large and clear-cut fault line between those companies which can grow revenues, and those which cannot.

The latter exist, and some can actually consistently outperform the S&P500 Index for several years at a time. In the past, Colgate's Ruben Mark did this for about a decade- the longest of any slow/no-growth company which I observed.

But, due to the lack of revenue growth, Colgate's margin of total return over the S&P was only a few percentage points per annum. Far, far below the average total return that the most consistent high revenue-growth companies achieved.

It's a stunningly simple theoretical argument which is borne out in empirical results.

While revenue growth allows all of the rest of the income statement, and, thus, balance sheet, to grow at a rapid clip, revenue stagnation or shrinkage does the reverse.

You can't cut 100% of operating expenses. Neither overhead, nor direct labor or materials. It's a long walk on a short pier.

Thus, without steady growth in consumer demand, low-/no-growth companies will quickly reach the end of what gains are feasible using only cost-cutting. After that, margins are pretty much purely a function of volume.

It's pretty simple. There's no need for a long article or hopeful conjecture.

No, the equity rally of the past few months will not survive another quarter of no revenue growth.

Cerberus Restructures

It took a few years, but private equity group Cerberus' investments in Chrysler and GMAC have finally come home to roost in a big way.

So big that the group was forced to offer its investors an option to exit the their Cerberus positions. According to the weekend edition of the Wall Street Journal, slightly over 70% of investor assets, some $5.5B, are being redeemed.

I wrote two posts, here and here, back in May of 2007 and January of 2008, concerning Cerberus' purchase of Chrysler, then some early performance signs after the buyout. Even that far back, I was sceptical that Cerberus could refine gold out of the dross that had and has become the third-ranked US-based car maker.

As one would have guessed, Cerberus' investments in the two entities were zeroed out when the private equity group went to the federal government for a rescue.

Looks like I was correct in my belief that Chrysler was just too far gone to be viable, even if my expectation that high interest rates would eventually be the firm's undoing. Cerberus didn't choke on high interest rates for its highly-leveraged play for Chrysler and GMAC but, instead, failed due to an inability to simply raise private capital for them.

As I mentioned in the May, 2007 post, there's something decidedly ironic and telling about the Schumpeterian aspect of Cerberus' failures. Just because something is cheap doesn't mean it's attractive.

The industry structure of automobile manufacturing has been problematic for at least a decade. Barriers to entry are low, wages in foreign countries require extremely productive US operations if those costs are to be offset, and increasing numbers of subsystems have become outsourced, making auto "manufacturing" more a case of auto "assembly."

Cerberus' senior managers do seem to have become overly-confident and foolishly optimistic. Now, they and their investors are paying a heavy price.

It's pretty eye-opening that more than 2/3 of their investors are going to beat a path out of Cerberus, assuming the private equity group goes ahead with its restructuring plans. That surely is a vote of no confidence whatsoever in the group's ability to both rescue its current slate of investments, and do a better job choosing future ones.

I can't say that I blame those investors. Cerberus has shown an appallingly-bad habit recently of buying mediocre, or worse, properties and being unable to handle them as market conditions deteriorated. This is supposed to be the strong suit of private equity, and, in that, Cerberus has failed.