By and large I have found Fed Chairman Ben Bernanke to be qualified, informed and vigilant in his position.
Beginning last summer, however, with the onset of the private sector's self-inflicted financial troubles, I have questioned Bernanke's ability to remain objective amidst media attacks.
Two recent pieces in the Wall Street Journal drew my attention to actions by Bernanke which I find to be troubling, and would even label as 'errors.'
The first was the Journal's lead editorial two Fridays ago, on February 29. In that piece, the authors noted that commodities such as gold, food and energy have been hitting record highs lately. Retrospectively, these are typically signs of coming inflation at the consumer level.
Meanwhile, Bernanke and the Fed have rather recklessly cut rates since this summer, attempting to solve a counterparty risk dilemma with lower rates and easier monetary policy.
To date, it's unclear that any of the extra Fed-supplied liquidity has affected the credit markets in a substantial, lasting manner. Instead, equity markets have reacted to the various rate cuts like heroin addict to his latest fix. After the effect wears off, he looks for the next dose, hoping it will be even larger.
The editorial points out that the Fed is notoriously bad at what used to be called "fine tuning." In this case, knowing when to suddenly switch from recession-fighting rate cuts to inflation-fighting rate hikes seems likely to be problematic.
As the Journal editorial put it so eloquently,
"For readers under age 30 who are wondering why they are suddenly paying $3.15 for gasoline and $2 for milk, the answer is that this is what an inflation looks like. Those of us of a certain age remember it well, if painfully, and judging by the noises coming from the Federal Reserve of late we had all better get used to it again.
First, Fed Vice Chairman Don Kohn declared that, while inflation was worrisome, the Fed now views recession as the more urgent danger to fight. Then on Wednesday, Fed Chairman Ben Bernanke told Congress that the Fed will do whatever it takes to stop the credit squeeze from becoming a recession. That's about as close as a central banker will get to saying that he's thrown price stability to the wind. If inflation rises -- as it now surely will -- then the Fed will worry about that later, after the economy is safely past the credit crunch."
Personally, I could not care less about Humphrey-Hawkins, the poorly-designed Senate law which foolishly commands the Fed to pursue both price stability and full employment.
The Journal concludes by noting,
"Then as now they were also dismissing such forward-looking price signals as gold and oil and instead focusing on such misleading indicators as "core inflation" and the money supply. Mr. Mishkin may be seen as a monetary wizard at the Fed, but to investors around the world he is beginning to look more like a high-class inflationist.
The people who aren't being fooled by all this are the American people. They don't pay their bills with "core" dollar bills, and they know those dollars buy less with each passing month. This explains their rising economic anxiety -- and anger -- better than trade or job losses do, especially since the job market has remained relatively healthy. Inflation is the great thief of the middle class, as even Americans who don't recall the 1970s are learning. With its all-in reflation bet, the Bernanke Fed is gambling with their money."
I have to admit, I am not happy with Bernanke. Rather than insulate himself from external critics and have the courage Paul Volcker did when he wrung inflation out of our economy over 25 years ago, Bernanke seems to actually be afraid of the Congressional Committees before which he must periodically appear.
As if all of this were not bad enough, yesterday's Journal reported that in Bernanke's recent speech to a conference of bankers, he said,
"In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure" than reducing the interest rate."
Meaning unilateral loan forgiveness under quasi-duress from the Federal government. In other language, this would known as a "taking-" the unlawful seizure of property without compensation. For the record, Barney Frank was thrilled to welcome Bernanke aboard his ideological investment confiscation train.
Reactions to Bernanke's sudden socialist uttering included,
"Reducing the principal rather than the interest rate is a "very different framework for thinking about the problem," said Andy Laperriere, an analyst at ISI Group, a brokerage firm. He said with so many borrowers under water, "any proposal that helps them will be very expensive for either the financial institution or the taxpayer," and a large program would potentially sweep in millions of borrowers who weren't going to default anyway.
Industry reacted coolly to Mr. Bernanke's proposal. The American Securitization Forum, which represents participants in the market for mortgage-backed securities -- pools of mortgages originated and sold by banks and other lenders -- said it had already developed procedures for modifying loans, including through principal reduction. To reduce principal, firms that service MBS pools on behalf of the end investors need "a clear basis for concluding that the related borrower is unable...rather than simply being unwilling" to repay."
No kidding! Doesn't Bernanke realize to what this sort of reward for an ultimate moral hazard- buying a home you can't afford- this will lead? Potential borrowers will never again take loss of their equity via foreclosure seriously. They'll simply wait to be part of a massive wave of subprime borrowing, the better to be part of those receiving the resulting Federal largess of loan forgiveness.
At a time when Congress complains that the Federal government is living beyond its means, but won't cut its own budget, we see it now demanding lenders allow US consumers to live beyond theirs, too.
I'd pay some extra tax dollars if it were targeted at bringing Tall Paul back out of retirement to lead the Fed for a few years. Not that I don't think Bernanke had been doing a good job until recently. Or that he doesn't understand the various aspects of his job. I just think Volcker was a Godsend whose discipline is now sorely missed, and will be, much more, I'm afraid, before too much longer.
Friday, March 07, 2008
Thursday, March 06, 2008
More on Marking To Market
Last week I wrote this post regarding the hazards of applying 'mark to market' to every balance sheet in sight. In the post, I asked,
"Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?
What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?"
I guess I'm in good company, because in yesterday's Wall Street Journal, Holman Jenkins echoed my post and sentiments in a column entitled "Mark to Meltdown?"
Jenkins wrote,
"Overstating the importance of accounting rules is, indeed, the essential error that leads to excessive twiddling with accounting rules. Whether a company values its assets at historic cost or market value or a value derived by some other formula, investors still have to make their own forecasts and judgments. A thermometer is equally useful whether it says water freezes at 0 degrees or 32 degrees -- though it still doesn't tell what the temperature will be next week.
But loose as well is a fear that exaggerated writedowns in the current credit crunch are rapidly chewing through the banking system's capital cushion. Banks will be forced to dump assets at fire-sale prices, leading to yet more writedowns and more fire sales. At best, banks will have to keep shopping cheap equity to foreign potentates to keep themselves afloat. At worst, massive regulatory insolvency lies ahead.
This horror show, we hasten to add, has proven more theoretical than actual, but it plays a key role in the meltdown scenarios of NYU economist Nouriel Roubini, which he recently retailed for a congressional hearing. And it's hard to doubt that fears of accounting-prompted distress sales are partly behind the melodramatic yields now available in the corporate and municipal bond markets."
Which is pretty much what I further opined in my earlier post,
"It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero."
We therefore have the Law of Unintended Consequences extracting perverse, severe penalties from today's credit markets. Somewhat arbitrary accounting rules are now governing the behavior of financial service firms to issue margin calls and trigger the unwinding of highly-leveraged positions in credit instruments, which is causing further, temporary cratering of values of otherwise-performing assets.
As Mr. Jenkins informs us,
"Mark to market was a gift to the world from SEC Chief Richard Breeden in the early '90s. With the help of accounting mavens, he argued that requiring banks and other companies to account for financial assets at current market prices, as if the institutions were being sized up for liquidation, would provide a rough-tough discipline for the edification of investors, regulators and managers.
A rose would smell as sweet if it were called skunk cabbage -- so we always maintain when somebody predicts either dire or utopian results from a mere accounting change. Still, many questioned Mr. Breeden's initiative at the time, among them Fed Chairman Alan Greenspan and Bank of America's Richard M. Rosenberg. Particularly notable were their warnings that the new rule, when combined with risk-based capital standards, might lead banks to hold fewer loans on their own books, packaging more of them as complex securities for sale to investors.
Overlooked, too, was a phenomenon we perhaps understand better today -- the propensity of the speculators who provide much of the market's day-to-day liquidity to go on strike during moments when their services are most needed. "Mark to market" then becomes something else, because markets no longer exist for many of these abstruse securities. Banks are left oxymoronically trying to estimate what market prices would be if markets existed."
Which, again, echoes something I've written about many times in the past year- the tendencies of younger trading mavens to fail to understand that sometimes markets simply cease to exist, in the classical sense of the definition. If you hold such instruments with borrowed money, you are in a bind. If you are forced to mark such positions to market in the face of a non-existent 'market,' you are also in a bind.
Mr. Jenkins closes his piece with this passage,
"But the best argument was articulated by the late Citibanker Walter Wriston, and it applies equally to most of the accounting innovations with which the world has been oversupplied in recent decades: "Consistency of accounting treatment is always more useful to managers and investors than the latest fad of accounting aficionados." "
Just so. And perhaps we should allow for context, too. As I asked at the end of my prior, linked post, why isn't this a subject on which FASB should rule? Have they been attending to it since, oh, last June, when the effects of this accounting policy began to send credit markets in a downward valuation spiral of 'devalue-sell-devalue-sell-devalue-sell-writedown-close?'
I think the much, much larger issue now is to consider, for the entire financial services sector, the contexts in which mark-to-market makes little sense, and should be suspended, versus when it is appropriate.
As I began to suggest in my earlier post, businesses and companies in the business of trading and investing with the constant expectation of selling and buying securities should probably mark their assets to market daily. If that causes them to use less leverage or avoid exotic structured finance instruments, so be it.
Financial service businesses intending to hold assets, whether they be whole loans, exotics, or what have you, beyond a pre-determined duration, should probably be able to value those assets on the basis of performance, rather than immediate market value.
As I wrote here in September of last year,
"Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?
It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.
Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.
It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"
More than anything else, it seems that commercial banks began behaving like investment banks, and have effectively eliminated an institution which used to anchor the US economy- the bank that judges credits based upon the prospect of actually holding them to maturity.
"Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?
What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?"
I guess I'm in good company, because in yesterday's Wall Street Journal, Holman Jenkins echoed my post and sentiments in a column entitled "Mark to Meltdown?"
Jenkins wrote,
"Overstating the importance of accounting rules is, indeed, the essential error that leads to excessive twiddling with accounting rules. Whether a company values its assets at historic cost or market value or a value derived by some other formula, investors still have to make their own forecasts and judgments. A thermometer is equally useful whether it says water freezes at 0 degrees or 32 degrees -- though it still doesn't tell what the temperature will be next week.
But loose as well is a fear that exaggerated writedowns in the current credit crunch are rapidly chewing through the banking system's capital cushion. Banks will be forced to dump assets at fire-sale prices, leading to yet more writedowns and more fire sales. At best, banks will have to keep shopping cheap equity to foreign potentates to keep themselves afloat. At worst, massive regulatory insolvency lies ahead.
This horror show, we hasten to add, has proven more theoretical than actual, but it plays a key role in the meltdown scenarios of NYU economist Nouriel Roubini, which he recently retailed for a congressional hearing. And it's hard to doubt that fears of accounting-prompted distress sales are partly behind the melodramatic yields now available in the corporate and municipal bond markets."
Which is pretty much what I further opined in my earlier post,
"It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero."
We therefore have the Law of Unintended Consequences extracting perverse, severe penalties from today's credit markets. Somewhat arbitrary accounting rules are now governing the behavior of financial service firms to issue margin calls and trigger the unwinding of highly-leveraged positions in credit instruments, which is causing further, temporary cratering of values of otherwise-performing assets.
As Mr. Jenkins informs us,
"Mark to market was a gift to the world from SEC Chief Richard Breeden in the early '90s. With the help of accounting mavens, he argued that requiring banks and other companies to account for financial assets at current market prices, as if the institutions were being sized up for liquidation, would provide a rough-tough discipline for the edification of investors, regulators and managers.
A rose would smell as sweet if it were called skunk cabbage -- so we always maintain when somebody predicts either dire or utopian results from a mere accounting change. Still, many questioned Mr. Breeden's initiative at the time, among them Fed Chairman Alan Greenspan and Bank of America's Richard M. Rosenberg. Particularly notable were their warnings that the new rule, when combined with risk-based capital standards, might lead banks to hold fewer loans on their own books, packaging more of them as complex securities for sale to investors.
Overlooked, too, was a phenomenon we perhaps understand better today -- the propensity of the speculators who provide much of the market's day-to-day liquidity to go on strike during moments when their services are most needed. "Mark to market" then becomes something else, because markets no longer exist for many of these abstruse securities. Banks are left oxymoronically trying to estimate what market prices would be if markets existed."
Which, again, echoes something I've written about many times in the past year- the tendencies of younger trading mavens to fail to understand that sometimes markets simply cease to exist, in the classical sense of the definition. If you hold such instruments with borrowed money, you are in a bind. If you are forced to mark such positions to market in the face of a non-existent 'market,' you are also in a bind.
Mr. Jenkins closes his piece with this passage,
"But the best argument was articulated by the late Citibanker Walter Wriston, and it applies equally to most of the accounting innovations with which the world has been oversupplied in recent decades: "Consistency of accounting treatment is always more useful to managers and investors than the latest fad of accounting aficionados." "
Just so. And perhaps we should allow for context, too. As I asked at the end of my prior, linked post, why isn't this a subject on which FASB should rule? Have they been attending to it since, oh, last June, when the effects of this accounting policy began to send credit markets in a downward valuation spiral of 'devalue-sell-devalue-sell-devalue-sell-writedown-close?'
I think the much, much larger issue now is to consider, for the entire financial services sector, the contexts in which mark-to-market makes little sense, and should be suspended, versus when it is appropriate.
As I began to suggest in my earlier post, businesses and companies in the business of trading and investing with the constant expectation of selling and buying securities should probably mark their assets to market daily. If that causes them to use less leverage or avoid exotic structured finance instruments, so be it.
Financial service businesses intending to hold assets, whether they be whole loans, exotics, or what have you, beyond a pre-determined duration, should probably be able to value those assets on the basis of performance, rather than immediate market value.
As I wrote here in September of last year,
"Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?
It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.
Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.
It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"
More than anything else, it seems that commercial banks began behaving like investment banks, and have effectively eliminated an institution which used to anchor the US economy- the bank that judges credits based upon the prospect of actually holding them to maturity.
Wednesday, March 05, 2008
Green Corporate Subsidies- Another Third-Party Payer Disaster In The Making?
A week ago yesterday, the Wall Street Journal carried an article entitled "Workers Get Incentives to Live Greener," written by Kelly Spors.
The article provides insights into a new trend which goes beyond corporations working to reduce the environmental impact of their business operations. As Spors writes,
"It irked Greg James to see some of his employees roll up to work in hulking, gas-guzzling sport-utility vehicles -- often driving more than 40 miles a day round trip.
So in 2005 he finally did something about it.
The chief executive and founder of Topics Entertainment Inc., a Renton, Wash., DVD and software publisher, Mr. James established an incentive program that offers its 55 employees $1,000 to trade in their automobiles for one with fewer cylinders in the engine. Buying a hybrid or biodiesel vehicle earns them $2,500, while car pooling at least three days a week pays $300 annually split between the ride sharers.
Ten employees have claimed the auto-purchase bonus so far. Mr. James estimates that by getting those new vehicles and boosting their gas mileage an average 10 miles per gallon, employees cut last year's gasoline consumption during commutes by 2,400 gallons."
It sounds pretty harmless, doesn't it? A well-meaning small-business owner does his bit to further his own environmental beliefs by rewarding employees who follow his own precepts?
But wait. Isn't that unfair? What about a handicapped employee who can't drive? Shouldn't s/he be entitled to some offset for not being able to buy a car and earn that bonus?
What about a struggling single mother of a handicapped child who can't afford a new car? Or carpool?
What about employees who live next to the plant and walk to work? Should they be denied eligibility for the carpooling bonus?
Call the Labor Department!!! Call the union!!!!
Spors continues by noting,
"Many companies, large and small, have become greener by reducing office waste and pollution or buying so-called carbon credits, which companies purchase to offset the impact of their pollution. But a growing number of small companies like Topics also are seeing value in encouraging employees to make environmentally friendlier choices as well -- at home, at work and in their commutes.
Among the incentives: giving bonuses to employees who buy more fuel-efficient vehicles and outfit their homes in more energy-efficient ways, as well as helping employees support environmental causes. Even low-cost measures, such as letting employees purchase energy-efficient light bulbs at the employer's bulk price, are making a difference in employees' behavior and energy use.
In an era when more young workers are seeking out employers with a socially responsible mission, such green incentives can help bolster recruitment efforts and foster goodwill. At small companies especially, green benefits can be an easy and effective way to ingrain a workplace's eco-friendly mission."
"Some companies find that the participation of even a few employees can have an impact. Green Mountain Energy Co., an Austin, Texas, renewable-electricity provider, lets employees buy renewable-energy credits to offset their carbon-dioxide emissions. It also matches donations to environmental groups made through payroll deduction, up to $10 per two-week pay period.
In addition, the company hands out prizes like gift certificates based on points that employees rack up by finding alternatives to driving to work, such as biking or taking public transportation.
Though only about 25 of Green Mountain's 150 employees participate in the commuter program, the impact has been substantial, with those people collectively driving about 21,000 fewer miles in 2007, says Gillan Taddune, the company's chief environmental officer."
As I read this example, I was reminded of our current healthcare mess. Didn't we get into this dilemma by creating, somewhat recklessly, in retrospect, third-party payers for necessities?
Do we really want transportation costs of employees twenty years hence dependent upon the whims of employers? What if employers secure a deal for mass transit for their employees, forcing them to commute via bus, and discriminate against those who wish to drive?
Why, in God's name, can't employers just pay employees cash, shares or options, and have done with it? Haven't we learned over the past 100 years that paying employees in kind eventually creates distortions in consumption, improper influence of the corporation into the private lives of its employees, and suspect values impositions?
What if Topic Entertainment's owner was a racist or anti-Semite? What if he awarded bonuses for employees sending their children to single-race schools? Or contributing to the Aryan Nation?
What if the owner of a firm was a Southern Baptist, and provided cash bonuses for every employee who attended a Southern Baptist church each week?
Would we think that such an imposition of values by a business owner on his employees was proper?
Who is to judge when an owner's values are appropriate, and when they are not? What is laudable mobilization of society's members for a desirable goal, and what constitutes improper manipulation of workers by their employer in an illegal manner?
I loved the article, and found it important in a very unexpected manner.
In 2008, after nearly 100 years of an organized labor movement in this country to protect workers' rights, we still see business interfering in the private lives of its employees. Creating yet more entanglements between workers' consumption patterns, affordability of choices, and employer funding.
Will we ever learn?
The article provides insights into a new trend which goes beyond corporations working to reduce the environmental impact of their business operations. As Spors writes,
"It irked Greg James to see some of his employees roll up to work in hulking, gas-guzzling sport-utility vehicles -- often driving more than 40 miles a day round trip.
So in 2005 he finally did something about it.
The chief executive and founder of Topics Entertainment Inc., a Renton, Wash., DVD and software publisher, Mr. James established an incentive program that offers its 55 employees $1,000 to trade in their automobiles for one with fewer cylinders in the engine. Buying a hybrid or biodiesel vehicle earns them $2,500, while car pooling at least three days a week pays $300 annually split between the ride sharers.
Ten employees have claimed the auto-purchase bonus so far. Mr. James estimates that by getting those new vehicles and boosting their gas mileage an average 10 miles per gallon, employees cut last year's gasoline consumption during commutes by 2,400 gallons."
It sounds pretty harmless, doesn't it? A well-meaning small-business owner does his bit to further his own environmental beliefs by rewarding employees who follow his own precepts?
But wait. Isn't that unfair? What about a handicapped employee who can't drive? Shouldn't s/he be entitled to some offset for not being able to buy a car and earn that bonus?
What about a struggling single mother of a handicapped child who can't afford a new car? Or carpool?
What about employees who live next to the plant and walk to work? Should they be denied eligibility for the carpooling bonus?
Call the Labor Department!!! Call the union!!!!
Spors continues by noting,
"Many companies, large and small, have become greener by reducing office waste and pollution or buying so-called carbon credits, which companies purchase to offset the impact of their pollution. But a growing number of small companies like Topics also are seeing value in encouraging employees to make environmentally friendlier choices as well -- at home, at work and in their commutes.
Among the incentives: giving bonuses to employees who buy more fuel-efficient vehicles and outfit their homes in more energy-efficient ways, as well as helping employees support environmental causes. Even low-cost measures, such as letting employees purchase energy-efficient light bulbs at the employer's bulk price, are making a difference in employees' behavior and energy use.
In an era when more young workers are seeking out employers with a socially responsible mission, such green incentives can help bolster recruitment efforts and foster goodwill. At small companies especially, green benefits can be an easy and effective way to ingrain a workplace's eco-friendly mission."
When I read this, I felt vaguely uneasy. Recollections of being taught about the personally intrusive methods of the late Henry Ford came to mind. And company towns in the coal fields of Kentucky and West Virginia.
Didn't Walter Reuther and company fight large corporations in the 1930s to stop corporate America from controlling employees' private lives?
Wasn't society eventually repulsed by Ford's in-home audits of the families of his employees, whereby his auditors assessed the extent of a family's abiding by a code of conduct of Ford's own making? If I recall correctly, employees were paid extra for scoring highly on the assessment.
The article mentions near its conclusion,
"Some companies find that the participation of even a few employees can have an impact. Green Mountain Energy Co., an Austin, Texas, renewable-electricity provider, lets employees buy renewable-energy credits to offset their carbon-dioxide emissions. It also matches donations to environmental groups made through payroll deduction, up to $10 per two-week pay period.
In addition, the company hands out prizes like gift certificates based on points that employees rack up by finding alternatives to driving to work, such as biking or taking public transportation.
Though only about 25 of Green Mountain's 150 employees participate in the commuter program, the impact has been substantial, with those people collectively driving about 21,000 fewer miles in 2007, says Gillan Taddune, the company's chief environmental officer."
As I read this example, I was reminded of our current healthcare mess. Didn't we get into this dilemma by creating, somewhat recklessly, in retrospect, third-party payers for necessities?
Do we really want transportation costs of employees twenty years hence dependent upon the whims of employers? What if employers secure a deal for mass transit for their employees, forcing them to commute via bus, and discriminate against those who wish to drive?
Why, in God's name, can't employers just pay employees cash, shares or options, and have done with it? Haven't we learned over the past 100 years that paying employees in kind eventually creates distortions in consumption, improper influence of the corporation into the private lives of its employees, and suspect values impositions?
What if Topic Entertainment's owner was a racist or anti-Semite? What if he awarded bonuses for employees sending their children to single-race schools? Or contributing to the Aryan Nation?
What if the owner of a firm was a Southern Baptist, and provided cash bonuses for every employee who attended a Southern Baptist church each week?
Would we think that such an imposition of values by a business owner on his employees was proper?
Who is to judge when an owner's values are appropriate, and when they are not? What is laudable mobilization of society's members for a desirable goal, and what constitutes improper manipulation of workers by their employer in an illegal manner?
I loved the article, and found it important in a very unexpected manner.
In 2008, after nearly 100 years of an organized labor movement in this country to protect workers' rights, we still see business interfering in the private lives of its employees. Creating yet more entanglements between workers' consumption patterns, affordability of choices, and employer funding.
Will we ever learn?
Tuesday, March 04, 2008
GE CEO Immelt's 2007 Compensation: The Comedy Continues
It's nearly spring, and just about a year since the Wall Street Journal last published GE's disclosure of its underperforming CEO's, Jeff Immelt's most recent annual compensation. My post on his 2006 compensation may be found here. In that post, to reprise history, I wrote,
"So, the news today is that Immelt received $8.3MM in "salary and bonus."... that makes a total of roughly $23MM in cash Immelt has now managed to loot from his employer since late 2001, when he began his reign as a failing CEO at GE. If the firm meets certain (fairly low-ball, as I recall from earlier articles) revenue, earnings and cash generation targets, and meets some stock price performance relative to the S&P, Immelt will receive as much as $18.6MM in 2007.
Immelt's base salary was $3.3MM in 2006, to which was added, unbelievably, a cash bonus of $5MM,"citing Mr. Immelt's 'offensive portfolio moves' and GE's 15% earnings-per-share growth in 2006."
Offensive indeed. It's another black day for corporate governance and responsible boards of directors."
Did anything change this year?
Well, according to today's Wall Street Journal,
"Chairman and Chief Executive Jeffrey Immelt received a salary and bonus totaling $9.1 million last year, a 9.6% increase over 2006, but GE's board granted him less new equity than in the prior year.
In 2007, Mr. Immelt exercised 180,000 stock options that were about to expire and acquired 79,000 shares of previously restricted stock. Together, those shares were valued at $5.9 million; Mr. Immelt retained all the shares, except those used to pay taxes."
So, did GE's CEO do as well for his shareholders as they did for him, via the always-generous GE board?
This year, GE's stock price performance, and the S&P500 Index, are depicted in the Yahoo-sourced chart on the left. The company's share price peaked in October, finishing the past twelve months lower than it started, and effectively tied with the S&P.
For a longer-term perspective, I've included 2- and 5-year charts of the same two series in the next two Yahoo-sourced charts.Looks like the shareholders lost in 2007- again. For one and two years, GE's share price tied and under ran the S&P's. Over five years, a much more fair time period, allowing for more variance in economic conditions, the index clearly and handsomely outperformed Immelt's pathetic leadership of the closed-ended-fund cum diversified industrial giant.
Of course, these are just price charts. How about total returns? How did GE do when dividends are included?For this view, I went to my Compustat data and analyzed GE's performance on some of the key variables which I have found distinguish consistently superior from other large-cap firms. The nearby table may be enlarged by clicking on it to open it in a separate window.
In a 
word, GE's performance since Immelt took over in late 2001 has been anemic. Average annual revenue growth was just 3.4%, while NIAT has grown only 4.4% per anum, on average. GE's average annual total return for the period is a -2.4%, while the S&P's average annual total return for the same period is a healthy 9.5%, almost its long-term average of over 11%.
word, GE's performance since Immelt took over in late 2001 has been anemic. Average annual revenue growth was just 3.4%, while NIAT has grown only 4.4% per anum, on average. GE's average annual total return for the period is a -2.4%, while the S&P's average annual total return for the same period is a healthy 9.5%, almost its long-term average of over 11%.
The same data, in chart form, appears here. Again, clicking on it will open it in a separate window for a better view.The green and red lines representing, respectively, revenue and NIAT growth, display jagged, inconsistent paths. Total return for GE, while initially shadowing that of the S&P, departed downward precipitously in the past few years of Immelt's reign.
Once again, GE's board has shown gross insensitivity to the idea of corporate governance, paying Immelt more than $9MM in cash, while telling shareholders.
"GE spokesman Gary Sheffer said the board gave Mr. Immelt more cash and less equity because Mr. Immelt is already heavily invested in the company. Mr. Immelt owns 1.36 million shares and has options and restricted-share grants for millions more; he has pledged not to sell any shares while he leads the company."
Amazing, isn't it? As I have written in previous posts, when a CEO has been paid north of $10MM in cash, does anyone think he really cares what happens to the company's stock price anymore? Added to Immelt's prior $23MM of cash compensation, GE has now paid him over $30MM in just six years. He can't have spent or paid so much in taxes to not have at least $15MM remaining. Then there are the share grants.
So Immelt has underperformed the S&P500 for yet another year, and for the period in total during which he has been CEO. How does GE's board justify paying more than $15MM total compensation to a guy who can't outperform a passive index? According to the Journal article, by announcing,
"The board of directors' compensation committee stated it "believes Mr. Immelt performed very well in 2007," having met or exceeded targets for growth in GE's earnings from continuing operations, revenue and cash flow, among other targets. The board said his performance "in a difficult economic environment" helped the company keep risk at "acceptable levels" and maintain its triple-A bond rating.
The proxy said Mr. Immelt received $396,267 of "other compensation," including $260,980 for personal use of company aircraft."
I won't go on ranting about this clear example of corporate excess and pay for non-performance. You can read my earlier comments on Immelt's lush overcompensation by reading posts on this blog under the "Immelt" label.
For this post, I'll just restate my belief that Immelt is in a job that shouldn't exist, as CEO of a corporation that no longer has economic justification. Until GE is split apart by private equity firms, which looks less likely anytime soon in this credit environment, he'll continue to effectively steal literally tens of millions of dollars of compensation from his shareholders while providing absolutely no added value over what they would earn by simply buying the Vanguard S&P500 Index fund.
Monday, March 03, 2008
Scale vs. Concentration Risk in US Commercial Banking
Have we unwittingly invited looming disaster in our commercial banking sector?
Declining prices and margins for banking services have driven consolidation for several decades.
The share of deposits among the top 5-6 banks is much greater now than a decade ago, and certainly much more than two decades ago. BofA is at the point of being prohibited from further acquisitions, without some careful accommodations, due to its deposit share bumping up against single-bank limits.
Surely a great benefit of this consolidation has been the expansion of consumer and housing credit, as well as more competitive and competitively priced asset management services.
But the flip side of these low cost, ubiquitous products and services is concentration of banking risk in only 5-6 firms.
Now, one large mistake has a much greater impact on US deposits, loans, money trading, etc.
Have we unwittingly gone to far in fostering consolidation, while also removing Glass-Steagall?
Wouldn't it be ironic if Sandy Weill, a non-banker, and not even an investment banker, at that, but merely a low-end retail brokerage 'consolidator,' was the ultimate cause of severe risk in the US commercial banking system?
By forcing the repeal of Glass-Steagall with his merger of Travelers and Citibank in the 1990s, Weill removed a major barrier to risk concentration in the US banking sector.
Was that really wise?
Would the current credit crisis have become so serious if the commercial banks, notably Citi and BofA, were not allowed to engage in securitization of their loans to customers, but, per Glass-Steagall, were prohibited from engaging in anything resembling investment banking and the issuance of such securities?
If those two banks had been forced to either be portfolio mortgage lenders, or package their loans through Fannie or Freddie, would the SIV debacle have occurred? Would they have engaged in subprime lending or issuing or holding suspect CDOs?
My long-ago mentor at Chase Manhattan Bank, then-SVP of Corporate Planning & Development, Gerry Weiss, was fond of saying, when asked about working to remove Glass-Steagall, something like,
'Are you kidding? We'll just find some new ways to lose a lot of money on badly risk-managed positions. Not to mention that, being commercial bankers, once we get into these businesses- M&A, underwriting, equity trading- we'll cut prices to gain share and ruin the business' profitability for all concerned.'
Judging by the behavior of Citigroup and BofA in last summer's CDO, SIV and other fixed income messes, I'd say he was right on the money, as it were, as usual.
Commercial banks appear to be no better off in terms of profitability, risk management or total return after the repeal of Glass-Steagall.
I'll go so far as to say that, for the safety of our banking system, we probably should reinstate the law. Because, at the rate the large commercial banks are making risk-management mistakes, it's only a matter of a few years before one of the big five - Citi, Chase, BofA, Wachovia, Wells Fargo- commercial banks blows a hole in its balance sheet to large to self-repair, and will require Federal intervention to stabilize it and sell the remnants.
Declining prices and margins for banking services have driven consolidation for several decades.
The share of deposits among the top 5-6 banks is much greater now than a decade ago, and certainly much more than two decades ago. BofA is at the point of being prohibited from further acquisitions, without some careful accommodations, due to its deposit share bumping up against single-bank limits.
Surely a great benefit of this consolidation has been the expansion of consumer and housing credit, as well as more competitive and competitively priced asset management services.
But the flip side of these low cost, ubiquitous products and services is concentration of banking risk in only 5-6 firms.
Now, one large mistake has a much greater impact on US deposits, loans, money trading, etc.
Have we unwittingly gone to far in fostering consolidation, while also removing Glass-Steagall?
Wouldn't it be ironic if Sandy Weill, a non-banker, and not even an investment banker, at that, but merely a low-end retail brokerage 'consolidator,' was the ultimate cause of severe risk in the US commercial banking system?
By forcing the repeal of Glass-Steagall with his merger of Travelers and Citibank in the 1990s, Weill removed a major barrier to risk concentration in the US banking sector.
Was that really wise?
Would the current credit crisis have become so serious if the commercial banks, notably Citi and BofA, were not allowed to engage in securitization of their loans to customers, but, per Glass-Steagall, were prohibited from engaging in anything resembling investment banking and the issuance of such securities?
If those two banks had been forced to either be portfolio mortgage lenders, or package their loans through Fannie or Freddie, would the SIV debacle have occurred? Would they have engaged in subprime lending or issuing or holding suspect CDOs?
My long-ago mentor at Chase Manhattan Bank, then-SVP of Corporate Planning & Development, Gerry Weiss, was fond of saying, when asked about working to remove Glass-Steagall, something like,
'Are you kidding? We'll just find some new ways to lose a lot of money on badly risk-managed positions. Not to mention that, being commercial bankers, once we get into these businesses- M&A, underwriting, equity trading- we'll cut prices to gain share and ruin the business' profitability for all concerned.'
Judging by the behavior of Citigroup and BofA in last summer's CDO, SIV and other fixed income messes, I'd say he was right on the money, as it were, as usual.
Commercial banks appear to be no better off in terms of profitability, risk management or total return after the repeal of Glass-Steagall.
I'll go so far as to say that, for the safety of our banking system, we probably should reinstate the law. Because, at the rate the large commercial banks are making risk-management mistakes, it's only a matter of a few years before one of the big five - Citi, Chase, BofA, Wachovia, Wells Fargo- commercial banks blows a hole in its balance sheet to large to self-repair, and will require Federal intervention to stabilize it and sell the remnants.
Will Commodity Prices Trigger Higher US Inflation?
CNBC's Rick Santelli had a very interesting debate with another regular commentator on the networks Squawkbox program one morning last week.
Santelli holds that commodity prices are soaring because producers are selling larger quantities of gasoline, upscale food, etc., to formerly third-world countries which are now growing significantly wealthier. Thus, their consumption is adding pressure to demand for grains, beef, oil, and other basic commodities.
The other fellow on the program that morning, whose name I forget, alleged, mostly, that because US product costs are predominantly labor, which is not getting more expensive, we won't see inflation.
Who is right? It's an important question.
Personally, I believe Santelli.
First, my own experience working with company-level cost data for over two decades leaves me believing that labor costs have become much smaller components of total costs in the average US firm. Due to investments in capital, in the form of tools, information, technology, etc., the productivity of the average US worker has remained high, relative to the rest of the world. Employment levels and, thus, costs, haven't grown at the same rates as they may have in prior decades.
In fact, one commentator opined that there isn't currently a lost-jobs-based recession yet because after the economic troubles of 2001-02, businesses didn't go on a hiring binge. By carefully retaining productivity levels and using fewer new workers, they aren't having to lay the workers off so quickly now.
Further, it's very believable to me that the world's commodity producers, operating, as they typically do, in an environment of either boom or bust, try not to produce too much excess supply. Thus, the rather sudden, relatively unexpected, in the West, rise of demand for energy and pricier food inputs in Asia have caught those commodity producers flat-footed. As demand outstrips supply, for a while, prices have nowhere to go but up, to clear the markets.
As an anecdotal example, I bought some pasta-based processed food products for my children recently. As recently as last fall, the item cost $1/box at retail. This past week, it was $1.5/box.
Sure, only 50 cents more. But a 50% rise in consumer-level price. Milk, baked and processed products using wheat or corn are the same.
If Santelli's debate opponent were correct, I doubt I'd be seeing these price increases. Instead, Santelli's logic already seems to be finding its way onto the prices of items on US grocery store shelves.
Santelli holds that commodity prices are soaring because producers are selling larger quantities of gasoline, upscale food, etc., to formerly third-world countries which are now growing significantly wealthier. Thus, their consumption is adding pressure to demand for grains, beef, oil, and other basic commodities.
The other fellow on the program that morning, whose name I forget, alleged, mostly, that because US product costs are predominantly labor, which is not getting more expensive, we won't see inflation.
Who is right? It's an important question.
Personally, I believe Santelli.
First, my own experience working with company-level cost data for over two decades leaves me believing that labor costs have become much smaller components of total costs in the average US firm. Due to investments in capital, in the form of tools, information, technology, etc., the productivity of the average US worker has remained high, relative to the rest of the world. Employment levels and, thus, costs, haven't grown at the same rates as they may have in prior decades.
In fact, one commentator opined that there isn't currently a lost-jobs-based recession yet because after the economic troubles of 2001-02, businesses didn't go on a hiring binge. By carefully retaining productivity levels and using fewer new workers, they aren't having to lay the workers off so quickly now.
Further, it's very believable to me that the world's commodity producers, operating, as they typically do, in an environment of either boom or bust, try not to produce too much excess supply. Thus, the rather sudden, relatively unexpected, in the West, rise of demand for energy and pricier food inputs in Asia have caught those commodity producers flat-footed. As demand outstrips supply, for a while, prices have nowhere to go but up, to clear the markets.
As an anecdotal example, I bought some pasta-based processed food products for my children recently. As recently as last fall, the item cost $1/box at retail. This past week, it was $1.5/box.
Sure, only 50 cents more. But a 50% rise in consumer-level price. Milk, baked and processed products using wheat or corn are the same.
If Santelli's debate opponent were correct, I doubt I'd be seeing these price increases. Instead, Santelli's logic already seems to be finding its way onto the prices of items on US grocery store shelves.
Friday, February 29, 2008
Gresham's Law of.... Credit Ratings?
Tuesday's Wall Street Journal lead editorial took on the cozy world of the credit rating agencies on the heels of Monday's reaffirmation of a AAA rating for MBIA and Ambac by S&P and Moody's.
Similarly, on CNBC earlier this week, co-anchor Joe Kernen queried guest host Jack Welch on whether MBIA truly has the financial stability of another AAA credit, GE.
It's worth noting that Jack didn't reply 'from the gut,' to use the title of one of his recent tomes. Instead, he punted and argued for 'getting past this problem' before cleaning up the bond insurers.
The Journal article asks,
"What happens when the feds license only a few companies to provide a service, and then require investors to buy that service?
For the answer, take a look at the mess in today's bond market, where investors have been hanging on whether the main government-appointed credit rating agencies -- Standard and Poor's and Moody's -- would downgrade bond insurers MBIA and Ambac. Equities rallied yesterday when the agencies maintained their AAA ratings.
By now no one should care what the rating agencies think, but the problem is that by law we have to care. Since 1975, the Securities and Exchange Commission has limited competition in the market for credit ratings by anointing only certain firms as "Nationally Recognized Statistical Rating Organizations" (NRSROs). A 2006 law has begun to lead to faster approvals of new entrants, but this follows decades of protection for the incumbent firms."
So there you have it. Our Federal government has done for rating agencies what they did for accountants- required their use, thus creating demand. Only, whereas there are a zillion small accounting firms which practice, there are just a handful of rating agencies.
Still, if you consider the former "Big 8," now down to something like the "Big 3 or 4 (?)," these are the only firms practically large enough to audit large US companies. And their statements no longer mean much on those 10Ks. Auditors long ago stopped avowing that the books they audit are actually correct or non-fraudulent. All they really say now is that their tests didn't find fraud. And, oh yes, they make some statement about following the very loose GAAP principles.
Similarly, rating agencies' ratings are now suspect. Like accountants, they like having customers, so they tend not to be too hard on them- at first. Even now, Ambac is allegedly as strong and as safe in which to invest as is GE.
The Journal goes on to note,
"The SEC went an entire decade, beginning in 1992, without allowing a single new competitor into the market. Thomson reports that in 2007 Moody's rated 95% of corporate bonds, while S&P rated 93%. (Corporate bonds usually carry at least two ratings, so offerings often feature ratings from both S&P and Moody's.) Fitch, at 37%, is the only other firm with significant market share.
Asset-Backed Alert reports a similar story for mortgage-backed and asset-backed issues, which represent pools of auto loans, credit-card receivables and the like. S&P rates 96% of these securities, Moody's 86%, and again Fitch -- also approved by the government -- is the only other significant player, with 58%.
Over time, federal and state laws and regulations have explicitly required NRSRO-rated securities to be held by money market funds, insurers and others. This in turn has created the impression that these ratings are something more than merely financial opinions, which are often less informed than opinions you can read in a newspaper. Every state and federal legislator eager to avoid a repetition of the subprime crisis should begin excising the term NRSRO from statutes and regulations.
S&P also proposes to limit conflicts of interest, by rotating lead analysts and creating a new risk oversight committee, as well as an Office of the Ombudsman. But every business has potential conflicts. In the newspaper industry, we sell ads to the same people we cover. The question is how firms manage these conflicts -- and whether the marketplace is allowed to discipline companies that fail investors."
I think this last point is the crux. There's a conflict of interest whenever a provider of a service is paid by a firm to issue an 'opinion' about that firm. It's simply difficult to believe that, over time, the agencies won't hand out favorable ratings to be sure of continued patronage by a firm.
By now, you'd think there's a sort of Gresham's Law operating in the ratings world. If Ambac and MBIA truly deserve a AAA rating, what does this say about the quality of the other AAA-rated firms issuing debt? Doesn't this debauch the value of every AAA-rated firm's and institution's debt now?
Similarly, on CNBC earlier this week, co-anchor Joe Kernen queried guest host Jack Welch on whether MBIA truly has the financial stability of another AAA credit, GE.
It's worth noting that Jack didn't reply 'from the gut,' to use the title of one of his recent tomes. Instead, he punted and argued for 'getting past this problem' before cleaning up the bond insurers.
The Journal article asks,
"What happens when the feds license only a few companies to provide a service, and then require investors to buy that service?
For the answer, take a look at the mess in today's bond market, where investors have been hanging on whether the main government-appointed credit rating agencies -- Standard and Poor's and Moody's -- would downgrade bond insurers MBIA and Ambac. Equities rallied yesterday when the agencies maintained their AAA ratings.
By now no one should care what the rating agencies think, but the problem is that by law we have to care. Since 1975, the Securities and Exchange Commission has limited competition in the market for credit ratings by anointing only certain firms as "Nationally Recognized Statistical Rating Organizations" (NRSROs). A 2006 law has begun to lead to faster approvals of new entrants, but this follows decades of protection for the incumbent firms."
So there you have it. Our Federal government has done for rating agencies what they did for accountants- required their use, thus creating demand. Only, whereas there are a zillion small accounting firms which practice, there are just a handful of rating agencies.
Still, if you consider the former "Big 8," now down to something like the "Big 3 or 4 (?)," these are the only firms practically large enough to audit large US companies. And their statements no longer mean much on those 10Ks. Auditors long ago stopped avowing that the books they audit are actually correct or non-fraudulent. All they really say now is that their tests didn't find fraud. And, oh yes, they make some statement about following the very loose GAAP principles.
Similarly, rating agencies' ratings are now suspect. Like accountants, they like having customers, so they tend not to be too hard on them- at first. Even now, Ambac is allegedly as strong and as safe in which to invest as is GE.
The Journal goes on to note,
"The SEC went an entire decade, beginning in 1992, without allowing a single new competitor into the market. Thomson reports that in 2007 Moody's rated 95% of corporate bonds, while S&P rated 93%. (Corporate bonds usually carry at least two ratings, so offerings often feature ratings from both S&P and Moody's.) Fitch, at 37%, is the only other firm with significant market share.
Asset-Backed Alert reports a similar story for mortgage-backed and asset-backed issues, which represent pools of auto loans, credit-card receivables and the like. S&P rates 96% of these securities, Moody's 86%, and again Fitch -- also approved by the government -- is the only other significant player, with 58%.
Over time, federal and state laws and regulations have explicitly required NRSRO-rated securities to be held by money market funds, insurers and others. This in turn has created the impression that these ratings are something more than merely financial opinions, which are often less informed than opinions you can read in a newspaper. Every state and federal legislator eager to avoid a repetition of the subprime crisis should begin excising the term NRSRO from statutes and regulations.
With these added strictures about holding assets which have been rated, the agencies truly had a gravy train. By restricting competition by its vetting process, the Federal government has virtually assured an environment of cozy, less-than-meaningful ratings. Without competition to demonstrate who is the more accurate agency, they all rate more or less similarly, collecting fees from the companies who must purchase their ratings, or risk being frozen out of investment by those institutions which require ratings.
In light of the mess now confronting S&P, Moodys and Fitch, the Journal article concludes,
Not surprisingly, the rating agencies are coming up with their own ideas for "reform," none of which seem to include more competition. In its 27-point proposal, S&P suggests more training for its analysts, better review of analytical models, and better disclosure of a security's collateral -- all welcome changes, but remember that Moody's and S&P also suggested reforms after the Enron rating debacle.S&P also proposes to limit conflicts of interest, by rotating lead analysts and creating a new risk oversight committee, as well as an Office of the Ombudsman. But every business has potential conflicts. In the newspaper industry, we sell ads to the same people we cover. The question is how firms manage these conflicts -- and whether the marketplace is allowed to discipline companies that fail investors."
I think this last point is the crux. There's a conflict of interest whenever a provider of a service is paid by a firm to issue an 'opinion' about that firm. It's simply difficult to believe that, over time, the agencies won't hand out favorable ratings to be sure of continued patronage by a firm.
By now, you'd think there's a sort of Gresham's Law operating in the ratings world. If Ambac and MBIA truly deserve a AAA rating, what does this say about the quality of the other AAA-rated firms issuing debt? Doesn't this debauch the value of every AAA-rated firm's and institution's debt now?
Thursday, February 28, 2008
Auction-Rate Securities Troubles & Liquidity
Last week I wrote this post based upon the Wall Street Journal article describing how two Lehman customers lost considerable value in their holdings which had been invested in auction-rate securities.
An anonymous reader commented,
"This market is experiencing a temporary liquidity crisis. The Maher's haven't lost a dime in these instruments and won't as long as they wait for the market to resolve itself. Even if it doesn't there are 3 ways for a resolution. A secondary market will be created, the debt will be called at par, or refinancing the debt. All of these solutions would enable the Maher's at getting their investments back without incurring a loss."
To which I replied,
"Technically, of course, you are correct in writing that the Maher's won't (lose a dime) as long as they wait for the market to resolve itself.
Just like, say, owning RCA or other equities in 1929?
Given sufficient time, the market could, and probably will, come back to where these securities are at least at par value.
Will a secondary market be created? Why? In whose interest is it to create and trade such an illiquid market? More likely, some hedge fund or private equity trading desk will scoop up the depressed-value bonds.
Can the debt be called at par? If so, why do you suppose this wasn't mentioned in the article? Or this morning on CNBC, when the various co-anchors and guests chortled at how the buyers were at the mercy of the issuers?
Refinancing? Yes, that was mentioned, which is a sort of call.
But the overall point still stands. Buyers evidently don't realize that exotic fixed income securities like this, without committed, guaranteed specialists who make markets, for a fee, always carry a risk that the market for them will simply cease to exist for periods of time.
And in those periods, investors will want some valuation.To that point, there's an interesting piece in today's Journal describing the various viewpoints about 'market value' pricing.
Still, the temporary liquidity crisis is a non-trivial risk, don't you think?"
Last Thursday's Wall Street Journal continued the theme, citing other brokerage customers who are being allowed to use their 'frozen' auction-rate assets as collateral for loans from their brokers.
Liquidity, indeed, is the point here.
According to the later Journal article, quite a few customers at various brokerage firms have been sold ARSs as 'cash equivalents.'
Surprise!
The anonymous commentator on my earlier post continued to bemoan the public's misunderstanding of, and lack of patience with ARSs, finally noting that now, with the spike in weekly reset rates, the instruments are no longer attractive to issuers.
To which I would respond, here, that (obviously) securities markets exist for those instruments which satisfy the needs of both borrowers and lenders, or sellers and buyers. When the normal behavior of a security is in a range outside which the expected behavior of the security by those who designed it, somebody typically loses interest (no pun intended)- either issuer or holder.
For ARSs, the lack of demand at recent auctions have caused what were thought to be occasional emergency measures to become ordinary. The truth is, in an environment that suddenly views most non-vanilla fixed income instruments as suspect and unacceptably risky, the market for these exotics has simply vanished.
Customers are being allowed to use the now-illiquid notes as collateral for loans, while issuers are hustling to call the notes in favor of issuing plain long term bonds.
As a final note, a contact of mine related being in a meeting of a brokerage firm's registered reps, in which it became apparent that many of them had no idea how the ARSs actually work. This is so typical of Wall Street retail brokerage. Brokers sell instruments they don't understand to customers who trust them and, thus, have no understanding of how the assets actually function in various market conditions, or what risks they bear.
When exotic fixed income instruments for which markets can simply vanish are sold as near-cash equivalents, nobody is well-served, and there's going to be pain all around.
An anonymous reader commented,
"This market is experiencing a temporary liquidity crisis. The Maher's haven't lost a dime in these instruments and won't as long as they wait for the market to resolve itself. Even if it doesn't there are 3 ways for a resolution. A secondary market will be created, the debt will be called at par, or refinancing the debt. All of these solutions would enable the Maher's at getting their investments back without incurring a loss."
To which I replied,
"Technically, of course, you are correct in writing that the Maher's won't (lose a dime) as long as they wait for the market to resolve itself.
Just like, say, owning RCA or other equities in 1929?
Given sufficient time, the market could, and probably will, come back to where these securities are at least at par value.
Will a secondary market be created? Why? In whose interest is it to create and trade such an illiquid market? More likely, some hedge fund or private equity trading desk will scoop up the depressed-value bonds.
Can the debt be called at par? If so, why do you suppose this wasn't mentioned in the article? Or this morning on CNBC, when the various co-anchors and guests chortled at how the buyers were at the mercy of the issuers?
Refinancing? Yes, that was mentioned, which is a sort of call.
But the overall point still stands. Buyers evidently don't realize that exotic fixed income securities like this, without committed, guaranteed specialists who make markets, for a fee, always carry a risk that the market for them will simply cease to exist for periods of time.
And in those periods, investors will want some valuation.To that point, there's an interesting piece in today's Journal describing the various viewpoints about 'market value' pricing.
Still, the temporary liquidity crisis is a non-trivial risk, don't you think?"
Last Thursday's Wall Street Journal continued the theme, citing other brokerage customers who are being allowed to use their 'frozen' auction-rate assets as collateral for loans from their brokers.
Liquidity, indeed, is the point here.
According to the later Journal article, quite a few customers at various brokerage firms have been sold ARSs as 'cash equivalents.'
Surprise!
The anonymous commentator on my earlier post continued to bemoan the public's misunderstanding of, and lack of patience with ARSs, finally noting that now, with the spike in weekly reset rates, the instruments are no longer attractive to issuers.
To which I would respond, here, that (obviously) securities markets exist for those instruments which satisfy the needs of both borrowers and lenders, or sellers and buyers. When the normal behavior of a security is in a range outside which the expected behavior of the security by those who designed it, somebody typically loses interest (no pun intended)- either issuer or holder.
For ARSs, the lack of demand at recent auctions have caused what were thought to be occasional emergency measures to become ordinary. The truth is, in an environment that suddenly views most non-vanilla fixed income instruments as suspect and unacceptably risky, the market for these exotics has simply vanished.
Customers are being allowed to use the now-illiquid notes as collateral for loans, while issuers are hustling to call the notes in favor of issuing plain long term bonds.
As a final note, a contact of mine related being in a meeting of a brokerage firm's registered reps, in which it became apparent that many of them had no idea how the ARSs actually work. This is so typical of Wall Street retail brokerage. Brokers sell instruments they don't understand to customers who trust them and, thus, have no understanding of how the assets actually function in various market conditions, or what risks they bear.
When exotic fixed income instruments for which markets can simply vanish are sold as near-cash equivalents, nobody is well-served, and there's going to be pain all around.
Wednesday, February 27, 2008
On "Market Value" Valuation
The Wall Street Journal published an article last Wednesday involving the use of so-called 'market value' methods for asset valuation. In it, the authors wrote,
"Credit Suisse Group yesterday said it expects to take a $2.85 billion write-down of financial instruments affected by the credit crunch, which will result in a $1 billion drop in quarterly profit, just a week after telling investors it had largely escaped the worst of the financial crisis.
The quick about-faces highlight the problem that companies, even those that are supposed to be financial experts, are having with a seemingly straightforward question: How much is something worth?
The difficulty lies in part in the increasing use of so-called market values to determine prices for items that companies aren't necessarily selling. This has become especially tough since the debt crisis has caused large parts of markets to seize up, meaning there often aren't any prices to use as reference points.
Supporters of the market-value approach say it will help prevent the kind of long-term economic malaise that gripped Japan in the 1990s, when that country's banks sat on problem loans. But companies fear it is distorting returns and speeding the financial crisis, even as investors wonder if companies may be overestimating potential losses to establish cookie-jar reserves.
The debate over how best to figure values is more than just academic. Major financial firms have recognized more than $150 billion in losses, based mostly on the use of market values. At the same time, the Securities and Exchange Commission and federal prosecutors are investigating whether some firms may have applied different market values to the same securities, depending on whether they were held by the firm or its clients."
It's an old debate. On one hand, as the foregoing passage notes, market value provides a real sense of the current value at which one could buy, or sell, an asset. That should, theoretically, be good for investors or those who wish to understand the balance sheet of a firm. Ostensibly, using market values provides investors, counterparties, and other interested observers with a clearer picture of the current value of an enterprise.
However, the market value method is not without its detractors. Consider these passages from later in the Journal article,
"Even when used properly, market values can prove problematic, because in trying to reflect investors' perceptions, they can ignore the underlying economic reality, says Damon Silvers, associate general counsel for the AFL-CIO, which has long been critical of the increasing use of market values in accounting. "You have a portfolio of real-estate loans, and those loans are performing, but now you're making it look like you're losing money, when in fact you're not," he says.
Plus, the approach "treats all the assets of an ongoing enterprise as though they are constantly for sale, and that does not convey very good information about the profit of the business, because they're not actually for sale," Mr. Silvers adds.
The debate about the appropriateness of the market-value approach aside, using market values holds another challenge for investors. It requires them to think differently about debt instruments and loans, viewing them like stocks whose value can swing from day to day or quarter to quarter."
These are very valid points.
Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?
What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?
It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero.
FASB spent years mulling over inflation accounting in the 1970s and '80s. Would it be asking too much to ask them to consider this issue now?
"Credit Suisse Group yesterday said it expects to take a $2.85 billion write-down of financial instruments affected by the credit crunch, which will result in a $1 billion drop in quarterly profit, just a week after telling investors it had largely escaped the worst of the financial crisis.
The quick about-faces highlight the problem that companies, even those that are supposed to be financial experts, are having with a seemingly straightforward question: How much is something worth?
The difficulty lies in part in the increasing use of so-called market values to determine prices for items that companies aren't necessarily selling. This has become especially tough since the debt crisis has caused large parts of markets to seize up, meaning there often aren't any prices to use as reference points.
Supporters of the market-value approach say it will help prevent the kind of long-term economic malaise that gripped Japan in the 1990s, when that country's banks sat on problem loans. But companies fear it is distorting returns and speeding the financial crisis, even as investors wonder if companies may be overestimating potential losses to establish cookie-jar reserves.
The debate over how best to figure values is more than just academic. Major financial firms have recognized more than $150 billion in losses, based mostly on the use of market values. At the same time, the Securities and Exchange Commission and federal prosecutors are investigating whether some firms may have applied different market values to the same securities, depending on whether they were held by the firm or its clients."
It's an old debate. On one hand, as the foregoing passage notes, market value provides a real sense of the current value at which one could buy, or sell, an asset. That should, theoretically, be good for investors or those who wish to understand the balance sheet of a firm. Ostensibly, using market values provides investors, counterparties, and other interested observers with a clearer picture of the current value of an enterprise.
However, the market value method is not without its detractors. Consider these passages from later in the Journal article,
"Even when used properly, market values can prove problematic, because in trying to reflect investors' perceptions, they can ignore the underlying economic reality, says Damon Silvers, associate general counsel for the AFL-CIO, which has long been critical of the increasing use of market values in accounting. "You have a portfolio of real-estate loans, and those loans are performing, but now you're making it look like you're losing money, when in fact you're not," he says.
Plus, the approach "treats all the assets of an ongoing enterprise as though they are constantly for sale, and that does not convey very good information about the profit of the business, because they're not actually for sale," Mr. Silvers adds.
The debate about the appropriateness of the market-value approach aside, using market values holds another challenge for investors. It requires them to think differently about debt instruments and loans, viewing them like stocks whose value can swing from day to day or quarter to quarter."
These are very valid points.
Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?
What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?
It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero.
FASB spent years mulling over inflation accounting in the 1970s and '80s. Would it be asking too much to ask them to consider this issue now?
Tuesday, February 26, 2008
Andy Kessler On 'Net Neutrality' & Ed Markey's Bill
Yesterday's Wall Street Journal featured an excellent editorial by Andy Kessler, an occasional contributor, entitled "Internet Wrecking Ball." In contrast to his last Journal piece, with which I mostly disagreed with, in this post last month, this time Kessler provides good evidence and insight to support his contention that Ed Markey, in combination with a few existing internet titans, are conspiring to give us all second-rate internet capabilities for a long time to come.
Kessler begins his explanation of the issue thusly,
"The Federal Communications Commission is holding a public hearing today at Harvard Law School in Cambridge, Mass., to build the case for the ill-conceived idea of preventing, as Mr. Markey's bill would, network operators from using technologies that may favor one application over another.
It's a bad idea because the only thing Mr. Markey's bill will preserve is mediocrity via the lack of competition, and full employment for regulators micromanaging a business whose very innovation comes from the lack of rules. With net neutrality, there will be no new competition and no incentives for build outs. Bandwidth speeds will stagnate, and new services will wither from bandwidth starvation.
The idea of network neutrality is that all of our Internet packets are equal, and that the spirit of the Internet and its ability to create wonderful new applications like Google, MySpace and Facebook is predicated on open (albeit limited) access for all. Yet, despite an overabundance of bandwidth pulsing throughout the U.S., we are still stuck with rationing to our homes. Haven't we learned that advancing technology is never served by arbitrary rules to divvy up scarce resources? Look at the dearth of good cell phone applications: Rules make incumbents lazy."
Kessler makes a very important point about the pace of technology in this sector. In a classically Schumpeterian manner, yesterday's 'winners' are hoping to codify their victory, thus slowing change to a crawl, if it is allowed to occur at all.
How did this happen to what should be a sector experiencing breakneck competition and improvement in service, capacity, and consumer value? Kessler writes,
"In plain English: Comcast is this country's second largest Internet provider and has been plagued by mostly illegal copyrighted video file sharing that is chewing up half or more of its precious bandwidth. More of that than you'd think consists of "Family Guy" episodes. Comcast, whose growth is slowing and whose stock is down 30%, is acting scared of the day when video is delivered one episode at a time instead of via Basic Cable, threatening its bread and butter.
So Comcast took matters into its own hands and applied a sneaky technical fix, a fake message that severely slowed these peer-to-peer video downloads. By the way, this same technique is used by the so-called Great Firewall of China to censor search requests like "Falun" or "Tiananmen." Nice company.
So that's it, isn't it? Comcast's franchise is threatened so it got out the bag of dirty tricks. Google, who you would think has a huge incentive to kill the video star, supports net neutrality. Google has become an incumbent, protecting its no-longer-modern textual ads."
As I wrote in this post last April, and Kessler now reinforces, Comcast is rightly worried about video programming disintermediation which will render its cable television product offerings nearly worthless much sooner than it had ever imagined. Even Google is sufficiently entrenched in the current technological environment to wish for its continued stagnation. When you're the largest guy on the block, and can intimidate everybody else, you don't mind if inward movement to the neighborhood is prohibited.
"We need policy to help cut a path for more competition, rather than protecting incumbents -- a Bandwidth Competition Act of 2008, not bogus net neutrality. All takers should be allowed access to poles or underground conduits. This is where neutrality should be enforced, instead of being a choke point.
Municipal or privately run wireless data services using Wi-Fi or WiMax should be sprouting like weeds. But they aren't being built because of lack of access to street lights, of all things, to set up access points. Verizon is busy rolling out a fiber optic service, FIOS, that will provide much higher speeds and real competition to Comcast. But it is slow going, as state by state video franchise rules still favor cable over any newcomers.
A stroke of a pen can cure these ills, incumbents be damned. They will adjust. I personally would climb telephone poles on my street to run fiber if I could get 100 megabit Internet service. Any takers? Talk about an economic stimulus; this is the type of infrastructure we need. The stock market will fund it all as well as resolve overbuild problems.
Don't think of Internet access as a static business -- someone put in phone lines 50 years ago or cable lines 20 years ago, and we are stuck with their limitations. Technology changes the game every few years. Even fiber lines put in today will be obsolete within 10 years and need upgrading. Same for wireless systems."
As a veteran of the last years of AT&T's crumbling monopoly, I can attest to all of what Kessler contends. Once access is opened, and bogus arguments for protecting whatever 'embedded base' is the focus of the particular technological debate, competition will blossom, and customers will be incredibly better served.
Once MCI opened the tiny crack in AT&T's armor by suing for the right to lease lines and resell them, thus arbitraging the dominant phone company's pricing policies against the real costs to serve customers, the end of AT&T was just a matter of time.
Like AT&T, Comcast's own infrastructure has a useful life, not an indefinite one. Its regulatory-granted monopoly made sense for the time at which it was granted, with the technology and market forces then in existence.
Things are different now, and the Federal and state regulatory schemes should acknowledge that by providing rules which favor customer benefits, not the maintenance of recently-enshrined oligopolistic market conditions.
Kessler begins his explanation of the issue thusly,
"The Federal Communications Commission is holding a public hearing today at Harvard Law School in Cambridge, Mass., to build the case for the ill-conceived idea of preventing, as Mr. Markey's bill would, network operators from using technologies that may favor one application over another.
It's a bad idea because the only thing Mr. Markey's bill will preserve is mediocrity via the lack of competition, and full employment for regulators micromanaging a business whose very innovation comes from the lack of rules. With net neutrality, there will be no new competition and no incentives for build outs. Bandwidth speeds will stagnate, and new services will wither from bandwidth starvation.
The idea of network neutrality is that all of our Internet packets are equal, and that the spirit of the Internet and its ability to create wonderful new applications like Google, MySpace and Facebook is predicated on open (albeit limited) access for all. Yet, despite an overabundance of bandwidth pulsing throughout the U.S., we are still stuck with rationing to our homes. Haven't we learned that advancing technology is never served by arbitrary rules to divvy up scarce resources? Look at the dearth of good cell phone applications: Rules make incumbents lazy."
Kessler makes a very important point about the pace of technology in this sector. In a classically Schumpeterian manner, yesterday's 'winners' are hoping to codify their victory, thus slowing change to a crawl, if it is allowed to occur at all.
How did this happen to what should be a sector experiencing breakneck competition and improvement in service, capacity, and consumer value? Kessler writes,
"In plain English: Comcast is this country's second largest Internet provider and has been plagued by mostly illegal copyrighted video file sharing that is chewing up half or more of its precious bandwidth. More of that than you'd think consists of "Family Guy" episodes. Comcast, whose growth is slowing and whose stock is down 30%, is acting scared of the day when video is delivered one episode at a time instead of via Basic Cable, threatening its bread and butter.
So Comcast took matters into its own hands and applied a sneaky technical fix, a fake message that severely slowed these peer-to-peer video downloads. By the way, this same technique is used by the so-called Great Firewall of China to censor search requests like "Falun" or "Tiananmen." Nice company.
So that's it, isn't it? Comcast's franchise is threatened so it got out the bag of dirty tricks. Google, who you would think has a huge incentive to kill the video star, supports net neutrality. Google has become an incumbent, protecting its no-longer-modern textual ads."
As I wrote in this post last April, and Kessler now reinforces, Comcast is rightly worried about video programming disintermediation which will render its cable television product offerings nearly worthless much sooner than it had ever imagined. Even Google is sufficiently entrenched in the current technological environment to wish for its continued stagnation. When you're the largest guy on the block, and can intimidate everybody else, you don't mind if inward movement to the neighborhood is prohibited.
"We need policy to help cut a path for more competition, rather than protecting incumbents -- a Bandwidth Competition Act of 2008, not bogus net neutrality. All takers should be allowed access to poles or underground conduits. This is where neutrality should be enforced, instead of being a choke point.
Municipal or privately run wireless data services using Wi-Fi or WiMax should be sprouting like weeds. But they aren't being built because of lack of access to street lights, of all things, to set up access points. Verizon is busy rolling out a fiber optic service, FIOS, that will provide much higher speeds and real competition to Comcast. But it is slow going, as state by state video franchise rules still favor cable over any newcomers.
A stroke of a pen can cure these ills, incumbents be damned. They will adjust. I personally would climb telephone poles on my street to run fiber if I could get 100 megabit Internet service. Any takers? Talk about an economic stimulus; this is the type of infrastructure we need. The stock market will fund it all as well as resolve overbuild problems.
Don't think of Internet access as a static business -- someone put in phone lines 50 years ago or cable lines 20 years ago, and we are stuck with their limitations. Technology changes the game every few years. Even fiber lines put in today will be obsolete within 10 years and need upgrading. Same for wireless systems."
As a veteran of the last years of AT&T's crumbling monopoly, I can attest to all of what Kessler contends. Once access is opened, and bogus arguments for protecting whatever 'embedded base' is the focus of the particular technological debate, competition will blossom, and customers will be incredibly better served.
Once MCI opened the tiny crack in AT&T's armor by suing for the right to lease lines and resell them, thus arbitraging the dominant phone company's pricing policies against the real costs to serve customers, the end of AT&T was just a matter of time.
Like AT&T, Comcast's own infrastructure has a useful life, not an indefinite one. Its regulatory-granted monopoly made sense for the time at which it was granted, with the technology and market forces then in existence.
Things are different now, and the Federal and state regulatory schemes should acknowledge that by providing rules which favor customer benefits, not the maintenance of recently-enshrined oligopolistic market conditions.
Sunday, February 24, 2008
Feldstein On Today's US Economic Dilemma
Last week, in Wednesday's Wall Street Journal, economist Martin Feldstein wrote an editorial entitled "Our Economic Dilemma." In his piece, Feldstein echoed several of my own themes from this recent post, which, in turn, drew on comments and writings from people such as Brian Wesbury and Bill Wilby.
For example, Feldstein wrote,
"But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.
In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy."
"The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.
But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.
The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment."
Here, Feldstein explains that the unwise over-expansion of housing, and, by implication, the funding of said over-expansion with opaque CDOs, have resulted in real losses of wealth that will likely affect consumer spending. Thus, growth will at least slow, even if not reverse us into a recession.
Summing up, Feldstein writes,
"There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.
The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble."
However, I'm not entirely convinced of his contentions in these passages. For example, how are examiners supposed to 'allow for the potential bursting of the house price bubble?'
In hindsight, that sounds fine. However, up until said bursting, you can bet the banks in question would be screaming bloody murder and exercising whatever political influence they had, via Congress, to affect the examiners who were, at that point, baselessly criticizing still-performing assets.
As to the SIVs existing, that's another matter. But, even there, ultimately the banks took them back onto their balance sheets because they were obligated to provide funding when external markets dried up.
Who can say which housing loans should have been called into question prior to the beginning of the period during which funding for housing-related structured finance instruments or subprime mortgages ceased to come forward?
Other than making the general comment that growth in mortgage markets remained too high for too long, it's another matter entirely to be the Federal agency which unilaterally reins in credit expansion for those particular loans. What if various minority groups had, in that event, pressured the Fed and banks in question to continue lending, or suffer charges of discriminatory lending practices?
Aside from those last passages, however, I find Feldstein's analysis of the situation very much in concert with my own. We face a demand-pull threat of inflation, not the cost-push sources of prior eras. Money has already been relatively easy when the Fed began to cut rates last year. It's unlikely those lower rates have really sparked much new business activity or lending, because the greatest bar to credit expansion has been counterparty risk, not rate levels.
All of which reinforces my belief that the Fed's prior, and even near term future rate cuts won't materially affect our economy, other than bake in higher inflation rates 18-24 months out.
If this is true, precisely what has the Fed rate cutting program delivered to us as a benefit?
For example, Feldstein wrote,
"But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.
In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy."
Clearly, Feldstein believes, as do I, that Fed rate cuts just won't do that much for whatever currently ails the US economy. It's my guess that if you asked Feldstein directly whether the Fed's rate cuts will have done much more than stoke future inflation, he would say "no."
He continues in his editorial,
"The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.
But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.
The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment."
Here, Feldstein explains that the unwise over-expansion of housing, and, by implication, the funding of said over-expansion with opaque CDOs, have resulted in real losses of wealth that will likely affect consumer spending. Thus, growth will at least slow, even if not reverse us into a recession.
Summing up, Feldstein writes,
"There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.
The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble."
However, I'm not entirely convinced of his contentions in these passages. For example, how are examiners supposed to 'allow for the potential bursting of the house price bubble?'
In hindsight, that sounds fine. However, up until said bursting, you can bet the banks in question would be screaming bloody murder and exercising whatever political influence they had, via Congress, to affect the examiners who were, at that point, baselessly criticizing still-performing assets.
As to the SIVs existing, that's another matter. But, even there, ultimately the banks took them back onto their balance sheets because they were obligated to provide funding when external markets dried up.
Who can say which housing loans should have been called into question prior to the beginning of the period during which funding for housing-related structured finance instruments or subprime mortgages ceased to come forward?
Other than making the general comment that growth in mortgage markets remained too high for too long, it's another matter entirely to be the Federal agency which unilaterally reins in credit expansion for those particular loans. What if various minority groups had, in that event, pressured the Fed and banks in question to continue lending, or suffer charges of discriminatory lending practices?
Aside from those last passages, however, I find Feldstein's analysis of the situation very much in concert with my own. We face a demand-pull threat of inflation, not the cost-push sources of prior eras. Money has already been relatively easy when the Fed began to cut rates last year. It's unlikely those lower rates have really sparked much new business activity or lending, because the greatest bar to credit expansion has been counterparty risk, not rate levels.
All of which reinforces my belief that the Fed's prior, and even near term future rate cuts won't materially affect our economy, other than bake in higher inflation rates 18-24 months out.
If this is true, precisely what has the Fed rate cutting program delivered to us as a benefit?
Friday, February 22, 2008
Boone Pickens On Oil Prices & US Energy Policy
Yesterday morning on CNBC's Squawkbox program, T. Boone Pickens made some major waves.
First, in the course of opening comments and questions, the co-anchors pressed Pickens on his views for oil and other energy prices in the coming year. Noting that he had correctly predicted $100+/bbl oil, Boone gave a rough forecast of softening prices from now until mid-year, followed by higher prices after that. He said the same for natural gas.
The CNBC staff immediately asked if he was now short oil and natural gas. After a moment's thought, in which he obviously considered being coy, Boone said "yes" to each question.
Within moments, futures on both commodities were trading down. It was reported that the major newswires immediately published Boone's remarks on his pricing views and short positions.
But that's not what this post is about. Instead, it's about a topic related to this post of a few days ago.
Boone went on to extol the benefits and practicality, feasibility, of wind power across the Midwest and Southwest US, and solar energy development in the latter region, mentioning Sweetwater, Texas by name as a model for economic redevelopment in concert with clean, domestically-produced energy.
So here's my question: what if Boone, though well-intentioned, is wrong?
Could he be overlooking Ricardian economics?
How much do we export? Is our oil usage for our 300MM population, or our 25% of global GDP? on the latter basis, it seems actually fair.
Don't we effectively produce for export, as well? Can you actually align US oil consumption purely with domestic consumption, or is it, in a value-added-chain manner, an input into GDP, too? Don't our exports of intellectual property-based value-added goods and services represent a usage of imported oil? Just like we import aluminum, steel, titanium, diamonds, and a dozen other important, necessary commodities for manufacture of US-sourced goods?
I'm reminded of the pre-Ricardian economic comments of one of the men we honor on President's Day. It's the wrong one for today, unfortunately, it being the birthday of our country's first President, George Washington. But Abraham Lincoln is remembered, and occasionally quoted, a la Boone Pickens' remarks yesterday, for this quote, contained in remarks by former Fed Bank President Bob McTeer, in this piece,
"For example, Abraham Lincoln was a very good amateur economist, as I will show later. But he wasn't good enough to get international trade right. Here's what he is supposed to have said about tariffs: "I don't know much about the tariff, but I know this. If I buy a coat in England, I get the coat and England gets the money. If I buy a coat in America, I get the coat and America gets the money." "
That's how I remember the quote as well. And I was born in Illinois- does that count?
By extension, Pickens' and Lincoln's views become one of zero trade. Anything that sends our currency overseas, creating external liabilities, is to be shunned.
But where do you draw the line? Can Boone, or any of us, really know just how much of the $500B annually that we send overseas for oil is 'too much,' given that we use that energy, rather than other, assumedly less efficient domestic sources, to create value?
If we could stop buying foreign oil tomorrow, and, instead, use the $500B to buy onshore energy, would we accidentally reduce our resource productivity, make our exports more expensive, lower our domestic standard of living and, in the end, actually damage our long term economic prospects?
So long as we create value with the imported oil, and the dollars we pay for it are not being used with malicious intent toward us, what's the problem?
I think it's that second clause that is the issue. It was in the prior post, where I noted that the desire of other, oil reserve-owning nations to effectively withdraw from tradeable energy spot markets, makes the whole game different.
But it's not about trade balances, per se. It's about the motives of our putative trading partners, isn't it?
In effect, it's less about economics and productivity than it is about long term national security. And again, as I wrote in this post,
"Rather than global warming or clean air, I think the Journal piece reveals what's really going to drive new energy technologies in the West."
And that was the Saudi plans to consume more of their own oil, eventually changing the economics of many things- aluminum and other basic materials' production economics, oil pricing and supply.
That said, I think Boone is right to simply call attention to the outflow of half a trillion dollars annually for oil. But while he's at it, why don't we tote up the bill for various other commodities, in order to understand just how much we pay, and for what, in order to drive our current economy?
In the end, it's not about oil, is it? It's about creating dollar liabilities in the hands of those who don't wish to merely use them to trade, but, potentially, use them for purposes calculated to undermine our country's long term welfare.
And that's a different issue entirely.
First, in the course of opening comments and questions, the co-anchors pressed Pickens on his views for oil and other energy prices in the coming year. Noting that he had correctly predicted $100+/bbl oil, Boone gave a rough forecast of softening prices from now until mid-year, followed by higher prices after that. He said the same for natural gas.
The CNBC staff immediately asked if he was now short oil and natural gas. After a moment's thought, in which he obviously considered being coy, Boone said "yes" to each question.
Within moments, futures on both commodities were trading down. It was reported that the major newswires immediately published Boone's remarks on his pricing views and short positions.
But that's not what this post is about. Instead, it's about a topic related to this post of a few days ago.
Pickens remarked that he had lain awake in bed the night before thinking about the topic, it was so important. He reinforced that, saying it was bigger than being long or short oil, or making money in his fund by his prescient energy price calls.
What Boone Pickens worries about is the $500B per year that the US now pays foreign oil producers to import the precious commodity. Half a trillion dollars. That's how Boone put it.
More than $1B per day.
This morning on CNBC, AutoNation CEO Mike Jackson reiterated Boone's concerns, citing the need for higher oil and gasoline prices, if the US is ever to reverse this trend.
Boone went on to extol the benefits and practicality, feasibility, of wind power across the Midwest and Southwest US, and solar energy development in the latter region, mentioning Sweetwater, Texas by name as a model for economic redevelopment in concert with clean, domestically-produced energy.
Boone went on to cite, as I noted in that prior post, the continuing trend toward nationalization of oil reserves. He pointed out that Exxon pumps only 3% of the world's current 85B bbls pumped per day. He then cited a statistic that the US has 5% of the world's population, but consumes 25% of its oil production. That this "isn't fair."
Maybe, maybe not.
So here's my question: what if Boone, though well-intentioned, is wrong?
Could he be overlooking Ricardian economics?
How much do we export? Is our oil usage for our 300MM population, or our 25% of global GDP? on the latter basis, it seems actually fair.
Don't we effectively produce for export, as well? Can you actually align US oil consumption purely with domestic consumption, or is it, in a value-added-chain manner, an input into GDP, too? Don't our exports of intellectual property-based value-added goods and services represent a usage of imported oil? Just like we import aluminum, steel, titanium, diamonds, and a dozen other important, necessary commodities for manufacture of US-sourced goods?
I'm reminded of the pre-Ricardian economic comments of one of the men we honor on President's Day. It's the wrong one for today, unfortunately, it being the birthday of our country's first President, George Washington. But Abraham Lincoln is remembered, and occasionally quoted, a la Boone Pickens' remarks yesterday, for this quote, contained in remarks by former Fed Bank President Bob McTeer, in this piece,
"For example, Abraham Lincoln was a very good amateur economist, as I will show later. But he wasn't good enough to get international trade right. Here's what he is supposed to have said about tariffs: "I don't know much about the tariff, but I know this. If I buy a coat in England, I get the coat and England gets the money. If I buy a coat in America, I get the coat and America gets the money." "
That's how I remember the quote as well. And I was born in Illinois- does that count?
By extension, Pickens' and Lincoln's views become one of zero trade. Anything that sends our currency overseas, creating external liabilities, is to be shunned.
But where do you draw the line? Can Boone, or any of us, really know just how much of the $500B annually that we send overseas for oil is 'too much,' given that we use that energy, rather than other, assumedly less efficient domestic sources, to create value?
If we could stop buying foreign oil tomorrow, and, instead, use the $500B to buy onshore energy, would we accidentally reduce our resource productivity, make our exports more expensive, lower our domestic standard of living and, in the end, actually damage our long term economic prospects?
So long as we create value with the imported oil, and the dollars we pay for it are not being used with malicious intent toward us, what's the problem?
I think it's that second clause that is the issue. It was in the prior post, where I noted that the desire of other, oil reserve-owning nations to effectively withdraw from tradeable energy spot markets, makes the whole game different.
But it's not about trade balances, per se. It's about the motives of our putative trading partners, isn't it?
In effect, it's less about economics and productivity than it is about long term national security. And again, as I wrote in this post,
"Rather than global warming or clean air, I think the Journal piece reveals what's really going to drive new energy technologies in the West."
And that was the Saudi plans to consume more of their own oil, eventually changing the economics of many things- aluminum and other basic materials' production economics, oil pricing and supply.
That said, I think Boone is right to simply call attention to the outflow of half a trillion dollars annually for oil. But while he's at it, why don't we tote up the bill for various other commodities, in order to understand just how much we pay, and for what, in order to drive our current economy?
In the end, it's not about oil, is it? It's about creating dollar liabilities in the hands of those who don't wish to merely use them to trade, but, potentially, use them for purposes calculated to undermine our country's long term welfare.
And that's a different issue entirely.
Thursday, February 21, 2008
More On Bond Insurance
This morning's guests on CNBC provided some truly interesting and valuable insights on several topics.
One guest was T. Boone Pickens, opining on oil and natural gas prices, as well as longer term energy concerns. I'll be writing about his comments in my next post.
The other guest was one who I have seen once or twice before on Squawkbox- Doug Dachille. Mr. Dachille, from his title and the name of his firm, seems to be head of a not-large investment management firm. As I searched my prior posts, I found this post, dated exactly two weeks ago, in which Dachille's prior appearance (with Jim Cramer) is described.
I was, for the most part, impressed by Dachille. His grasp of macroeconomics left something to be desired, but his logic and comments on fixed income issues were refreshing and provocative.
This morning's appearance was no different, in terms of the quality and value of Dachille's remarks.
His focus was on the very hot topic of what is to become of AMBAC, MBIA, FGIC and other so-called financial instrument insurers.
The discussion began with remarks about noted short-seller William Ackman's proposed 'good insurer/bad insurer' plan, as well as NY State AG Dinallo's similar idea, both of which have put pressure on the insurers to do something prior to a rating agency re-evaluation of their credit ratings next week.
Dachille did an admirable job of cutting the Gordian knot surrounding the business of these bond insurers.
In essence, Dachille argued that their business is superfluous. Period. That their existence is now the result of some hoary old legislation or internal investment rules by various pension or government funds regarding the minimum rating which a security must have to be held in their portfolio.
Dachille noted that the insurers cost approximately 10-15bp for their function. In comparison, according to Dachille, fixed income managers are paid roughly 35bp.
Both fees are not necessary, according to Dachille, because only one 'due diligence' need be performed. If the insurers are truly taking the risk, via insurance, then at least a commensurate amount of fee should be removed from the managers, because their work is made easier, and risk removed for their customers.
Dachille questioned why an insurer whose financial resources are obviously inadequate to serve their obligations, whose stock price has fallen so much in the past year, and whose ratings are about to be changed to a level below many of their customers, should have any material affect on, or benefit to, a bond issuance?
Santelli agreed wholeheartedly. Both engaged in a brief dialogue suggesting that the bond insurers no longer serve an economic purpose, because they confer a sort of average risk rating, by virtue of their coverage, when buyers should really do their homework to more accurately price individually-issued municipal securities for risk.
Thus, Dachille's overall view is that there isn't really a crisis because these firms don't really add economic value now anyway.
Granted, he admits that banks holding suspect, effectively under- or soon-to-be-uninsured CDOs, will have to take further writedowns. On this note, he observed the parallel between the insurers' "crisis" and the super-SIV plans last fall.
Those plans, he noted, came to naught as banks began to just write down their losses. He feels the same should occur now, because, one way or another, the holders of these insured, but ineffectually so, instruments, will have to realize their lower values eventually.
I found much sense and value in Dachille's observations and recommendation. After years of a charade, the missteps by the bond insurers into non-municipal waters have accidentally exposed the lack of true economic utility of even their core business.
One guest was T. Boone Pickens, opining on oil and natural gas prices, as well as longer term energy concerns. I'll be writing about his comments in my next post.
The other guest was one who I have seen once or twice before on Squawkbox- Doug Dachille. Mr. Dachille, from his title and the name of his firm, seems to be head of a not-large investment management firm. As I searched my prior posts, I found this post, dated exactly two weeks ago, in which Dachille's prior appearance (with Jim Cramer) is described.
I was, for the most part, impressed by Dachille. His grasp of macroeconomics left something to be desired, but his logic and comments on fixed income issues were refreshing and provocative.
This morning's appearance was no different, in terms of the quality and value of Dachille's remarks.
His focus was on the very hot topic of what is to become of AMBAC, MBIA, FGIC and other so-called financial instrument insurers.
The discussion began with remarks about noted short-seller William Ackman's proposed 'good insurer/bad insurer' plan, as well as NY State AG Dinallo's similar idea, both of which have put pressure on the insurers to do something prior to a rating agency re-evaluation of their credit ratings next week.
Dachille did an admirable job of cutting the Gordian knot surrounding the business of these bond insurers.
In essence, Dachille argued that their business is superfluous. Period. That their existence is now the result of some hoary old legislation or internal investment rules by various pension or government funds regarding the minimum rating which a security must have to be held in their portfolio.
Dachille noted that the insurers cost approximately 10-15bp for their function. In comparison, according to Dachille, fixed income managers are paid roughly 35bp.
Both fees are not necessary, according to Dachille, because only one 'due diligence' need be performed. If the insurers are truly taking the risk, via insurance, then at least a commensurate amount of fee should be removed from the managers, because their work is made easier, and risk removed for their customers.
Dachille questioned why an insurer whose financial resources are obviously inadequate to serve their obligations, whose stock price has fallen so much in the past year, and whose ratings are about to be changed to a level below many of their customers, should have any material affect on, or benefit to, a bond issuance?
Santelli agreed wholeheartedly. Both engaged in a brief dialogue suggesting that the bond insurers no longer serve an economic purpose, because they confer a sort of average risk rating, by virtue of their coverage, when buyers should really do their homework to more accurately price individually-issued municipal securities for risk.
Thus, Dachille's overall view is that there isn't really a crisis because these firms don't really add economic value now anyway.
Granted, he admits that banks holding suspect, effectively under- or soon-to-be-uninsured CDOs, will have to take further writedowns. On this note, he observed the parallel between the insurers' "crisis" and the super-SIV plans last fall.
Those plans, he noted, came to naught as banks began to just write down their losses. He feels the same should occur now, because, one way or another, the holders of these insured, but ineffectually so, instruments, will have to realize their lower values eventually.
I found much sense and value in Dachille's observations and recommendation. After years of a charade, the missteps by the bond insurers into non-municipal waters have accidentally exposed the lack of true economic utility of even their core business.
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