Monday, August 17, 2009

Monday's Link Bonanza

I have to say there was an incredible amount of good reading over the weekend. One of the best things I read but I thought was too out there for some readers was a conspiracy theory piece about how the Fed provides levered liquidity to the broker dealers on certain pre-announced days that is used to buy S&P futures and juice the market. This is the author's explanation for some of the late day spikes we have seen in the indexes. If you want to read it click here.

Otherwise, spend some time on today's links. You won't regret it.

Home sellers’ expectations coming down: According to data from Trulia Inc. people all of the country who are selling their homes have been cutting their asking prices significantly.

Connecticut, Massachusetts, Rhode Island and Illinois had the highest share of homes with price reductions at 33 percent, followed by six states at 29 percent: Oregon, Washington, New Jersey, Minnesota, New Hampshire and Maryland.

Jacksonville, Florida, had the highest rate of reductions among cities tracked as 38 percent of listings there had been cut. Portland, Oregon, followed at 35 percent. Milwaukee, Minneapolis, Boston and Seattle each had 34 percent and Albuquerque, New Mexico, and Chicago had 33 percent.

Prices were cut 22 percent in Detroit; 16 percent in Las Vegas; 15 percent in Miami; 13 percent in New York City and Phoenix; 12 percent in San Francisco and Los Angeles; and 10 percent in Washington and Honolulu, Trulia said.

While this does put more downward pressure on housing prices, I would argue that the fact that expectations are becoming more rational is a very good thing. The closer we get to prices in which houses will clear, the closer we will be to a bottom in non-distressed sales. The concern, of course, is that continued foreclosures, especially as more mortgage resets occur next year, will prolong the bottom-finding process.

As reported versus operating earnings: I got the link to this piece in the Financial Times from The King Report. It is a discussion of which earnings we should be focusing on when we evaluate individual companies and the S&P index. As reported earnings that are based on GAAP accounting include non-recurring items and are obviously lower as companies have been hammered by so called onetime events. Operating earnings on the other hand exclude onetime items like restructuring charges and asset write downs. Investors who are focused on the long term earnings power of companies are often fine with excluding certain items so that they can get a good sense of what the company will be able to earn when this cycle is over. However, according to the article, this may be a mistake as onetime items seem to pop up more often than the name implies:

There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.

The truth is that the current environment may be unique in its impact on companies so the 2003 data may not apply as well now. The scary thing is that there is now a record $54 gap between as reported earnings and operating earnings on the S&P. That sure makes it hard put a meaningful P/E multiple on the index. In any case, this article ends with a passage that I think incorporates my concerns about future earnings as well as anything I have read. It is basically John Hussman’s argument as well:

There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.

Money coming off the sidelines may not be a good thing for the market: I got the link to this article in Reuters from Seeking Alpha. I can’t even count the number of times I have heard so called pundits on CNBC talk about all the money waiting on the sidelines that can juice the market at any point. But what if when that money does eventually flow into the market it indicates unjustified optimism and signals a market peak?

One of the stock market's favorite accepted nuggets of wisdom is the notion that there's a pile of money waiting in the wings, itching to jump back into the market.

Investors should be careful what they wish for: Such a move is more likely to signal a topping-out in the recent rally than a sign that it will ignite a new run in the market.

It’s an interesting thought. We know that the tech bubble suckered retail investors in after it ran up after the initial downturn. Of course those poor people got hammered when the market fell for good. So most likely, when watching flows into and out of mutual funds it makes sense to look at the direction of flows as a contrarian indicator. As James Montier always says, you don’t get true bargains or see a durable bottom until revulsion occurs. But are we anywhere near revulsion? Definitely not:

Currently, investors hold about one dollar in liquid assets for every dollar in shares, which includes mutual funds. That's right at the post-war average. Unlike the early 1980s, this suggests that despite the horrid performance of markets as the economy fell into recession, investors have maintained a resilient outlook on equity markets, one ingrained from the last 30 years.

After everything that has happened counterparty risk has become even more concentrated: What is the inherent problem with the forced consolidation that has occurred in the financial services industry? Well, now there are fewer firms out there to spread around the risks. That means fewer counterparties to choose from when firms are looking to hedge. Now firms that were too big to fail before the crisis present even more risk to the entire system. I’m not sure that is a positive outcome of everything that has happened over the last 2 years.

Citibank’s counterparty liability exposure decreased significantly to $17 billion as of end-March 2009, relative to $126 billion as of March 2008, largely due to continuing concerns on having Citi as a counterparty (see Figure 2).

Goldman Sachs’ counterparty risk to the financial system is the largest, at $91 billion as of end-March 2009, relative to around $100 billion as of March 2008; the change is noteworthy since others have gained or stabilized their market share only due to mergers.

One would hope that the firms that had been through a near death experience would proactively work to limit their counterparty exposure, especially given the ramifications of the Lehman failure. Alas, that hasn’t happened and unless Obama and Congress create some legislation that addresses counterparty risk, we can only expect the system to become even more fragile and dependent on a handful of firms.

However, counterparty risk has not abated in the past year, and has perhaps concentrated further post-Lehman…Furthermore, global liquidity has suffered as a result of LCFI clients avoiding their high grade collateral to flow freely within the LCFIs or LCFIs themselves locking up collateral in their balance sheets.

Regulatory capture confirmed by a former SEC regulator: This piece from Baseline Scenario is a response to a guest post by a reader named Bond Girl about regulatory capture. It is by a 27 year SEC enforcement veteran by the name of William Coffey. In the post he confirms what we fear most: the financial industry has in effect captured the regulators. However, he argues that it is not corruption that causes this. In fact, he claims that the regulators are victims of the industry’s efforts to manipulate the regulatory structure. I don’t know if I buy the victim argument but this is a very good read for those who are interested in the lengths the financial industry will go to keep the golden goose alive and unregulated.

Bond Girl is right, the industry “captured” the regulators and the regulatory system. But not in the passive sense that true regulators over time came to identify too closely with the interests of the regulated. This is not a case of financial regulators falling victim to the Stockholm syndrome. The vast majority of capture resulted from intentional efforts by the finance industry to advance their narrow interests at all costs and defeat meaningful regulation. (Emphasis Mine) Unfortunately, we live in a country that can be bought from the top down and the finance industry exploited the situation very successfully. But do not blame the regulators. Career regulators are as much the victims of these events as the public’s economic welfare.

Finally, someone is asking the right questions: In his piece in this weekend’s NY Times, Joe Nocera highlights the decisions of two judges who are currently hearing important cases in New York. The first judge is presiding over the SEC’s minuscule $33M settlement with Bank of America over the Merrill Lynch deal. The second is the judge who is deciding whether or not to allow bail for Madoff’s right hand man DiPascali. Nocera does a good job describing the humorous situation in which the prosecutors and defense are working together to convince the judges that the deals they have agreed upon are legitimate.

However, by far the most interesting thing to me is the questions being asked by Judge Rakoff who has basically said no to the SEC’s deal with B of A:

The questions he asked on Monday were the kinds of basic questions the country has been asking for months: if Merrill hadn’t paid those bonuses, wouldn’t its losses have been reduced by $3.6 billion? And wouldn’t that have meant that Bank of America needed less government assistance? And to what extent were the Merrill bonuses borne by the taxpayers?

The idea that we can’t get these basic questions answered is just ludicrous. I can’t understand why the SEC is so willing to sweep this under the rug. It seems clear that shareholders should have been notified about the losses at Merrill and B of A’s misgivings about the deal. If I had to guess the reason is that Bernanke and Paulson may have acted inappropriately (as I originally suggested here) and the government basically wants this all to go away. Good thing for taxpayers we have some judges who are interested in knowing the truth.

Speaking of the truth about the B of A- Merrill Deal: The September edition of The Atlantic has a very well written piece about the final days of Merrill Lynch. In it William Cohan aggregates all the information from the testimonies of the men who were most involved as well as commentary from other insiders.

The following account of the events that transpired during the waning days of the Bush administration comes from those transcripts, from the subsequent testimony of Lewis and Bernanke before Congress in June, and from interviews with insiders and knowledgeable observers. (Paulson, Bernanke, and Lewis all declined to be interviewed.) The narrative that emerges is troubling. It raises serious questions about the sanctity of legal contracts in post-crash America, and about the fast-evolving relationship between American government and industry.

I agree that the narrative is troubling, especially for investors. The actions of Ken Lewis really bring up the question of who the chairmen and CEOs of companies actually work for. Last I checked it was the shareholders and in that capacity all actions should be in accordance with what is best for the shareholders. Lewis claimed he didn’t have a choice. It was either he keep quiet and go through with the deal or try to invoke the MAC clause to protect his shareholders and get forced out by the government.

Asked whether he was angry that he didn’t feel he had a choice in the matter, Lewis replied, “I think I was a little shocked. Everything got back to the fact that I was shocked at how strongly they felt about the consequences… I think they were doing it in good faith. They thought everything they said—about the danger that Merrill’s failure would pose to the financial system—“was true.” Lewis conceded he could have said no and resigned, but he never considered doing that.

Of course Lewis chose to keep his job and those of his buddies on the Board. But, as indicated above, there was always another option. He could have said to Bernanke and Paulson that he had an obligation to notify his shareholders and let them decide on whether the deal still made sense. If that meant he had to resign or that he would lose his job then so be it. Let me remind you that IT WAS HIS F*CKING JOB to do just that. The fact that he didn’t shows that he is far more concerned with the empire he built/over-paid for and his legacy than he is about the welfare of shareholders. Are you at all surprised?

Maybe we shouldn't compare a new government insurance company to Medicare: This weekend’s NY Times had an amazing amount of great material. This piece is an article by the University of Chicago’s Richard Thaler on health care reform. He argues that a new government insurance company will probably not kill health care as we know it but also probably won’t save it. But, he says that if the right rules are not put in place then the government insurance company could have a very negative impact. It is a very good read but the part that stood out to me is his discussion of how we should look at Medicare when contemplating this new public option:

But what about the often-stated fact that Medicare has much lower operating costs than private insurance companies? Won’t this allow the public option to compete successfully? As Victor Fuchs, the dean of American health economists, recently argued in The New England Journal of Medicine, this is not an apt comparison because the new public plan would have marketing and other administrative costs that don’t apply to Medicare with its captive market.

This is an interesting point. If Medicare had to market itself to compete with the private insurers, would its costs be so low? I also somewhat believe the argument that hospitals and doctors accept lower payments for Medicare patients and turn around and charge more for the same services to people covered by private insurance in order to offset impact of Medicare patients on the bottom line. Here is the link to the piece in the NEJM and the following encapsulates the author’s thesis quite nicely:

Supporters of a government health insurance company often point to Medicare as a model, noting its low overhead and high beneficiary satisfaction. But a new company would face a very different situation from that of Medicare, which has a captive audience and doesn't have to sell insurance and administrative services in competition with other companies. The new company would have to worry about adverse selection, and it presumably wouldn't have Medicare's access to the federal treasury to cover deficits. Moreover, Medicare, despite its assured market and huge buying power, is headed for insolvency; thus, it is a poor model for a new program that would be dependent on voluntary enrollment in a competitive marketplace.

I don’t know exactly what to think but this is the first time I have heard that Medicare is on the verge of insolvency. Definitely something to think about when you hear people talking about how the success of Medicare will translate into the success of another government insurance company that actually does have to compete to survive.

Zero Hedge on the stratified consumer: I have saved the best piece of a great weekend for reading for last. This post by Tyler Durden of Zero Hedge is an absolute must read for anyone concerned about the state of the US consumer. In this article Durden highlights how levered consumers are and most interestingly discusses which consumers actually drive growth in consumer spending.

What is immediately obvious is that based on estimates by Bank of America, the 50% of US population which makes up the middle class, is responsible for the same amount of total consumption as the 10% of the upper class. Another observation is that the balance, 40% of population considered Low-Income consumers, is responsible only for 12% of total consumption.

This indicates that spending by the upper class has a disproportionate impact on total consumption and thus GDP. These are the people we need to keep spending if consumption as a percentage of GPD is not going to fall precipitously. This is because these people have significantly more disposable income than everyone else.

The disposable income difference between the richest 10% and even the next richest decile is staggering: a 3x order of magnitude. And a fact that Taleb fans would likely appreciate most, the pretax income difference between the median and mean for the top decile is shocking: $206,900 versus $397,700. This is skewed by a statistically low number of outliers earning an abnormally large amount of disposable income. (Check out the relevant chart here)

Ahh the Bill Gates effect as articulated by Taleb. Just as when Bill Gates walks into a room the average net worth of the people in the room skyrockets while the median does not change by much, the mean disposable income of the top decile is massively skewed by a few people who make an inordinate amount of money.

What is the takeaway? According to Durden if Obama is intent on taxing the rich to pay for all of the new spending and debt then that could have an outsized negative effect on spending and consumption because these people make up a disproportionate share. Not only could that dampen GDP growth but it could also prolong the excess supply hangover that is currently impacting businesses all over the country.

(Picture courtesy of