Wednesday, September 30, 2009

Wednesday is link day

Reasons to like the China story, but not the investment opportunity: Hat tip to Yaser Anwar for giving us access to the latest comments from Dylan Grice at SocGen. In his latest piece, he discusses both why investing in China could be lucrative and why it could be dangerous at the current levels. The investment thesis on China is not so dissimilar from the case for investing in tech stocks in the late 1990’s. Yes, the internet changed our lives in an incredible way. But, in terms of an investment, especially after the story had become well known, betting on tech stocks turned into a nightmare. The reason, of course, was valuation. No matter how good a story is and how likely it is to come true, if the stocks are extremely overvalued it is very tough to make money on them. Similarly, the emergence of the Chinese may change the world forever. China may well become the most powerful nation on the planet. There are certainly risks (as Grice points out) but the bull story for China over the long run probably is pretty compelling. However, as Grice so eloquently says, “Value should always get in the way of a good story.” In other words, investors need to distinguish between a good story and an invetsment that is priced to provide excess returns. Below is a bullet point summary from Grice of his views on China:

-Any investment contains risks, and investing in China may contain more than most. But the price Mr Market is currently offering appears to offer little compensation for taking them. There are many reasons to be strategically bullish on China, but valuation isn’t one of them.

-Last week I argued that China could become the most spectacular bubble, sorry, bull market, the world has ever seen. Financial history shows that large geopolitical swings frequently coincide with manias, while financial deregulation acts as the catalyst for rapid credit growth. Both are likely to exert increasing sway in coming years.

-Miyamoto Miyashi, the legendary Japanese Samurai, said that in strategy it was important to see distant things as if they were close, and to take a distanced view of close things. So as a long-run story, the Chinese super-bubble theme is worth keeping in mind.

-But a good story isn’t an investment case. Anyone investing in the late 1990s into the story that the internet was going to change the world, for example, likely lost a fortune, even though the story was 100% correct. Value should always get in the way of a good story.

-Prospective investors in China today face significant risks: the quality of the data and the inflation of bank credit cloud the near-term outlook, while water shortages, or China’s apparent historical propensity to take the wrong policy turn when seemingly poised for greatness pose longer-term investment risks too.

-Price is what you pay, value is what you get. Using a simple Graham and Dodd type valuation approach, the Chinese market trades at around 23x cyclically adjusted earnings, marginally higher than its recent average. It’s not obvious that the market’s current pricing offers much in the way of a margin of safety.

Confusing competitiveness with profitability: During the recent G20 meeting, there apparently was a lot of discussion regarding the need for higher capital levels at banks. So far there have been some whisper numbers but nothing concrete. While it is not hard to see that higher capital levels could potentially make the entire banking sector less prone to nasty blowups, the specific details will make or break whether or not reforms are effective. The level clearly needs to be high enough that a financial institution can withstand unexpected losses. The problem is that if the percentage of capital is set at a level unacceptable to financial institutions, they will use their strong lobby to stymie any reform movement. I think even the most defiant CEO understands that at least some changes are forthcoming. However, we know that these people will do anything they can to water down the impact of new regulations. These actions are justified by arguing that if capital standards are too onerous, certain institutions will become uncompetitive in the global market place. Don't believe it. What they are really saying is that if one country has more stringent rules than another, the banks located in the more regulated environment will not be as profitable. Less leverage means a lower return on equity and could mean smaller bonuses for the banksters. If competitiveness is measured by the ability to pay out exorbitant bonuses then maybe the opponents to leverage caps or larger capital buffers have a point. But, as Simon Johnson points out below, the rest of us should not shed any tears for these people. The US should act to make the entire financial system more secure regardless of what other countries do:

It’s time to get past the thinking that our economic prosperity is tied to the “competitiveness” of the financial sector, when that means doing whatever finance wants and keeping capital standards low.

As we discovered over the past 12 months, undercapitalized finance is not a good thing – it is profoundly dangerous and expensive. Other countries should be encouraged to raise capital standards also, but if they can’t or won’t, then their financial institutions will (a) not be allowed to operate in the United States, and (b) be allowed to interact in any way with a US bank only to the degree that the US entity carries an extra (big) cushion of capital in those transactions. Any US entity found circumventing these rules will be punished and its executives subject to criminal penalties.

Of course, this process needs to be WTO-compliant and the G20 is as good a place as any to manage the high politics of that. But stop worrying about what other countries might or might not do. Establish high capital requirements in the US, and make this a beacon for safe and productive finance.

And prepare for the crises that will sweep undercapitalized parts of the world financial system in the years to come.

Forbearance and “extend and pretend didn’t work in Japan and it won’t work here: In his latest missive, John Hussman discusses how the leaders and regulators in the US have refused to force banks to recognize their losses and restructure their debts. Of course, this type of inaction is reminiscent of the attempts of the Japanese to emerge from its real estate crash by allowing banks to earn their way out of the cycle. We now know that policy did not work and in fact created numerous zombie banks. That begs the question of whether or not the US is in actuality doing anything different. I understand that the US is not Japan and that times are different. But from a broader perspective, if the definition of insanity is doing the same thing over and over and expecting different outcomes, what does that say about global policy makers?

Historically and across countries, according to the IMF, 86% of systemic banking crises have ultimately required government restructuring plans that included closing, nationalizing and merging banks. Yet the policy response of the U.S. has been akin to putting a band-aid on an untreated infection. Worse, not only has the underlying infection been overlooked, but thanks to the easing of FASB mark-to-market rules early this year, we have at least temporarily stopped reporting on the status of that infection.

After the bubble burst in Japan in 1990, Japanese banks were not compelled to properly disclose their losses either. The predictable result is that the problems resurfaced later, but worse, because they had not been addressed…

Forbearance only works, however, if you're buying time to do something to restructure debt. Instead, we've celebrated bailouts and the easing of reporting requirements as if they are a substitute for restructuring. In my view, this is a mistake that will haunt us…

With the financial markets cheerily celebrating the end of the recession, credit spreads back to 2007 levels, and analysts referring to the mortgage crisis as largely a thing of the past, it is natural to ask why I would start pounding the tables again about debt restructuring. Old news. Problem solved. Why even bring it up?

The simple answer is that we have not solved the mortgage mess. We have temporarily buried it under a pile of public money, bailing out bank bondholders at public expense. As I've noted before, the best time to panic, in the financial markets, is before everyone else does. Similarly, the best time to consider responses to credit strains is before they surface. My sincere hope is that if, and I believe when, financial trouble resurfaces, we will be wise enough as a nation to prevent policy makers like Geithner and Bernanke from making the same bailout mistakes twice, protecting irresponsible lenders, and further burdening the nation with debt in the process.

Why we should to continue to be worried about US housing: Hat tip to The Pragmatic Capitalist for posting the link to this article in Fortune. If you read my blog or follow Whitney Tilson’s housing crusade or keep track of what Mark Hanson is writing about, nothing in this article will be news to you. There are still many structural headwinds facing the housing market that somehow continue to get overlooked by the media and government pundits (is that an oxymoron by the way?). In fact I was listening to a speech by Philly Fed President Plosser in which he specifically highlighted that housing had turned around. (I do give him credit though for being very candid about the risk of inflation and how hard it will be for the Fed to turn of the liquidity spigot.) Accordingly, I feel it is my duty to continue to articulate the reasons that housing prices may not yet have bottomed. My goal is not to turn each and every one of my readers into housing bears. The aim is to make people aware that there is still some risk to the downside and to hint that it might be prudent to take the mass media’s accounts with a grain of salt. In terms of this particular article, I think there are two items that are worth noting specifically:

Prices Are Still High

Although home prices have plummeted from their stratospheric levels of 2005 and 2006, they are still well above their historical norms. The Case-Shiller Home Price Indices, for example, shows that home prices in 20 major cities are still 41% above the level of January 2000 (at the peak in July 2006 they were 106% above that level). A report from the Census Bureau this month shows that incomes have not grown this decade. How are Americans supposed to afford 41% more house with no increase in income? While home prices may not revert all the way back to their long-term average, by at least this measure, prices are still very high.

Shadow Inventory

The market has been terrible for three years. Many Americans who might like to move have simply been waiting things out. Banks have put so many homes into foreclosure that they are backlogged in actually releasing the homes onto the market. And homebuilders are still bleeding money as they sit on vast tracts of undeveloped land that they'd like to slap homes on as soon as they find some buyers. Every time things start to look good, this shadow inventory starts to come back on the market, keeping prices low.

It is important to remember that even with the recent drop in prices, housing (on average) is still way up during this decade. The problem with this is that household income has not grown. So, if you think of housing price to household income kind of like a price to earnings ratio, this would imply a high P/E relative to the 2000 period. (I am aware that a better measure of a house’s P/E ratio is the price to equivalent rent. I am just trying to illustrate a point.) The takeaway is that people should be careful not to get anchored to the recent fall in prices when they measure the value of a home. Just because the price is down does not mean it is cheap. To understand value, people need a baseline from which to compare and the data from 2000 provides a sobering reminder of what a debt fueled bubble can do to prices.

The slow crawl back to financial reality: In his weekly article, Martin Hutchinson of The Prudent Bear takes readers through the recent fantasies that investors have been caught up in. He starts with the fantasy that sophisticated models could protect investors from risks and potential blowups. The crash of 1987 and the implosion of LTCM should have put this fallacy to rest. He also discusses the tech bubble and how the idea that all of these dot coms could be profitable at the same time (based on the size of the market and global GDP) was completely ludicrous. Then, as a result of the burst of the tech bubble, the Fed was under the delusion that deflation was on the horizon and subsequently took interest rates to incredibly low levels (well, at least back then) and left them there for too long. Finally, he discusses the current period and the plethora of foolish beliefs held by the Fed, regulators, the banks and even homeowners.

The problem is that while some of these fantasies look silly to most people in hindsight, very little is being done to get us back to reality- based capitalism. Maybe I am being too harsh and behind closed doors the people creating fiscal and monetary policy understand what must be done, but it sure seems as though many are trying to re-create the bubble that just exploded. Hutchinson suggests that all of the liquidity and stimuli being pumped into the market are preventing the necessary corrections from happening. In other words, the Fed and Treasury are not letting the markets regulate and punish those who made foolish decisions based on convenient fantasies. While allowing the natural process to occur without distortion may be quite painful in the short run, we would all likely be better off if excesses were cleared away and those who deserved to fail were actually allowed to:

A new webzine, CFOZone, has highlighted a study showing that companies which declare "pro-forma" earnings (dolled up by management to reflect the most favorable assumptions) suffer increased attention from short sellers, about $1.3 million worth initially after the pro-forma earnings declaration – just north of 1% of trading volume. This is good news; it suggests that the market is becoming hostile to attempts to fool it. The sooner we move to a reality-based capitalism, the better – but it may take some considerable time…

As the bubble that has developed since March is showing, the bailout of the world's financial system has stymied the normal bear-market correction mechanism that restores reality to the markets. Further nonsense like the declaration by the Federal Open Market Committee Wednesday that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period" only encourages the unreality – if good quality borrowers can borrow short-term at a cost well below the rate of inflation (let alone the likely future rate of inflation), then fantasy continues to be subsidized…

A reality-based market seems almost like Nirvana. A market that punishes dodgy accounting rather than rewarding it. A financial system that rewards savers adequately. A capital market that selects only sound borrowers and rational projects. A banking system that imposes no costs on taxpayers, and treats even its retail customers with respect and integrity.

It's a goal well worth striving for, and may well begin restoring U.S. prosperity when it arrives. But it will very likely require a horrendous period of downturn and destruction before it can be attained, as the costs of fantasy manifest themselves.

(Map of China courtesy of

Sunday, September 27, 2009

Weekend Link Fest

Is all the hoopla about malpractice costs just a red herring? When the topic of health care reform is brought up, the discussion often includes the burdensome costs of malpractice insurance and jury awards, the strain that lawsuits put on our court system and the incessant fear that doctors have about being sued. But when it comes to reducing costs, few people ask which of these items are actual material. Let’s start with the second two. First, it is not hard to imagine that thousands of malpractice lawsuits take up an inordinate amount of time and court resources. I have no idea how many are frivolous or brought about by ambulance chasers, but my guess is there is a way to both speed up the process and save on costs through prudential reform. Next, from what I hear from my friends who are doctors, the fear of a malpractice suits unequivocally leads to the administration of more services. No resident or doctor wants to get sued because he or she did not order the correct precautionary tests or procedures. So in that way there is no question that potential lawsuits add costs to the system. But what about the costs of insurance and jury awards? How big a percentage of total costs do these represent? According to this article in the NY Times, very little:

The direct costs of malpractice lawsuits — jury awards, settlements and the like — are such a minuscule part of health spending that they barely merit discussion, economists say. But that doesn’t mean the malpractice system is working.

The fear of lawsuits among doctors does seem to lead to a noticeable amount of wasteful treatment. Amitabh Chandra — a Harvard economist whose research is cited by both the American Medical Association and the trial lawyers’ association — says $60 billion a year, or about 3 percent of overall medical spending, is a reasonable upper-end estimate. If a new policy could eliminate close to that much waste without causing other problems, it would be a no-brainer.

At the same time, though, the current system appears to treat actual malpractice too lightly. Trials may get a lot of attention, but they are the exception. Far more common are errors that never lead to any action.

After reviewing thousands of patient records, medical researchers have estimated that only 2 to 3 percent of cases of medical negligence lead to a malpractice claim…

All told, jury awards, settlements and administrative costs — which, by definition, are similar to the combined cost of insurance — add up to less than $10 billion a year. This equals less than one-half of a percentage point of medical spending. There have been years when malpractice payouts rose sharply, but there have also been years when they did not. Over the last two decades, the amount has increased roughly in line with total medical spending, according to a study in the journal Health Affairs, based on a national database...

The problem is that just about every incentive in our medical system is to do more. Most patients have no idea how much their care costs. Doctors are generally paid more when they do more. And, indeed, extra tests and procedures can help protect them from lawsuits.

The article clearly tackles a number of subjects that I think are very relevant. The first is that of malpractice costs. Not that $10B is small potatoes but in the grand scheme of total spending it is a tiny drop in the bucket. The estimates of the costs of wasteful treatment are about 6 times as large but even when combined, $70B is a fraction of total spending. I’m not saying that the incentives and costs created by the specter of malpractice suits could not be affected positively by reform. I am just trying to point out that this is only one aspect of the system that needs an overhaul, the most important of which is addressed in the last paragraph above. Doctors are incentivized to offer more services and most patients have no reason to dissuade doctors because they never see the cost. This dynamic is exactly what needs to be altered if we have any chance of reducing spending on health care and our ballooning national deficit.

Too big to fail= too big to exist: Thanks to Karl Denninger for posting these comments from former S&L regulator Bill Black regarding too big to fail institutions. I’m not sure I have seen a more succinct and articulate synthesis of the problem these behemoths pose. I think he properly identifies the real problem (which we know Simon Johnson agrees with): the bigger these companies get the more powerful they are politically. How is it that you think our regulators and politicians got so captured by the financial system participants? It’s a very similar situation to the one in which a single customer owes the bank a ton of money. If you owe the bank $100K, the bank owns you. But if you owe the bank $100M, you own the bank in the sense that your failure can bring down the bank as well. In the case of the TBTFs, they got so big that they could not be wound down in an orderly fashion and had so many assets and liabilities that they in effect owned the system and the regulators. Needless to say, if we are to avoid further financial crises, the standing of these institutions must be reduced substantially. Here are Black’s comments:

The Treasury has fundamentally mischaracterized the nature of institutions it deems “too big to fail.” These institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous.

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded.

We need to comply with the Prompt Corrective Action law. Any institution that the administration deems “too big to fail” should be placed on a public list of “systemically dangerous institutions” (SDIs). SDIs should be subject to regulatory and tax incentives to shrink to a size where they are no longer too big to fail, manage, and regulate. No single financial entity should be permitted to become, or remain, so large that it poses a systemic risk.

I like that: SDIs. Reminds me of an STD. Anyway, Black also goes on to present some rules and limitations for these companies that include not being able to acquire other firms or grow, higher taxes proportional to size, multiple examinations and audits on a regular basis, leverage limits and higher capital requirements. In other words, he wants what would be revolutionary reform that would leave the TBTFs looking nothing like they do now. Unfortunately, based on the strength of their lobby and size of their political contributions, such dramatic change is quite unlikely. However, in a perfect world in which we could start all over again, Black’s common sense proposals would create a very safe and secure foundation for our financial system. Too bad the oligarchs, banksters and manipulators would probably intentionally crash the entire global system before they let such reforms pass.

A former sell side analyst who called the crisis? Hat tip to Zero Hedge for posting the link to this interview with Josh Rosner, a former sell side guy who apparently warned of the impending financial crisis. This is a VERY good interview and I suggest you read it in its entirety. What I want to highlight is first his commentary on the conflicts of interest that plague the sell side equity research analysts:

Damien: What exactly has you diverging toward the independent analyst route?

Josh: One is the most obvious potential conflicts of interest between investment banking clients and research — right where perhaps analysts puts a more favorable spin on the securities of companies they’ve got a banking relationship with. Furthermore, the willingness to be pressured by large institutional clients who want you to consider stocks or securities that they’ve got heavy exposure to.

It seems to me that the independence of your view is really paramount. In the largest and most complex financial institutions, the institutions themselves do not offer levels of disclosure and transparency that make them truly analyzable.

Damien: Is it hard to get access because you don’t play the game?

Josh: I have to rely solely on the cold hard facts of their filings and public disclosures coupled with my macro-economic analysis. Wall Street is so soiled it becomes hard for an analyst at a traditional Wall Street firm to actually have an economic outlook. The guy who’s covering the mortgage bankers is not covering the mortgage insurers. The guy who’s covering the mortgage insurers is not covering the GSEs. The guy who’s covering the GSEs is not covering the thrifts. However, changes within a sector occur where all of these sub-sectors meet. So, the traditional sell-side analyst is stuck relying much more heavily on management to give them macro guidance and highlight structural changes in the industry. Consequently, their independence ends up jeopardized.

One of my criticisms of the sell side research industry is that the analysts are put into their own silos that force them only to focus on the companies they specifically cover. Accordingly, they have trouble seeing the forest through the trees and often have no sense of how broader macro factors can affect their coverage universe. Plus, you have the additional bias created when the company also provides investment banking services to a firm on an analyst’s coverage list. If you believe that there is a Chinese wall that actually reduces any conflict of interest then you might as well spend your time searching for the end of the rainbow for that infamous pot of gold.

Finally, what I really liked about this interview is that Rosner also gives us some of his insight on the macro environment and the financial system. The two takeaways are that the collapse of the shadow banking sytem cannot be offset by fixing the banks and that in reality we haven’t fixed anything yet, just added a band-aid to a gaping wound.

Damien: So, there’s been a swap of providing credit?

Josh: Right. Commercial and savings institutions were 54% of total non-revolving consumer debt in 1989, and then only provided 30-34% since 2002. I bring it up because even if we make our banks whole, even if we plug the holes in their balance sheets, provide them capital or force them to raise capital, create new demand for borrowings, and create a steep yield curve, the reality is we’ve lost the system by which we funded a trillion dollars of collateral in this economy in 2007. And that’s 2007 alone.

What have we done to fix the issue? We haven’t fixed either the banks nor have we fixed the credit markets. Fixing would actually be a fundamental repair — not a patch like we have now. We’ve put up scaffolding to make sure when bricks fall off the buildings they do not hit people below. In our case, the scaffolding has names like Commercial Paper Program, TALF, PPIP, the TGLP, and quantitative easing.

Wait, Congressmen aren’t bound by insider trading laws? Hat tip to Zero Hedge and the CPA blog for posting the link to this transcript from NPR. I attribute my ignorance of the facts in this case to my relative newness to the investment management world. I had no idea that Congressman do not have to abide by insider trading laws. This is unbelievable to me. Talk about the ultimate insiders. They get to talk to Federal Reserve and Treasury leaders who shape our entire economy and can push asset prices up or down based on tiny decisions. Thus, foreknowledge of these decisions could potentially lead to incredible investment opportunities. Of course, during the crisis last year a few people apparently took advantage of their superior information:

STEVE HENN: A year ago this week Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke dashed to Capitol Hill. They hastily met with a small group of congressional leaders to tell them that the country was teetering on the edge of financial catastrophe.

Paulson and Bernanke asked Congress to spend hundreds of billions to save the banks…

The next day, according to personal financial disclosures, [Representative] Boehner cashed out of a fund designed to profit from inflation. Since he sold, it's lost more than half its value.

Sen. Dick Durbin, an Illinois Democrat, who was also at that meeting sold more than $40,000 in mutual funds and reinvested it all with Warren Buffett.

ALAN Ziobrowski: Senators make significant abnormal returns, some place around 1 percent above the market, 12 percent a year.

Alan Ziobrowski is a business professor at Georgia State University. Using hundreds of personal financial disclosures from the 1990s, Ziobrowski analyzed more than 6000 stock transactions by members of Congress going back up to 15 years.

Ziobrowski: We have every reason to believe they are trading on information that the rest of us don't have.

Craig Holman is at Public Citizen, a consumer watchdog. Holman believes lobbyists shouldn't be allowed to sell tips to hedge funds and members of Congress shouldn't trade on non-public information. But right now it's legal.

HOLMAN: It's absolutely incredible, but the Securities and Exchange Act does not apply to members of Congress, congressional staff or even lobbyists.

Consistent abnormal returns--if this is not smoking gun evidence of legal corruption I am not sure what is. I would love to know what the original rational was for exempting member of Congress from these rules. Just think for a second about the potential conflicts of interest here. How could you know that a lawmaker was not voting his book, meaning that he or she voted for legislation that would benefit his/her financial position? Also, how can we be sure that a Congressperson would put his or her constituents before profit motive? I understand that these conflicts are inherent to the position but they are exacerbated by the fact that these people can legally trade on non-public information. Luckily, there may be some reform on the horizon. A bill called the STOCK Act is being circulated that would remove the exemption. For anyone looking for a new cause to take up, this might be a very worthwhile one.

Ugh, PPIP rears its ugly head: Let me just say it. I never liked the PPIP. I always thought it left the taxpayer on the hook for potential losses and let private investment vehicles keep far too much upside for the amount of equity they put in. But now we have our first PPIP deal as discussed by the Rortybomb blog. From the NY Times article posted by Mike Conczal:

Agency officials said the deal meant that investors would be paying about 70 cents on the dollar for the loan portfolio…Had the government not provided Residential Credit with the ability to borrow most of the money it needed at low interest rates, agency officials said, the investors would have probably paid about 20 cents on the dollar less than they did.

So the leverage allowed the investors to pay 70 cents on the dollar instead of 50 cents. That would indicate to me that the assets were actually worth closer to 50 cents but as predicted, the structure of the PPIP inflates asset prices. This is exactly what we need. More distortion of the fair value of assets. Here are Mike’s comments:

So private investors have come in with $64m, to get a 50% stake in a company that purchases $1.3bn in mortgages. The Treasury provides the other $64m, while the FDIC provides 6-to-1 leverage to purchase this. The actual bid on the loan is $727m…

Residential Credit puts up $64m, on a $727m bid for $1,300m in assets. If the assets are worth less than $727-$64 = $663m, then every additional dollar comes from me and you, the taxpayer. If the assets are worth more than $727m, then we split the earnings with Residential Credit.

So for small price of $64m, or about 8% of the bid, they get half the upside gains while only absorbing a bit of the downside loses. We are also on the hook for a lot of interest rate risk, which I’m not going to bother to quantify. This is a terrible deal…

My sentiments exactly. Taxpayer takes the majority of the downside and can only receive 50% of the upside. This is what we call an asymmetric return profile. Great for Residential Credit. Horrible for you and me. By the way, these assets were from a FAILED bank. So the taxpayer just took on all the downside risk without the associated benefit of unclogging an existing bank's balance sheet so it can lend. What was this supposed to accomplish again?

The way to stop climate protection reforms is by lying to the American people: Or, at least that’s the tactic that Paul Krugman claims the Republicans and those who oppose such reforms have sunk to. In fact, contrary to all of the commentary that suggests that the US economy would be doomed if Congress passed laws to reduce our impact on the earth, the CBO apparently believes the costs would be minimal:

Earlier this month, the Congressional Budget Office released an analysis of the effects of Waxman-Markey, concluding that in 2020 the bill would cost the average family only $160 a year, or 0.2 percent of income. That’s roughly the cost of a postage stamp a day.

By 2050, when the emissions limit would be much tighter, the burden would rise to 1.2 percent of income. But the budget office also predicts that real G.D.P. will be about two-and-a-half times larger in 2050 than it is today, so that G.D.P. per person will rise by about 80 percent. The cost of climate protection would barely make a dent in that growth. And all of this, of course, ignores the benefits of limiting global warming.

So where do the apocalyptic warnings about the cost of climate-change policy come from?

Are the opponents of cap-and-trade relying on different studies that reach fundamentally different conclusions? No, not really. It’s true that last spring the Heritage Foundation put out a report claiming that Waxman-Markey would lead to huge job losses, but the study seems to have been so obviously absurd that I’ve hardly seen anyone cite it.

Instead, the campaign against saving the planet rests mainly on lies.

Krugman suggests that opponents of climate protection are using the same scare tactics that people who are against health care reform are using. The Democrats are going to kill grandma! Any taxes on carbon emissions are going to make the US uncompetitive and destroy our standard of living! Now, I have no idea how accurate the CBO’s or any other estimates are. But trying to drum up opposition through ludicrous assertions is pretty despicable in my eyes. Why can’t we have thoughtful non-partisan debate about something that could determine our fate as a species? It’s stuff like this that makes me wonder if our political system is beyond repair.

Total borrowing is up, but maybe not as much as you would think: One of the most common arguments among those who believe that the US economy could be in for a nasty fight with deflation is that despite the Treasury’s unabashed borrowing and the Fed’s money printing (sorry quantitative easing), the de-leveraging and credit freeze that is going on elsewhere will likely offset the government’s efforts. Well, now we finally have some data from which we can ascertain which side is “winning:”

This week, the Federal Reserve published its quarterly report on debt levels in the economy. While Uncle Sam borrowed more, others borrowed less…[T]otal domestic debt — the amounts owed by individuals, governments and businesses — climbed just 3.7 percent from the second quarter of 2008 through the second quarter of this year. That is the smallest increase since the Fed started these calculations in the early 1950s…

Until this recession, the idea that American individuals would ever cut their overall debt levels seemed as likely as an August snowfall in Miami. But that was before the bottom fell out of the housing market, something that Florida condo developers had considered to be equally unlikely.

Over the year, total household debt fell by 1.7 percent, and mortgage debt — the largest component of household debt — fell a bit more, at a 1.8 percent pace. This is the 10th recession since the Fed began collecting the numbers, but the first in which the amount of home mortgage debt fell. Some of that decline, of course, came from foreclosures that canceled debt and left lenders with big losses.

It looks as though so far the government’s increased borrowing binge has been larger than the decline in consumer and business indebtedness. But obviously not by much. As mentioned in the article, the 3.7% increase in total debt is the smallest increase since the Fed starting counting. Honestly, this data point really is troubling. If you stop and think for a second about what this means, even without more data you come to the logical assumption that debt was consistently rising faster than GDP during many of the last 60 years. If I saw a business that was piling on debt at a much faster rate than earnings were growing, I would understandably start to worry about that company’s ability to service its debt. Credit growth that stimulates new business creation and GDP growth is certainly necessary for a vibrant economy. However, borrowing that just puts businesses and consumers further into a hole and makes them completely beholden to the banks (maybe that is the point—a person who has such large liabilities may be less likely to speak out or act out against the establishment) creates a pathetic nation of debtors.

Anyway (as I step down off of my soapbox) the most interesting thing to note from above is the miniscule fall in total household debt. With household debt to GDP levels at historic highs and so many people unemployed, you would assume that much more de-leveraging would have occurred during the last year. If economists and investors are concerned about future consumer spending after a 1.7% decline in household debt, wait until these people really start paying down debt as opposed to spending. To fix their balance sheets people are likely going to have to save a lot more, pay down much more debt, and consume substantially less. This is the kind of data that bolsters the deflationists’ arguments and may signal very tough times ahead for US businesses and the economy as a whole. Accordingly, my advice is to beware bearded men who claim that the economy is out of the woods.

(Cartoon courtesy of

Friday, September 25, 2009

Happy Friday Links

Whispers about Wells Fargo’s derivative book grow louder: Hat tip to Zero Hedge to posting the link to this piece from Clusterstock. We already know that the Wachovia Pick a Pay Portfolio is a huge mess. We are also seeing the Wachovia commercial book start to deteriorate. But now there are apparently concerns that the derivative contracts that Wachovia wrote could blow up as well. Based on how poorly everything else was underwritten, would that surprise anyone at all? From the Clusterstock article:

We read closely the company’s annual report. It has a brief and very boring discussion of exposure to credit derivatives. But nowhere does the company express an awareness of (or exposure to) what we now think of as Collateral Call Risk.

It was not bond defaults that killed AIG, after all. It was collateral calls.

Recall that AIG also thought that it was exercising the utmost caution, hiring a Wharton/Yale professor to build "risk models," and AIG was confident that many of the bonds on which it wrote insurance would never default. And AIG was right—many of those bonds didn’t default and still haven’t. But that wasn’t enough to save AIG.

What AIG's risk models missed was the possibility that AIG would have to post additional collateral in the event of a decline in the value or ratings of bonds that had yet to default. They had only analyzed the likelihood that they would be forced to pay off credit default swap policies insuring bond defaults.

According to the author, there is very little data available regarding what is in this derivative book. We don’t even know for sure if these contracts require Wells to post collateral if the situation starts moving against WFC (although the right to demand collateral is apparently standard with this type of contract). However, if I owned shares of WFC I would be really concerned about the rumblings coming out regarding all of the loans and derivatives inherited from the Wachovia deal. For a stock that has just about quadrupled off of its 52 week low there seem to be some significant potential headwinds that may not be currently priced in.

Excessive Executive Compensation+ Wall Street Fees= Lower Shareholder Returns: In last weekend’s piece in the NY Times, Gretchen Morgenson tackled the topic of corporate directors and their fiduciary responsibility to shareholders. The costs of excessive executive compensation are usually rather abstract and tough to quantify. However, Morgenson cites research from a man named Frederick Rowe (who is the president of a nonprofit shareholder advocacy group) who tries to pin down just how much investors lose in terms of returns as a result of dubious decisions by directors:

Mr. Rowe said investors must force directors to slash the “friction” costs that drain their companies’ coffers and diminish investment returns. “Friction takes the form of fees and costs generated by Wall Street, excessive compensation paid to company managements and all their helpers, finders’ fees for placing money, and political contributions to keep the wheels of commerce greased,” he said.

How expensive is this friction? Mr. Rowe estimates that the excess costs associated with management compensation, Wall Street fees and political expenditures by corporations reduce investor returns about 3 percent on average every year. Given that there is $10 trillion in retirement savings now invested in the stock market, pretty soon you’re talking real money.

Consider this calculation: If the stock market generates average annual returns of 8 percent over time, in 30 years that $10 trillion would have grown to more than $100 trillion. But shave 3 percent off those returns and shareholders are left with just about $40 trillion. Almost $60 trillion gets diverted.

3% per year can be the difference between a fund manager raising a ton of new money and going out of business. So, this is certainly not a trivial amount. However, the exact number is not necessarily important. What is important is to force companies to reduce friction. This can only be accomplished if large stakeholders are willing to be more active and reforms are implemented that make it easier to influence complacent or even conflicted management teams.

Moody’s agrees with me about future housing prices: After studying the real estate bust in the early 1990’s I concluded that it was very likely that real estate prices would not roar back like the stock market has. Based on the data I looked at, it took 14 years for someone who bought at the peak to see that value again. Moody’s is estimating that it could be until the 2030’s when the hardest hit areas get back to their bubble peaks. Yikes. That’s because, in reality, real estate is an illiquid asset that should not be looked at like a stock. Before the debt-fueled binge this real estate was essentially a slow growth asset that appreciated at a relatively normal trend line pace. So, for the people who are waiting to sell “when the market comes back,” I have a feeling they may be waiting a very long time, especially if everyone has the same plan. Mark Hanson often references a shadow inventory of houses that people want to sell but are in essence waiting for an uptick in values. Unfortunately, this common outlook may only increase the supply glut and offset any positive demand dynamics. From Moody’s via Zero Hedge:

Even under strong economic and demographic conditions, the demand for homes will increase moderately relative to both, with sales per households lower during the recovery period than the during the first half of this decade. The pace of new and existing single-family home sales will increase to 6.2 million per annum by 2012, well shy of the 7.5 million units sold at the peak in 2005. Similarly, homebuilding will rebound, but a lingering overhang of inventories, combined with consolidation in the industry and caution on the part of both homebuilders and lenders to builders, will keep the pace of construction from reaching the peak it achieved at the end of 2006 of over 2 million units. The overhang of inventories from the earlier construction boom will be drawn down by the end of 2011, bringing the supply and demand for homes in balance…

Hard hit areas such as Florida and California will only regain their pre-bust peak in the early 2030s, well after the nation does. New York will also be a laggard, although its overall decline in prices will be less severe. The main constraint on New York's outlook is Wall Street. In general, the length of the downturn and the length of recovery in a region will depend on the degree of aggressive lending or overinvestment in housing that occurred during the boom. On the recovery side, states with weaker job growth will also take longer to return to peak.

Moving toxic assets from one pocket to the other: If I own a stock that has lost 50% of its value and I decide to move it from my TD Ameritrade account to Charles Schwab, does the stock have a different value? Of course not. All I have done is move it from one pocket to another. But when you are a big investment bank, apparently there are different rules. Witness the magic occurring at Barclays:

Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year (presumably from the equity investors, although that seems steep). Returns from the investments will be paid as follows, in this order (and this is important): (1) fund management fees; (2) a guaranteed 7% return to investors; (3) repayment of the Barclays loan; and (4) residual cash flows to the investors.

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

But regulatory capital arbitrage is only one kind of arbitrage. For ordinary accounting purposes, the toxic assets are not on its balance sheet. So if they fall in value, Barclays will not have to recognize a loss – at least not until Protium defaults on its loan, which could be as far as ten years in the future. So the bank has the same true economic exposure, but can pretend it isn’t there for a long time.

Talk about a great way to hide dodgy assets and hope investors forget they are there. Even though Barclays has to hold capital based on the loan exposure, according to the structure outlined above I surmise that future losses will not flow through to the income statement. Accordingly, Barclay’s can avoid the potential EPS hit and unload assets at a price that could be far greater than what a third party would be willing to pay. If this seems like it has the potential to be a sham transaction that’s probably because that’s the case. But, since "extend and pretend" as well as "mark to whatever the bank feels like" are not only sanctioned but encouraged by the governments in charge, none of this should come as a surprise.

Where does private equity go from here? In his weekly article, Andrew Ross Sorkin of the NY Times includes commentary from Guy Hands of PE shop Terra Firma. It is a little disconcerting to hear that an insider is so bearish on the prospects for many PE firms:

Mr. Hands is not rooting for the industry’s demise, but he is predicting it will wither. The firms still have funds big enough to last them at least a decade, as they provide steady fees. “Right now, the big firms have a tower of fees,” he said. “But the tower starts to collapse over time.”

As the funds dry up, Mr. Hands expects the firms will struggle to raise enough new money to support the hundreds of employees they now employ. His prediction has a precedent — that’s what happened to venture capital after the late 1990s. The industry shrank sharply after it became clear that too much money was chasing too few deals.

But the pattern may play out in slower motion for private equity. “Neither the banks nor P.E. want to come clean about mistakes,” he wrote in his notes. “Hence companies will live as zombies unable to grow their businesses or make long-term commitments. Meanwhile banks will try to suck out as much money as they can in fees and postpone recognizing the full extent of the losses of their underwriting decisions.”

In the end, he said, “Many P.E. firms are hoping that daylight doesn’t shine on the corpses of their companies, so they are reluctant to restructure too quickly.”

Sweet, we can have zombie banks and zombie PE firms owning zombie companies. All we need now is actual zombies and the US will start to look like a Resident Evil video game. In all seriousness, Mr. Hands makes and interesting point. These over-levered companies that were acquired as a part of a bubble time LBO will likely have to fight just to stay above water. Of course this won’t be good for the jobs markets as these companies continue to try to cut costs so they can pay off their daunting debt loads. Of course, the returns from companies that can barely service their debt are likely to be quite mediocre. It’s really hard to know how this will play out but I can imagine private equity investors doubting that whatever these companies are being valued at reflects the current reality. Too bad they often have to pay fees based on some arbitrary value and really only have the option to sit and hope that the economy improves or credit markets become more favorable.

Don’t discount the possibility of a 1937-like repeat: We have been reminded over and over again about how the government during the Great Depression put the stimulus brakes on too soon and the country then plummeted back into a recession/depression in 1937. Ben Bernanke has promised that he won’t let that happen again. That means the punch bowl will be out even after all of the partygoers have gone home. This means Helicopter Ben will be dropping money from the sky even after jobs start to come back. This is one specific case in which I tend to trust Bernanke. I wholeheartedly believe that he will do anything to avoid crippling deflation and being too early in raising interest rates. The fact that there will likely be a plethora of unintended negative consequences of these actions is well documented. However, that is a topic for another time. But, as discussed in this piece from MSN (hat tip to The Pragmatic Capitalist), we have to remember that this recession is unique and the risk of a double dip cannot be ignored (regardless of what cheerleader Ben is saying):

The year of the Big Test will be 2011. By that year, the money from the first stimulus will have been spent, and the economy will either be in the midst of a sustainable recovery or not.

I think anybody who tells you they can predict now whether we'll have a sustainable recovery under way in 2011 is either out to fool you or is fooling himself.

This isn't your average recession. This is a great big global recession coupled with a great big global financial crisis.

This Great Recession is therefore much more subject to fits and starts and reversals than the average recession, because every time the economy starts to run smoothly, the banking system stands ready to throw another wrench into the works.

I'm not predicting the return of 1937 in 2011. I don't think I've got the kind of super-X-ray economic vision to call that one right either. But I would like us not to get carried away by the 57% rally in the stock market (as of the close Sept. 18) and become convinced that everything is fixed.

Can we stop talking about cash on the sidelines? I start to worry when I hear pundits coming up with non-fundamental reasons the market could go higher. A few of the most common of these are the cash on the sidelines and the managers who have missed the rally arguments. Maybe I don’t understand, but last I checked stock trading was a zero sum game (aside from transaction costs) and unless things have changed it is still true that if someone buys then someone has to sell. Doesn’t that mean that when someone comes off ofthe sidelines by buying then his or her counterparty moves onto the sidelines by selling?

Anyone advising clients to "buy the dip" based on sideline cash shows a fundamental lack of knowledge about how markets work.

For every buyer of securities there is a seller except at IPO time, secondary offerings, etc. Thus, it is virtually impossible for money to come into the market in normal day-to-day trading transactions.

For example: If one firm invests $100,000 in equities, then another firm will be selling $100,000 in securities. The end result of the transaction is "sideline cash" moves from firm A to firm B.

Furthermore, because of monetary printing, one should expect the amount of "sideline cash" to rise over time. Sideline cash is higher than it was 10 years ago and will be higher 10 years from now barring a huge number of IPOs or secondary offerings that would suck up some of that sideline cash or a period of heavy monetary draining by the Fed.

When I hear this argument I start to think people are grasping at straws to explain the rally or the potential for further gains. Same goes for the idea that the market will go higher because so many fund managers have missed the rally and in order to catch up to the S&P 500 and not miss more appreciation they will throw everything they have into the markets. Sorry, but the only arguments I actually listen to for why the market should go higher or lower are based on valuation. Everything else is just short term noise in my eyes. So when I see the S&P 500 trading at about 26x earnings (according to David Rosenberg of Gluskin Sheff) it is hard for me to believe stocks are cheap right now or that there is any reason to jump into the market head first.

(Picture courtesy of