Financial

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2
Sep 10

The Economy at Street Level

While we have examined macroeconomic issues extensively, rarely do we focus on the micro. We need to look at what is happening to real people.  Examining economics at street level is not as scientific or as mathematically precise as our econometric brethren would be.  We would probably fail the basic intro econ course at a prestigious academic institution.  Nevertheless, the timeless philosopher, Yogi Berra, says it well: “you can observe a lot by just watching.”

Walking

The best way to learn what is going on somewhere is to walk, not drive.  I live in a small city, a bedroom community for a larger city.  The median family income is $62,000 and the per capita income $35,000.  The city is racially diverse and attempts to cater to its upscale resident consumers.  Dropping my car for service at the local auto dealer (there are Porsche, Volvo, Mercedes, Lexus, Subaru and Buick dealers within walking distance),  I politely declined the courtesy shuttle and, to observe business conditions, walked home.   Covering about a mile through one part of our retail  and commercial district, I observed the following:

  • Ten retail establishments were vacant.
  • Each of several small office buildings had “space available” signs.
  • Each of the apartment buildings and garden apartment complexes I passed advertised one and two bedroom apartments for rent.
  • An office building which started construction six months ago has not progressed.
  • Almost every retail establishment had sales in progress, and restaurants advertised specials.
  • A major wind and rain storm hit our city in March.  Several damaged city trees have not been removed and badly buckled sidewalks have yet to be repaired.

Listening

The economy continues to impact friends, neighbors and family.  Here is what the Washington beltway political elites are not hearing:

  • One question, I regularly ask: on a percentage basis how much has your income declined from your most recent peak earnings year?  Other than one medical specialist who said his income has not declined, the response is a decline of 25-50%.
  • For an over-fifty executive, attorney, senior information technologist or finance specialist the job prospects are almost nil.   These are highly trained, experienced competent individuals who have been out of work from one to two years.  Unarticulated age discrimination is endemic in our system.  This type of candidate probably has a better chance of getting hit by a meteorite than getting a full time position with a firm.
  • Sending a high school senior to the state university has come back in vogue.  In the past, State U lacked the cache of the Ivy League or better private schools.  Suddenly this option has gained new luster.
  • Instead of the direct path to graduate school, new college graduates, even Ivy League grads, are scrambling for jobs.  Many new alumni of prestigious universities are interning with no pay or $10 per day stipends.  The entire economic value of graduate and even undergraduate degrees is under question.
  • Overseas vacations are out and domestic, and automobile vacations are in.  And we’ve all recently heard a new word:  staycation.
  • Since the banks have tightened lending requirements, the re-sale house market is virtually dead.  Sellers cannot find qualified buyers.
  • Small business owners and professionals have had their credit lines reduced, which de facto has cut back on business expansion.
  • Friends who are doctors and dentists are finding that they cannot fill their weekly schedules and are going to 3 and 4 day workweeks. Even in large firms, attorneys are having difficulty generating billable hours.
  • Home equity lines have been slashed, further undercutting spending plans.  I question why some of my high earning friends were using these lines for luxury expenditures in the first place.

It May Not Be Science but It Is Real Life

Again I have presented “street level” anecdotal information on the real economy.  I believe this anecdotal information more accurately presents the state of the economy, compared to the endless cheerleading from financial media and the Administration.

Perhaps some of the elite should bring their own cars in for service, avoid the courtesy shuttles, and walk home.    Rather than this cheerleading, what Yogi might say about our current recession is the real truth for many people: “it ain’t over until it’s over.”

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26
Aug 10

Artificial Sweeteners Turn Sour

Last week in Artificial Sweeteners we discussed how government intervention has distorted the economy, the stock market and the housing market.  The basic thesis:

Excessive economic stimulus and a misguided zero interest rate policy has created false bottoms in the housing and stock markets.   See Artificial Sweeteners

Dour economic statistics released this past week only confirm that thesis.  While extrapolating from one month’s statistics is dangerous, nevertheless the numerosity and interrelated nature of recent reports raises questions whether there ever was an economic recovery.

Scanning the Headlines

The past week we have been bombarded by negative economic reports from housing to employment to durable goods.  A quick look at the headlines:

The Super Sweetener

The Congressional Budget Office calculates that stimulus added 4.5% to GDP.  Further, these programs created up to 3.3m jobs.   One estimate is that without stimulus, GDP would have been negative 3.5%.   What happens next?

So now that the stimulus is tapering off, America has the following rather unpleasant things to look forward to: a 4.5% reduction in run rate GDP as the direct economic boost disappears, the gradual loss of 1.4 to 3.3 million jobs, and the eventual realization that non-recurring, one time items can not be projected into perpetuity, despite what Keynesian dogma may preach. See CBO Estimates that Stimulus Boosted Q2 GDP by 4.5%, Standalone Number is likely under around -3.5%

Shoveling Money to No Avail

Morton Zuckerman captures the folly of current economic policy:

Tons of money have been shoveled in to rescue reckless banks and fill the huge hole in the economy, but nothing is working the way it normally had in all our previous crises. See End of American Optimism

All we have created is a “new normal” of slow or little growth. Compared to sales growth of 4% in past recessions, sales are increasing at a little over 1%.

…there are at least 14.5 million Americans still searching for work: 1.4 million of them have been jobless for more than 99 weeks, 6.5 million have been jobless for over 27 weeks. This is a stunning reflection of the longer-term unemployment we are coping with.

The unemployment numbers are worse than reported. Last year the Labor Department admitted it over-counted the number of jobs by 1.4 million….

Since April, the Labor Department has counted 550,000 nonexistent jobs under this so-called birth/death series. Without these phantom jobs, the economy this year created virtually no jobs—certainly not the 600,000 the administration has been touting.

The Obama administration projects the unemployment rate will drop to 8.7% by the end of next year and 6.8% by 2013. That is totally unrealistic. See The End of American Optimism.

A policy of artificial sweeteners has misled the American public and merely put off the day of reckoning.  Trillions of stimulus dollars have masked underlying weakness in the American economy.  Instead of these sweeteners, banks should have been forced to write off bad debt, insolvent firms should have gone bankrupt, government interference in the economy should have dwindled,  and programs increasing employment costs should have stopped.

If the economy were permitted to self correct, we would be on our way to recovery rather than be suffering the sour aftertaste of artificial sweeteners.

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19
Aug 10

Artificial Sweeteners

Artificial sweeteners have been the subject of health concerns.  Aspartame, for example, has been found to be a migraine headache trigger.  Products containing it carry a health warning for PKU, a rare hereditary disease.  Today we learn that diet sodas markedly increase the risk of pre-term deliveries.  See Add Diet Soda to the List of Things to Avoid While Pregnant.

Similarly, the Federal Reserve and the Administration have not trusted that the economy can heal through natural market forces.  Instead we have been served up the economic equivalent of artificial sweeteners.  Concerned by slow growth, not even negative growth, the government again is firing up the machinery for money printing and stimulus.

In each instance, the government is intervening, distorting, and artificially “sweetening”  the bond market, the housing market and, indirectly, the stock market.  What are the consequences?

There is No Free Lunch

Martin Hutchinson in The Peril of False Bottoms targets faulty government policy as the reason for our anemic economic recovery.  Excessive economic stimulus and a misguided zero interest rate policy has created false bottoms in the housing and stock markets.    A false bottom is defined as a stabilized “price far above the likely long-run price equilibrium of the assets concerned.”

Bernanke has precedent for providing excessive liquidity and holding interest rates too low for too long.  Greenspan reacted to the internet stock market crash by flooding the market with liquidity.  Doing this drove the market to over 14,000 on the Dow Jones Index and created a housing boom.   In the 2008-2009 real estate and stock market crash we learned  how flawed this policy was.

More on False Bottoms

Hutchinson points out federally inspired housing market distortions:

House prices are currently 47% above their level in January 2000, according to the S&P Case-Shiller 20-city index, compared to a 49% rise in prices since that time – in other words, they are in real terms at the same level as at the top of an immense speculative boom.During the recent contortions, the U.S. monetary and fiscal authorities have established false bottoms in two markets. The first is housing, where subsidies to first-time buyers, ultra-low mortgage rates, government guarantees on $700,000 home mortgages and foreclosure-avoidance schemes have prevented the housing market from falling even to its average level where the average house price is about 3.4 times average earnings. The Peril of False Bottoms

These misguided policies have consequences:

…with additional buyers having been sucked into the market, it is now likely that house prices will fall further than this. Indeed, if the appalling suggestion put forward last week that the government through Fannie Mae and Freddie Mac forgive $1 trillion of defaulted home mortgages is put into effect, they will undoubtedly do so. Nothing could be more designed to destroy confidence in the housing market than a massive subsidy to the most foolish and improvident home buyers, at the expense of the thrifty and careful renters who are the major source of potential new demand for housing.

If the buyer pool is attacked in this way, or forced into unnecessary losses by being made to buy too soon, house prices may not bottom out at the market-clearing level … but may continue falling.  The Peril of False Bottoms

Wither the Stock Market?

The stock market is the second false bottom:

Currently at 10,650 as I write, the market is 35% above its appropriate “middling” target. The “trailing” P/E ratio of 20.4 on the Standard and Poors 500 is also above its historic average, even though corporate and bank earnings are currently inflated by ultra-low financing costs and a steep yield curve. Thus at some point we can expect reality to intrude, and the market to drop to its likely cycle low in the region of 5,000 on the Dow Jones index.

Again market prices are too high for any intelligent buyer.  And worse, buyers will then be unavailable to buy stocks at the bottom. The Perils of a False Bottom

Politics v. Economics

Politicians are worried about the next election.  Thus, we see the desperation of the Administration to throw economic caution to the wind.   Zero interest rates, forgiveness of imprudent debt, subsidies to overpaid public sector workers (with no corollary “give backs”) are all hallmarks of erratic and misguided government policy.  They also sacrifice long-term prudence for the feel good of short term stimulus.

Who will pay this price?  Unfortunately, it will be stock market investors, pension plans, life insurance companies and homeowners.  Directly or indirectly, that is virtually all of us.  We need to beware politicians handing out artificially sweetened candy. Just like aspartame and our physical health, artificial economic sweeteners can be harmful to our financial health.

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16
Aug 10

Bring Back the Robber Barons

Bill Gates and Warren Buffet have encouraged wealthy families to give half their wealth to charities, and many have done so.  One year into the effort, Buffet announced that forty families have agreed to pledge more than half their wealth to charity.   Emblematic of our current age, most of these families have made their money in the finance industry.

A Different Time in America

Once upon a time in America there was an entrepreneurial class that did more than shuffle pieces of paper.  They produced real things.  Historians originally referred to this group as “Robber Barons” because the large fortunes they amassed involved ruthless and sometimes uncompetitive business practices.  While some made their fortunes in finance, the overwhelming majority laid the foundation for America’s 20th century industrial dominance:

  • John Jacob Astor  (real estate, fur)
  • Andrew Carnegie (steel)
  • Jay Cooke (finance)
  • Charles Crocker (railroads)
  • Daniel Drew (finance)
  • James Buchanan Duke (tobacco)
  • James Fisk (finance)
  • Henry Morrison Flagler (railroads, oil, the Standard Oil company)
  • Henry Clay Frick (steel)
  • John Warne Gates (steel)
  • Jay Gould (railroads)
  • Edward Henry Harriman (railroads)
  • Milton S. Hershey (chocolate)
  • Mark Hopkins (railroads)
  • J.P.Morgan (banking, finance, steel, industrial consolidation)
  • Henry B. Plant (railroads)
  • John D. Rockefeller (Standard Oil)
  • John D. Spreckels (San Diego transportation, water, media)
  • Leland Stanford (railroads)
  • Cornelius Vanderbilt (railroads)

These individuals were also the backbone of American philanthropy.  For example, think of:  Carnegie (libraries); Rockefeller (University of Chicago, the Rockefeller Foundation) and Leland Stanford (Stanford University).  The Robber Barons not only focused on industrial wealth creation.  They were equally concrete and focused in charitable giving that provided tangible benefit to American institutions and society.

In contrast, the Gates Foundation focuses on world health concerns, a worthy but certainly more amorphous goal.  As an aside, the Gates-funded vaccination and AIDS treatment programs have received criticism for singular focus on certain diseases to the derogation of comprehensive health care and diversion of important medical resources.  Few of the Gates Foundation initiatives benefit Americans.

The Over Financialized Economy

The wealthy donors signing on to the pledge are one more reminder of the over financialized American economy.   See The Mirage of a Financialized Economy; The People v. Wall Street.  Today’s fortunes were earned at the expense of the industrial economy, rather than in pursuit of its success.   Two recent commentaries support the deleterious effect of an economy over-focused on the financial:

Boston-based asset manager Jeremy Grantham in Summer Essays criticizes his own profession:

“In 1965, 3% of GDP that was made up of financial services [and that] was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%.

This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.”

Professor Steve Keen, an Australian economist and author of Debtwatch believes that the percentage of GDP going to the financial sector should be even lower:

Because of that debt level, bank profits have gone through the roof as a share of GDP. Back before we had a financial crisis—when debt levels were far lower than today—so too were bank profits as a share of GDP. A sustainable level of bank profits appears to be about 1% of GDP.  See Bank Profits a sign of economic weakness, not health

Bring Back the Robber Barons

We need a political and economic re-set button.  The Obama and Bush Administrations have attempted to uncritically favor the financial sector through loan guarantees, TARPs and other artifices.  No one has asked the critical question of why we are favoring this sector that has absorbed a disproportional share of GDP at the expense of a productive reality-based economy that makes real things and employs real people.

No wonder unemployment has remained stubbornly high, and the economy is poised to enter a “double dip” recession.  Perhaps we need a new class of wealthy people focused on creating real wealth and jobs in America.   Maybe it is time for some twenty-first century Robber Barons.

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5
Aug 10

Zero Interest Rates Equals Zero Jobs

Following World War II, typical economic downturns and recoveries have been “V” shaped.  That is, a sharp downturn in Gross Domestic Product and rising unemployment followed a quick turnaround in both economic activity and employment numbers.   This time is different.  We are witnessing zero or negative job growth and an anemic recovery.

Today’s situation is a different animal: a balance sheet recession.  Both businesses and individuals took on too much debt. And that debt was unsupported by income.  We are now saving to pay down that debt (the most recent savings rate increased to 6.4%), or defaulting on obligations (in May home foreclosures rose 44% to a new record).

Paradoxically, second quarter earnings demonstrate that corporations are beating earnings estimates and reporting healthy profits.   Gluskin, Sheff reports that

…78% of the companies reporting have beaten estimates and earnings per share are up 42% year over year versus initial expectations of 27%.

Companies have focused on tight cost controls to achieve these results.  The most recent durable goods report provides a clue to how costs are being controlled.

Orders for non-military capital equipment excluding aircraft climbed 0.6 percent last month after jumping 4.6 percent in May, more than previously reported, figures from the Commerce Department showed in Washington. See Second Quarter Earnings: Companies Beat But Investors Shrug

Looking further, we see we are in a jobs depression. Karl Denninger slices through the obfuscatory government data and finds that from July 2009 to July 2010 unemployment is 17% worse. See Watch the Birdie (Jobless Claims). After trillions of dollars of stimulus and guarantees and a zero interest rate policy, all we have to show for the effort is zero, or negative, job growth.

My strong suspicion is that management is substituting capital for labor.

A Brief Anecdote

One of my friends is the cost cutting guru for his company.  Always on the lookout for new labor saving technology, he found a type of packaging machine that could replace five employees currently performing the function manually.  His view is that labor saving technologies are the only thing preventing the economy from crashing.  By laying off those five employees, the machine pays for itself in two years or less.

On the other hand, employees unionize, get sick, go on vacation, file worker’s compensation and discrimination claims, and go out on pregnancy and family medical leave.  As an employer, machines suffer none of these disabilities.  Substituting capital for labor is firmly rooted in all corporate cost cutting strategies.

Unintended Consequences

With Obama, Bernanke, Geithner and Summers setting economic policy, I always feel it is improvisation night.   This team seems to bounce from one economic policy to the next with little thought given to unintended consequences.

-          Zero Interest Rates – I have written about the pernicious effect of zero interest rates on savings, especially for senior citizens.  See e.g. Is the Administration Determined to Make the Elderly Poor? Nothing from Nothing.  However, the upside is that low interest rates encourage the creditworthy to borrow for capital investment.  For example, IBM was able to borrow at 1% for 3 years.  If you can purchase labor saving machines with low interest rate loans and tax depreciation savings, why not?

-          Expensive Social Programs – Ignoring high levels of unemployment and economic stagnation the Obama Administration pushed ahead to pass health care reform.  The law does not apply to businesses with less than 50 employees.  The perverse effect is obvious:

…potential tax penalties for employers with more than 50 workers could cause many smaller businesses to rethink any hiring or expansion plans.

“It could have a negative effect on hiring as businesses figure out just how much the new law and offering health benefits will actually cost them,” many … small business clients have kept their staffs below 50 workers to avoid the complicated compliance requirements of laws such as the Family and Medical Leave Act.

“The new tax penalties for businesses with more than 50 employees will certainly make many business owners think twice about expanding and hiring more people….”  See Small Businesses Ponder Impact of Health Care Reform

Add in the threatened expansion of unions through the Employee Free Choice Act and no wonder large and small businesses are reluctant to hire.

Machines Make Better Employees

At its core, the Democratic Administration has failed in its campaign promises to reduce unemployment and get the economy back on track.  Through its zero interest rate policy the Federal Reserve and the Administration have “manufactured” our current high unemployment rate.  Today’s jump in new unemployment claims, to a weekly rate of only emphasizes the point. See Weekly Initial Unemployment Claims Increase to 479,000

The net effect is that machines provide better value than employees.  The labor market has structurally changed and not for the better.  Zero interest rates coupled with zero forethought is harming the working population.

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15
Jul 10

Pension Insecurity

Substantial recent financial media focus has been lavished on subprime mortgages, credit derivative bets on a decline in the residential housing market, flash crashes in the stock market, bank insolvencies, major corporate bankruptcies, and sovereign debt defaults. They have paid less attention and provided less insight into the perilous state of pension funds.

Both public and private pension funds face an emerging crisis.  We need to examine some disturbing trends in both sectors.

New Jersey Pension Fund Crisis

In No Garden-Variety Pension Crisis, Andrew Briggs asks hard questions about the funding of New Jersey’s public pension plans.  If the state used private sector pension accounting, the underfunding would rise from an already horrendous $46b to a mindboggling $170b.  This deficit is more than five times the 2011 $29.4b state budget.

The real question is, when will the plan run out of money?  Assuming the plan can earn 8%, which may be an aggressive assumption in the current environment, the plan would run out of money in 2019.  However, NJ has increased its risk profile for the fund.  The state has moved 60% of its pension assets into riskier alternative investments, such as hedge funds and private equity.  Thus, there is a 25% chance the fund can run out of money as early as 2017.

The article concludes that NJ is not alone.  Connecticut, Indiana, Illinois and other states are due to run out of money before the end of the decade.  (See Bailout Nation Lives: Revisited, a Short Update).

Diageo

And while we are worried about risky funding strategies utilizing hedge funds and private equity, pension funding creativity reaches new heights with a plan by the Diageo Corporation. This beverage conglomerate intends to “fund” its plan with more than 2 million barrels of scotch whiskey.

Diageo said … it would transfer ownership of £430 million, or $645 million, worth of whiskey to a pension funding partnership. Diageo employees would not receive their pensions in whiskey rather than cash, but the move does give them a guarantee that they would not walk away empty-handed should the company default.

“A pension funding partnership will be formed, which will hold maturing whiskey spirit as assets,” ….

As part of the deal, Diageo agreed to pay the pension partnership £25 million a year as it sells the recently distilled whiskey once it matures after three years and replaces it with new stock. The agreement would expire after 15 years, at which point Diageo would buy back the whiskey, which comes from distilleries such [as] sic Oban on the west coast of Scotland. See Diageo Uses Scotch to Plug Gap in Pension Plan.

I personally love Diageo products.  Talisker, Lagavulin, Oban and others are some of the finest whiskies in the world.  See Tis’ the Season for Deflation and Update on Deflation. In my prior posts on Diageo, I pointed out that some of their premium products were in dramatic price decline.  Now it becomes clear that weak pricing power and pension underfunding for Diageo are connected.  If Diageo had pricing power, it would have sufficient profits to fund its pension plan with cash.  In a deflationary world, should their pension plan beneficiaries hope to count on the future price of scotch whiskey in order to receive their benefits?

GM, A Cautionary Tale

We have seen innovate funding techniques before.  In 1993, GM asked federal pension regulators to approve an innovative plan to meet a $24b pension deficit.

Under the plan announced today, GM would contribute shares of its class E common stock to the pension plan. The value of that stock is tied to the performance of a wholly owned subsidiary, Electronic Data Systems. Its closing price today on the New York Stock Exchange was $31; based on that price, the total value of the contribution would be $5.7 billion.  See G.M.Acts to Secure Pension Using Stock.

Regulators acceded to the GM request.  The rest is economic history:   GM recently went bankrupt, and the plans remain massively underfunded.

Poverty Follows Financial Innovation

In its time of pension deficit, Diageo is not the only creative funder. The UK is rife with new schemes:

The British supermarket chain J Sainsbury said earlier this year it would transfer property into a pension vehicle, while Whitbread agreed to hand over a share in its portfolio of restaurants and hotels. The investment firm Man Group moved some hedge fund assets into a trust as a security for its British pension plan in March.

“We’re seeing a huge growth in the use of non-cash funding,” Marc Hommel, leader of the pensions practice at PricewaterhouseCoopers in London, said. “There are big pension deficits and sponsors are cash-strapped. These mechanisms provide security for the pension plans in exchange for less cash.”  See Diageo Uses Scotch to Plug Gap in Pension Plan.

Mr. Hommel probably did not intend to be humorous, but one must ask whether these new methods of providing  “security” make the funds more or less secure.  I would submit that when one has to innovate and pull financial “rabbits out of the hat” both equity holders and pensioners of these companies face a lot more risk.  And so do we, the taxpayers and funders of our enormous public pension funds and guarantors of private pensions through the Pension Benefit Guaranty Corporation.

In this current age of funding gimmicks, maybe we should refer to pensions as a social insecurity system.

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8
Jul 10

The Tragedy of the Commons Part II: Modern Finance and BP

In Part I, we discussed the “tragedy of the commons” paradigm.   Financial excess in the housing market was a major factor leading us into the current financial crisis.  Finance is not the only area of concern.  Let’s turn our attention to BP.

BP, the Gulf of Mexico and the Eastern Seaboard

We are now approaching 80 days after the BP Deepwater Horizon oil rig spill.  Up to 100,000 barrels of oil are still spilling into the Gulf of Mexico.   The government now believes that by August 2010 there is an 80% chance that the spill will reach Miami coastal waters.  Once the oil slick starts moving up the Atlantic coast, some experts believe it will damage the fishing industries as far away as the Chesapeake Bay and even the Grand Banks off Newfoundland. See BP’s Crude Politics and the Looming Environmental Mega-Disaster

A dynamic tension exists among private profit, America’s need for oil, especially domestic oil, the government’s need for lease and tax revenue from the industry, and environmental concerns.  Despite campaigning against lax Bush Administration enforcement of oil drilling limits the Obama Administration ignored an environmental warning contained in a DC Court of Appeals decision.  Citing financial necessity, the Administration was able to overturn the ruling:

Less than four months after President Barack Obama took office, his new administration received a forceful warning about the dangers of offshore oil drilling.

The alarm was rung by a federal appeals court in Washington, D.C., which found that the government was unprepared for a major spill at sea, relying on an “irrational” environmental analysis of the risks of offshore drilling.

The April 2009 ruling stunned both the administration and the oil industry, and threatened to delay or cancel dozens of offshore projects in Alaska and the Gulf of Mexico.

Despite its pro-environment pledges, the Obama administration urged the court to revisit the decision. Politically, it needed to push ahead with conventional oil production while it expanded support for renewable energy. Obama Decried, Then Used Some Bush Drilling Policies.

The Risk of a Pro-Drilling Policy

A pro-drilling policy with minimal governmental supervision set the stage for the Deepwater Horizon tragedy.  Macondo History Before the Blowout provides a full analysis of the mistakes made at Deepwater Horizon.  First, Congressional investigators documented that BP took numerous short cuts: a cement log was not run, a lockdown sleeve was not used, they failed to circulate a sufficient quantity of mud, instead of a more sturdy liner they used a weaker production casing, and 6 rather than the recommended 21 centralizers were used.   While these shortcuts most likely contributed to the problem, the author focuses on human error.  The BP drilling engineer in charge ignored four major well events, referred to as “kicks” in the industry.  These are warning events.  One can surmise the engineer was trying to complete an over budget drilling project, quickly.  Drilling engineers are trained in mandatory safety courses to recognize “kicks” and take appropriate action.  Perhaps in a desire to expedite the project, he chose or was pressured to disregard obvious safety warnings.

Blowouts are a strong possibility when drilling. They are not rare events.  The author goes on to state “it is inexcusable that BP should have been so completely unprepared for the aftermath. BP should have had the containment built and tested ahead of time.”  By contrast, the Shell Corporation had a system on standby.

In pursuing its private interest in increasing shareholder value, BP despoiled a very large “commons.”  Avoiding an obvious extra expense, BP did not have a containment system on standby.  If the worst happens, BP will have fouled fishing grounds as far north as Newfoundland, and part of the Gulf region will become uninhabitable.  Of course, if BP goes bankrupt,taxpayers again will be asked to shoulder the clean up expense.

Private Interests, Public Policy and Protection of the Commons

The message and lesson of the Tragedy of the Commons is that there are dangerous activities requiring strict, intelligent and active regulation.  Neo liberal economists believe that regulation should not hinder the free market.  They assert that the free market will always self correct.  But in a technologically advanced and interconnected world, the stakes are far higher.  Unfettered capitalism can literally collapse the financial system as demonstrated by the recent financial crisis, or the eco system as demonstrated by the ongoing BP oil spill.

No one would question the right to limit private profit made through the sale of anthrax or nuclear materials.   We know that some activities are so inherently dangerous that the state should intervene and carefully control usage.   We are now learning that previously deemed “safe activities” can now have horrendous and unacceptable societal cost.

Nothing would please me more than for the financial industry to pursue whatever risky schemes they wish to engage in.  Just be prepared to bear your own losses.  Unfortunately, we learned that when it all explodes, we deem it a national crisis requiring domestic intervention to save the banks, insurance companies and industrial companies with finance arms (GE and GM).   In a parallel analogy, we have learned that an oil spill could paralyze an entire region of the country and perhaps the entire eastern seaboard.

We cannot afford too many more tragedies in our commons.  If we find ourselves privatizing profits and socializing losses, proactive and aggressive government regulation and intervention is going to be required.  At issue now is the viability of society itself, and that outweighs private gain anytime.

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25
Jun 10

Bridging the Gulf

Richard Bove is a purported expert on bank securities and is now vice president of equity research for Rochdale Securities, LLC.   He recently recommended purchase of a dozen gulf coast banks headquartered in Alabama and Louisiana, four of which have major exposure to Florida as well.   Mr. Bove’s thesis:  the Deepwater Horizon oil spill could benefit bank deposits just as a hurricane has done.   He reasons that federal funds plus the $20b BP established escrow fund will find their way into these gulf coast banks. See Bove: Oil Spill Could Boost Bank Deposits; Analyst Says Banks Could Benefits from Oil Spill

A savvy investor should consider the source of recommendations.   In 2007 and 2008, Mr. Bove was dismissing subprime mortgage problems and minimizing the financial crisis.  Months before the collapse of Bear Stearns and Lehman Brothers, Mr. Bove was still recommending these stocks, albeit, with reduced price targets. See e.g. Richard Bove’s Recent Note on Lehman Brothers

Perhaps there is a larger picture that Mr. Bove and other analysts are not noticing in the Deepwater Horizon crisis.

Implications of the Oil Spill

Destruction of marine life, the ocean, marshes, beaches and wetlands has been the focus of Deepwater Horizon news reports.  Only at the margin of such reporting do we read about the effect upon humans and the future habitability of the Gulf Coast.

-          Breaching the sea bed has not only resulted in oil spewing into the gulf, but also a host of toxic chemicals and gasses: methane, benzene, hydrogen sulfide, methylene chloride and others. See Health Risks from Oil Spill: “Some of the Most Toxic Chemicals We Know” , “Every Place can be Ground Zero”, CDC Advises “Everyone to Avoid Oil

-          These gasses are already present in the atmosphere in concentrations above federally recommended guidelines.  See May Levels of Toxic Gasses in the Gulf Back Up Claims by Lindsey Williams

-          Individuals as far away as Atlanta have complained of breathing, headaches, and nausea related to the spill and gas emissions. See Oil Blowout Fumes Sickening People in Atlanta

-          A major gulf storm could transform these chemicals into a “toxic rain” with harmful effects upon livestock, crops and humans. See Oil Hurricanes May Cause Toxic Rain and Food Security Issues

-          Florida uses desalinization plants along the gulf coast to provide freshwater .The state has warned of a water shortage if the spill reaches Tampa Bay and other plant locations. See Three Oil Leaks in Gulf Possible, FL Power and Water Supplies May be at Risk

-          Similarly, Florida officials have warned about power shortages as nuclear and conventional power plants both rely upon gulf waters for cooling. Oil from the spill could clog the intakes.

-          The Gulf Coast relies upon fishing, tourism and retiree populations.   Real estate brokers report the market is dead. See e.g. Gulf Real Estate  Prices Continues Slide as BP Oil Spill Continues

What If?

Sometimes we need to go a little further than Mr. Bove’s partisan and simplistic analysis and ask the worst case question: What if?  What if the Gulf Coast becomes uninhabitable?  Those recommended regional banks have commercial loans to businesses in the region.  It does not take genius to extrapolate the downward effect on real estate if people en masse move out of the area.   If Californians are walking away from houses with declining value, will Gulf Coast residents continue to pay their mortgages when they may need to evacuate their home and move north to avoid toxic gasses?  Who will be manning the businesses and farms in the region?   Will these fleeing residents continue to pay their credit card bills?

Past is Not Always Prologue

Like many Wall Street analysts, Mr. Bove recalls the past and extrapolates from it to predict the future.   Perhaps the Bove’s of the world need to be less historian than futurist.  That is, they need to ponder the uncomfortable possibility that this time things may just be dramatically different.  Perhaps the analysts need a little more non-televised rumination and non-linear thinking before their self promotional visits to CNBC.  If Mr. Bove could not conceive of Lehman or Bear Stearns failing, why should we trust that he can predict the profitability of Gulf Coast banks?   Maybe it is time for him (and us) to bridge the knowledge gulf.

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14
Jun 10

Caution! Spin May Be Harmful to Your Portfolio

CNBC, Fox Business and Bloomberg feed us a steady stream of bullish analysis.  Barron’s, The New York Times and the Wall Street Journal push more of the same, and amplify the bullish message: buy stocks now, they are undervalued.  However, these analysts have been consistently wrong.  A new McKinsey study analyzes this phenomenon:

“Analysts have been persistently over-optimistic for 25 years,” a stretch that saw them peg earnings growth at 10 percent to 12 percent a year when the actual number was ultimately 6 percent. “On average,” the researchers note, “analysts’ forecasts have been almost 100 percent too high,” even after regulations were enacted to weed out conflicts and improve the rigor of their calculations. …[A]nalysts have been forced to lower their estimates after it became apparent they had set them too high. See For Analysts Things are Always Looking Up.

Why the persistent bullishness?  Human beings are optimistic and want to believe in good outcomes.  And why not?  When the markets rise, Wall Street investors make more money. Bullishness comports with the Administration’s political agenda to make Americans feel better.   When Americans are bullish about the economy and spend more money, they set the stage to create a virtuous self-reinforcing economic recovery.

Unfortunately, this economic recovery is different from previous post-war recoveries and does not respond in the same ways.

What are Stocks Worth?

David Goldman in Inner Workings writes some of the most incisive commentary on the markets.  He believes that stocks may trade in a range of Dow 8,000 to 12,000 and at the moment, at Dow 10,000 probably reflects an accurate value for the market.  However, he is worried about a “double dip”  recession, which is a renewed downturn in the second half of this year and cites five areas of concern:

  1. Fiscal austerity and bank failures in Europe could transmit economic weakness to our banks and economy.
  2. US consumers will continue to be under pressure from poor employment prospects and a declining housing market.  Focusing on a housing recovery, Goldman pours cold water on that thought:

The notion of a housing recovery seems fanciful when America has only 25 million households with two parents and two or more children, but 72 million housing units with three or more bedrooms. The baby boomers bought far more house than they required and hope to sell it at a profit; now they will retire to smaller quarters and the overhang of large-lot single family homes may take decades to work off.  See What are Stocks Worth?

3. Fiscal austerity is already taking place at the state and municipal level.

4. Pressures are increasing to reign in federal deficits.Asia will not turn out to be the growth engine leading the US and the world out of recession.

5. Analysts are underestimating the negative wealth effect from losses in the housing and equity markets.

The Great Correction

Bill Bonner, founder of the Daily Reckoning, calls our current economic environment the Great Correction. See Heavenly Recovery or Hellish Correction? We are paying the price of becoming overly indebted.  The “recovery” spotted by so many pundits differs from all post-war corrections:

  1. We would have seen a recovery in jobs.  Since the beginning of the correction 8.2m jobs have been lost and none recovered.
  2. Inflation would have increased.
  3. Money supply would have increased and people would have been borrowing, spending and investing.
  4. Housing would be on the upswing with prices recovering.

We have spent trillions of dollars to try and stop a correction and we are failing.

Think More, React Less

Bonner and Goldman are two of the most incisive and prescient economic and financial analysts and are cautioning investors.  While I do not give investment advice on this blog, perhaps this is one of those times where we need to turn off financial television, put down the newspaper and ignore the financial markets.  The spin can make us both dizzy and poorer.

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10
Jun 10

Bailout Nation Lives

Where is the coordination of economic policy among the Federal Reserve, the Treasury and Congress?  In testimony before Congress, Ben Bernanke, Chairman of the Federal Reserve warned against large budget deficits:

The Fed chief repeated his call for lawmakers to come up with a long-term plan to reduce the federal budget deficit, which is projected to widen to a record $1.55 trillion this fiscal year. “Unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth,” he said.  See Bernanke Says Fed Prepared to Counter Effects of Europe Crisis

It is clear that bailouts are not consistent with fiscal responsibility.  But it seems the Administration and Congress are tone deaf to these no more bailout pleas.

No Constituency Left Behind

We have analyzed the bailout actions of the Bush and Obama administrations. See Are We a Socialist Country? It has been a long and undistinguished progression from Bear Stearns, AIG, American Express, GM, Chrysler, GE and others.  We have collectively decided that banks, insurance, automotive, industrial, credit card and other companies are too systemically important to fail, and are therefore bailout worthy.

Despite all protestation the Obama Administration appears to be on a constant search for new bailout candidates:

-          A $23B Bailout for Teachers – Education Secretary Arne Duncan urged Congress to support a $23b jobs bill to prevent teacher layoffs.

-          Why Leave Out Pension Funds? – Senator Casey, D-PA proposes affording two large multi-employer Teamster pension plans federal protection.  The estimated cost would be $8-10b.

-          US Largesse Goes Global – Through IMF membership, the US taxpayer will be funding the bailout of Greece and other European nations. IMF Chairman Boutros-Ghali pointed out the perilous financial position of the IMF and the need for more member capital contributions.  Rep. McMorris Rodgers, R-CA highlights the hidden cost to us:

“This should give pause to Treasury Secretary Geithner and others who boasted that the IMF’s bailout bonanza wouldn’t cost U.S. taxpayers a dime,” said Rep. McMorris Rodgers.  “In truth, the cost to U.S. taxpayers goes up every few weeks.  After the Greek bailout, it stood at about $7 billion; after the EU bailout, it stood at about $60 billion.  Now – based on Mr. Boutros-Ghali’s comments – we’re talking at possibly $100 billion or more.  This has got to stop.” See Congresswoman McMorris Rodgers Responds to IMF Statement Europe Bailout will Cost  US Taxpayers 100 billion+

-          As we have pointed out, Fannie Mae and Freddie Mac are uncapped, growing, perpetual bailouts. See Shredding the Social Fabric.

The Hidden Costs of Bailouts

Politicians are constantly on the prowl for a free lunch.  Bailouts and promises of “little cost to the taxpayer” provide that seemingly free repast.  A closer look at the bailout phenomenon shows us its high and hidden price tag.  A look at some unintended consequences:

  • Bailouts only add to the burgeoning federal deficit.
  • Ultimately, they will be paid for either through higher taxes, higher inflation or both.
  • We are eroding financial discipline.  GM was roundly criticized for giving away a new Corvette to a Detroit Tiger, who pitched a near perfect game.
  • Likewise, we are eroding fiscal discipline in states and municipalities, which should be cutting budgets and raising taxes rather than seeking bailouts.
  • We are compromising our most basic federal system of separation of powers, as a state and local function, education, becomes a federal ward.
  • We are encouraging moral hazard with reckless and profligate behavior (and prudent behavior is punished).
  • Bailouts beget other bailouts, as it become impossible to draw the line when future constituencies come to Washington for their bailout.
  • Today’s funding of bailouts limits the flexibility of the Administration to respond to future, more serious crises.

Fundamentally, bailouts are unfair, as one group is leveraging its political clout to earn a bailout at the expense of innocent taxpayers.  Rewarding the profligate and the irresponsible makes little sense as public policy.  It is time to end the bailouts.

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