Sunday, September 28, 2008

No Skin in the Game

Congress and the Bush administration have agreed to terms on a $700 billion bailout package for Wall Street. Under the plan, the Treasury will purchase mortgage-backed securities that no one else wants to buy from banks. This infusion of cash will recapitalize the banks and hopefully stimulate inter-bank trading to resume at something close to normal levels.

For the taxpayer’s $700 billion, we get several things. First, the government gets the securities, which will hopefully be worth something. The idea is that the Treasury can get a better deal by waiting for the right buyer to come along. Right now, panic selling has these securities worth pennies on the dollar. By driving panic out of the market, the prices of these mortgage-backed assets will recover some of even most of their value. If they don’t recover in value, the taxpayer will eat the loss.

In addition to the bonds themselves, the government will get warrants that give the Treasury an equity stake in the companies that participate in the plan. So if the stocks of the banks go up, post rescue, the government (i.e., the taxpayers) will recover some value. Finally, there are some limits on senior executive compensation that go along with accepting the government’s largesse.

We have been assured that this bailout was necessary to prevent total collapse in the banking system. The end was near! If that had happened, consumers would have been unable to get mortgages or car loans, and businesses would have been cut off from lines of credit necessary to continue operations. If you accept that, congress and the administration had no choice but to act. The problem is, I’m not buying it.

I understand that the rates banks charge each other for short term loans have spiked in he last two weeks, and that trading in the credit markets has been at much lower volumes that usual. But nobody has connected the dots to show why the credit markets wouldn’t calm themselves without the largest government intervention in history. Nor has anyone made the case for why credit worthy borrowers would not have been able to get loans, even if the interest rate was higher than it would otherwise be.

Nobody in the banking industry has come forward to say: “I’ll take the hit. Passing this legislation is so important that I will forego salary and bonus for 2008.” Kenneth Lewis, the CEO of Bank of America, which just acquired Merrill Lynch, wrote an editorial in Friday’s Wall Street Journal urging passage of a bailout plan. But since Bank of America is in such good shape that they don’t need the help, I guess ol’ Ken doesn’t feel the need to sacrifice any of his hard earned compensation to convince Main Street voters that the crisis is as dire as portrayed.

When Lee Iacocca was brought in to turn around Chrysler in the early eighties, he asked congress for loan guarantees to help him raise money for the turnaround plan. In order to build credibility for the effort, he agreed to forego salary and bonus until the company returned to profitability. I sure would like to see some of the Wall Streeters volunteering to do something similar.

If the situation is as serious as it is reputed to be, that is the least that they could do. Of course, maybe the end wasn’t so near. Maybe the taxpayers just got played.

Wednesday, September 24, 2008

Would you buy a used car from these men?

I watched a little of the C-SPAN coverage of the Paulson/Bearnke show last night. This was the Senate hearing where the Treasury Secretary and the Federal Reserve Chairman were pitching their plan to use $700 billion to buy up mortgage bonds and rescue the financial markets. As I understand it, their contention is that unless the government buys up all of these assets, the banks will not trade with each other, leading to other businesses and consumers being unable to get credit to run or expand their operations.

The august personages that sit on the Senate Banking Committee were, not surprisingly, reluctant to hand over an amount greater than the entire defense budget to two bald guys sitting at a folding table saying “yup, we really do need that much money.”

Based on the short section of the hearing that I watched, I felt like this was the gist of things:
Q: What assets will are you buying?
A: We don’t know yet. No point in thinking about that until you know you’ve got the money in hand.

Q; How will you price the assets you are buying?
A: We think we’ll use a reverse auction, but we’re not sure yet. The method of making purchases will vary based on the type of asset we are buying. Can we have the money now?

Q: How will you know if the prices you pay are fair prices?
A: Well, at this point we don’t know. We plan to hire some really smart guys to figure that out, just as soon as you give us statutory authority to spend enough money to buy Switzerland.

Q: What will you do if the taxpayers buy all of the crummy assets from Wall Street, and those guys turn around and award themselves multi-million dollar bonuses as a result?
A: We agree that would make the taxpayers feel cheated. But what is important here is that if you don’t hand over the money, the Wall Street boys will throw a tantrum and push us into a recession.

Q: Secretary Paulson, what kind of government oversight is included in your plan?
A: I never needed government oversight when I was running Goldman Sachs and awarding myself multi-million dollar bonuses, but there is this tweedy looking nerdy guy next to me. Would he count? On second thought, I welcome additional government oversight, just as long as they don’t get in the way while I’m writing checks.

Can you spell “half baked?” I wouldn’t give these guys any (more) money either.

Monday, September 22, 2008

It's the Leverage, Stupid!

It has been an amazing couple of weeks in the financial markets. Fannie Mae and Freddie Mac: nationalized. Lehman Brothers: bankrupt. Merrill Lynch: acquired by Bank of America. Insurance company AIG: 80% owned by the Federal government. Last week’s news is that commercial bank Washington Mutual and investment bank Morgan Stanley are both searching for buyers to acquire them before they go the way of Lehman Brothers. This week’s news is that the Federal government is engineering a $700 billion plan to acquire troubled mortgage assets from Wall Street companies.

And all of this is on top of the collapse of Bear Stearns and IndyMac Bank earlier this year, not to mention the massive multibillion write offs that have hammered almost every large financial institution in the country.

The root of this turmoil is the collapse of the housing bubble. Houses that used to sell for $500,000 are now selling for $350,000. Houses that were selling for 250,000 are now selling for $175,000. More declines in housing prices are forecast for next year. People who purchased houses with 100% loan to value mortgages, or who pulled all of the equity out of their house with home equity lines of credit (HELOC, in banking jargon), are being foreclosed upon in record numbers, leaving their bank with collateral that is now worth less than the balance owed on the loans.

But there have always been foreclosures, big bankruptcies have occurred before. What makes the impact of current conditions so severe? In a word: leverage.

One of the reasons the stock market crash of 1929 led directly to the Great Depression was leverage on the part of individual investors. During the stock market boom of the twenties, investors could buy 5 shares of stock while putting in the cash for only one share. The rest of the money was borrowed. The practice of buying stock with borrowed money is called buying on margin.

When the market crashed in 1929, stock values dropped low enough that the cash the investors had put in was wiped out. The brokerage that had loaned them the money then turned around and required the investors to come up with more cash. This is known as a margin call. In 1929, the margin calls set up a feedback loop. To raise cash, investors sold more stock. The increased selling lowered prices further, which led to more margin calls. More margin calls, more selling, lower prices, more margin calls. Rinse, repeat.

The problem was set off because investors had borrowed too much money compared to the equity they put into their portfolios. They did it because the more shares they controlled with borrowed money, the bigger the return on the equity they had put in. At least, that was true as long as stock prices were going up.

Borrowing money, or leverage, amps up returns when assets prices are rising, but it has the reverse effect when asset prices are falling. Falling like they are these days.

Leverage is everywhere in today’s economy. Let’s say you buy a new car that costs $25,000. You trade in your old car for $5000, and finance the rest. In this instance, you have leveraged your equity (the value of your trade-in) by a factor of four. If you buy a house with a standard 20% down payment, you are leveraged four to one.

Industrial companies use leverage as well. They finance their operations through a combination of stockholders equity (capital) and debt instruments like corporate bonds. Usually the ratio is less than one to one. That is, they have more capital than debt. The thing about debt is that you always have to make the interest payments. With equity, you can always cancel your dividend when you hit a rough patch.

In the last few years, Wall Street firms have piled on an astonishing amount of leverage. The investment bank Goldman Sachs has leverage of 22 to 1 currently. Before it collapsed, Lehman Brothers had leverage ratios of over 30 to 1. That means it only took a 3% loss to wipe out the equity in the firm.

But despite the media coverage, we can’t blame all of the current financial crisis on greedy Wall Street financiers. There is plenty of mud to throw at Main Street folks as well.

Consider a homeowner who buys a $200,000 house and takes out a $160,000 mortgage. That guy is leveraged 4 to 1, right? Now watch the homeowner take out a $30,000 HELOC a year later. Now the homeowner is leveraged 19 to 1. That’s getting up into Wall Street territory. During the bubble inflation years, it was possible for subprime borrowers to take out 100% loan to value mortgages. The banks went to people who had a history of not paying off their debts, and let them take on leverage ratios of over 100 to 1. That’s like giving a six year old a can of gasoline and a book of matches, and then telling the kid to go out and play.

Now our financial system is burning down around us.

Debt is a good servant, but a bad master.

Wednesday, September 17, 2008

The Fundamentals of the Economy

John McCain gave a speech yesterday where he said "The fundamentals of the economy are strong." He was immediately excoriated for that remark.

"How out of touch is that guy? Wall Street is collapsing! People are losing their homes to foreclosure! Gas prices are up! I found a double yolked egg when I went to make breakfast this morning! Damn Bush and those neocons!"

You know what? All of those things may be true (except for the double yolk egg part. I usually eat cereal for breakfast). But I happen to agree: the fundamentals of the economy are strong.

This is not to say that things are booming, because they're not. I work for a company that makes subassemblies for the major appliance market. We've taken a big hit this year, both in sales that are off because of the slowdown in the housing market, and in our costs, because commodity and energy prices are up so much this year. I've had to conduct several rounds of layoffs to get our company's workforce down to the right size for our current volume of business.

But we're still selling product, still meeting payroll, still investing for the future in both people and equipment. Just as you can have slow sales, but a fundamentally sound business, so too can you have a recession, even a severe recession, and still have a fundamentally sound economy.

I don't want to make light of the real suffering going on out there right now. People are losing their jobs and their houses, and that has just got to suck. High gas and food prices are taking a bite out of my income just like everyone else's. But I went out jogging the other day, and I noticed a funny thing: there was no blood in the streets. I would have noticed too, becuase it hadn't rained for several days.

Layoffs are up, but 94% of us still have a job. Foreclosures are up, but over 97% of homeowners are still making their mortgage payments. The stock market is down, but it is not shut down. You can still buy and sell stocks. At a personal level, it easier to get a table at the local Outback Steakhouse, but only after 8:00 at night. The dollar doesn't go too far if you're in France for vacation, but it still spends just fine in Wal Mart or Target.

At least, I think it still spends fine in Wal Mart or Target. I haven't bought anything at either store in months. Gas prices are up, so I compensated by cutting back on the amount of Chinese made crap I buy.

My point, however, is that the economy is still functioning. People are adapting and adjusting to tough times, and when this deleveraging process we're going through runs it's course, we are going to get back to growing and creating businesses. We're going to do this without a lot of help from the government, by the way.

The people who work for my company are coping with the current economic environment in a variety of ways. Some are carpooling to work to save gas. Some are finding second jobs to replace the overtime they've lost. Some are cutting back vacation plans. One thing they are not doing is cutting back on helping each other. When a coworker or family member hits a rough spot, they chip in to help to the same extent as in better times. At a fundamental level, they are muddling through this rough patch. So, yeah, I think John McCain is right when he says that the fundamentals of our economy are strong.

Tough times never last, but tough people do. At the core, Americans are tough people.

Sunday, September 14, 2008

Little Houses on the Prairie

Have you heard about the Tiny House movement? This is a very loose grouping of individuals, foundations and companies that are championing the concept of living in very small houses. As in a house of about 100 square feet, on the extreme end. I had a friend with a bigger tree house than that when I was a kid.

The New York Times had a front page article on the subject this week. You can read about it http://www.nytimes.com/2008/09/11/garden/11tiny.html

The people who espouse the cause of tiny houses seem to fit into two categories. Some of them talk about the desire to simplify their lives, break free from materialistic consumer culture, ala Thoreau when he moved to Walden Pond. Others appear to be motivated by Green movement considerations. They talk about reducing their footprint, carbon and otherwise.

The companies that identify themselves as Tiny House companies both build these houses and sell plans. Most of these tiny houses are built on a trailer chassis, so the builder can make the house and then have it towed to the home site. Since the companies profiled in the Times article sold only a few hundred sets of plans combined last year, I think KB Homes and Toll Brothers are safe for the time being.

Now, I have to admit that the thought of reducing my maintenance and utility expenses can be mighty attractive at times. My wife and I live in a 3000 sq. ft. house. I think it’s ridiculous to have only two people in a house that size. She thinks that if she had more closet space, she could go out and buy more clothes, and if she had a larger attic, she could store more of her collection of Santas to bring out at Christmas (150 at last count). We continue to live in a 3000 square foot house, so I don't think aI need to tell you who wins the argument.

There does seem to be a holier than thou element to this whole business. “Look at me, I only need 500 square feet.” “That’s nuthin’. I’m down to 250 square feet. That’ll really save the planet.” If you really want to save money and simplify your life, you don’t need a specially built house.

A small living space built on a trailer chassis? Here in Red State country, we call that a single-wide mobile home.

Thursday, September 4, 2008

Sarah Palin, Take Two

One of the things that annoyed me about the press coverage on Governor Sarah Palin over the Labor Day weekend was the question posed by several news outlets, including the New York Times and Newsweek. Along with the stories about her daughter’s pregnancy and her husband’s twenty year old DUI, this question kept popping up: Was Sarah Palin properly vetted? This is kind of like asking someone if he’s stopped beating his wife yet.

The subtext of this question seems clear to me. When someone asks “Was she properly vetted,” what they really mean is “How could you have picked her without getting our seal of approval first?”

The arrogance this reveals on the part of the national media, those based in New York and Washington, is appalling.

Sarah Palin is a state governor, which is a pretty small club. She was elected after her second statewide political race, having unsuccessfully run for lieutenant governor in 2002.

She has been governor of Alaska for the last twenty months. During that time, she has been continuously vetted by her constituents, the citizens of Alaska. And they must like what they see, because Sarah Palin has an 80% approval rating.

This is the highest approval rating for any governor. It may be hard to believe, but you can have good sense, even if you don't live in Washington or New York.

Tuesday, September 2, 2008

Sarah Palin, Take One

As the whole world knows by now, last week John McCain announced that he had selected Alaskan governor Sarah Palin as his Vice presidential pick. Like everyone else outside of Alaska, my first thought was: Who?

After several days of 24 hour news coverage, a number of negatives, and potential negatives have come to light regarding Governor Palin. Some of the fodder for attacks against her was apparent immediately. Before being elected governor of Alaska in 2006, her total experience as an elected official was as city councilwoman and mayor of Wassila, Alaska, a small town of about 10,000.

Some of the other issues surrounding Palin are that her 17 year old daughter is pregnant, as mayor of Wassila she hired a lobbyist to get earmarked money (a practice she now opposes), and she has been accused of firing a member of her cabinet because he would not fire her ex-brother-in-law as a state trooper. Oh, yes, her husband had a DUI twenty years ago.

The fact that Sarah Palin was a relative unknown, new to the national media spotlight, combined with these revelations about her past, have made many in the media speculate that she was insufficiently vetted for the VP slot.

In spite of these concerns, I think that John McCain made a brilliant political move with this pick.

Both campaigns selected VP candidates to combat perceived weaknesses of the presidential candidate. Barack Obama picked Joe Biden to shore up the tickets foreign policy credentials. John McCain picked Sarah Palin. What does she bring to the party?
-As a pro-life, NRA lifetime member, she energizes the Republican base of social conservatives, who have never been excited about McCain.
-At 44 years old, she counterbalances the 72 year old McCain, bringing a sense of youth to the ticket.
-As a governor, she has more executive experience than the rest of both tickets combined. She is also a politician who is a complete Washington outsider. You could not get farther from Washington and stay in the continental US. This co-opts Obama’s theme of change, and reinforces McCain’s reputation as a maverick, independent of the current administration.
-Did I mention that she’s a woman? Both tickets now offer a chance to make a historic choice.

Sarah Palin also brings a stealth weapon to the campaign: her husband, Todd Palin. A large part of why Hillary Clinton was able to stay in the primary race for so long was because Barack Obama could not “close the deal” with a key demographic in big industrial states: white, blue collar men. Todd Palin is the epitome of that demographic. He works as a production operator in the oil industry, when he’s not working as a commercial salmon fisherman. In his off time, he wins long distance endurance snowmobile races. The “First Dude” of Alaska is clearly a man’s man.

Reformer, fiscal and social conservative, telegenic hockey mom with five kids. Sarah Palin is the red state answer to Carla Bruni Sarkozy.