Thursday, January 29, 2009

Viscous circles, Virtuous Cycles, and the Stimulus

The US House passed a $813 billion dollar stimulus package spending bill yesterday. The vote went along party lines, with the Republicans, in a remarkable show of party unity, voting 100% opposed. It will now proceed on to the Senate.

There has been a steady drumbeat of bad economic news in the last few weeks, with a number of major companies, from Alcoa to Starbucks, announcing major job cuts. Both consumer and business confidence are at low ebbs. So I think a stimulus package is probably a good thing at this point. But I think there hasn’t been much discussion about the purpose behind the stimulus. Put another way, what is the stimulus intended to accomplish?

Most of the rhetoric has been about job creation. The debate has been couched in terms of what puts people back to work faster, spending or tax cuts. My perspective is that the emphasis on job creation is misplaced. As a conservative, I would argue that the purpose of government is not to guarantee everybody a job (an impossible task in any case). The major purpose of government is to safeguard our liberties, with a minor in promote the general welfare.

The purpose of the stimulus should be to create an inflection point in the general trend line of the economy. To do that, we need to break up the current negative feedback loop driving decision making.

I can see my mother now, saying “What the Hell does that mean?”

First, let’s talk about inflection points. Anytime you look at a graph, the line is trending downward over time, or it is trending upwards over time. If you have a graph that shows both, the spot where the trend changes from down to up or up to down is the inflection point. The economy is trending down right now, and from the news, it is trending down pretty steeply. What the stimulus should do is reverse that trend, to get the economy growing again. That will be difficult because the downward trend is being fed by a negative feedback loop.

Here is the mechanism at work: demand is soft, so companies layoff workers. Once they are laid off, those workers cut back on their spending. Since they are not spending, demand for products and services drops further. With lower demand, more companies announce layoffs, leading to another round of reduced spending, lower demand, and more layoffs. The cycle feeds on itself. Another term for a negative feedback loop is a viscous circle.

Adding to the problem are the effects of fear. People who haven’t lost their jobs yet say “I could be next,” and cut back on their spending as well to conserve cash. This is perfectly natural (by which I mean I’m doing it too), but it steepens the decline.

In a growing economy, as demand increases, businesses hire more employees. Those new employees start spending more, increasing demand, leading to more hiring, driving spending higher, and so on. This is a positive feedback loop, also known a virtuous cycle. Once businesses increase in confidence, they start investing in capital. Capital investment both drives the cycle higher and leads to productivity improvement, bringing higher standards of living as well as more jobs.

The emphasis on turning the economy around versus merely creating jobs is critical. A goal of job creation will lead to an expansion of government payrolls. The easiest way to make sure everyone has a job is to keep hiring. But once you add government positions, it is hard to remove them. You end up with higher government costs for the long term.

An emphasis on a short term surge to kick start the private sector leaves the long term heavy lifting to the private sector. And it is the private sector which will develop the productivity improvements that will raise living standards in the long run.

Tuesday, January 27, 2009

Ski Trip '09

I just got back from my annual ski trip this weekend. Although I live in Tennessee, I still go out with the Ski Club of Sarasota. This marked my nineteenth year of going skiing with the club. This year I went on one of the trips organized by the Florida Ski Council. The Council puts together several trips a year where all of the member clubs send a contingent. This allows the Council to pool the buying power of the various clubs, and negotiate a better deal from the ski area.

This year’s trip was to Snowmass, a resort located near Aspen.

Now, the thing about skiing is that after you schuss down the hill, you have to spend about seven to ten minutes riding the ski lift back up the hill. Since you get on the lift in the order in which you reach the bottom of the run, the people who ride up with you are a pretty random assortment of the people who are skiing that day.

It is very quiet on the lift, so I kill time by yakking with my fellow passengers. It was an interesting cross section of Americans, with more than a few Australians thrown in. A couple of quick impressions were formed:

A ski vacation to a destination resort like Snowmass is an expensive undertaking. With everything in, from airport parking and baggage charges down to the $23 cheeseburger lunch on the mountain, I dropped about $2000 per person for the trip. In tough economic times, you would expect a big ticket discretionary expense like a ski vacation to be dropped by a lot of people. Anecdotally, this appeared to be the case, as a number of my fellow travelers noted the complete lack of lift lines. This was confirmed by one property manager I rode up with, as he told me bookings in the properties he managed were off by over 30%.

Counterintuitively, this same property manager told me that some of the owners he represented were turning down low-ball offers to rent houses. These owners would turn down valid offers at below the listed rental rate, preferring to take themselves out of the market before they cut their price. I can only conclude that represents either A) a failed negotiation: the owners who turned down the offer will wish they had accepted it when no other offers come along; or B) the owners do not care if their property is drawing an income or not.

Since houses in the Aspen area sell for millions of dollars, proposition B supposes that there is a significant population of owners who can afford to park millions of dollars of equity into property that they only use a few weeks out of the year.

I’m in the wrong line of work!

Thursday, January 15, 2009

"Who is this guy FICA..."

Timothy Geithner, the president of the Federal Reserve Bank of New York, is Barack Obama’s nominee to become the next Treasury Secretary, i.e., the guy who hands out all the fat checks of bailout money. During his confirmation hearings, it has come to light that he filed his taxes improperly for three years running, and had to pay a bunch of back taxes. With interest.

Here’s what happened: In 2001, 2002, and 2003, Geithner was employed by the International Monetary Fund. Because the IMF is an international organization, they do not collect Social Security and Medicare taxes from their US employees (I remember the Friends episode where Rachel got her first paycheck ever: “Who is this guy FICA, and why does he get so much of my money”).

Now, the US employees of international organizations such as the IMF are not exempted from Social Security and Medicare taxes. Instead, even though the employees get a W-2, they also have to pay self employment taxes. That tax rate is about 15%, because the employee pays both halves: the half that is normally withheld from a paycheck, and the half that the employer normally pays without reporting it on the pay stub.

I remember the first time my wife took a foray into owning her own business, and encountered this self employment tax. Wife (in tears): “I worked so hard for that money. Now I have to pay 15%, plus more for income taxes? I don’t think it’s fair for the government to get so much of my money.” Husband: “Welcome to the Republican Party, my love.” But I digress.

Apparently, Mr. Geithner failed to report this self employment tax for those three years (plus a small portion of 2004, but who’s counting?). He did his taxes himself for 2001, and then used an accountant for 2002 and 2003 tax years. This oddity of being an employee, but still having to pay self employment taxes, only hits a few people. So it is perhaps understandable that both he and his accountant missed it. When the IRS caught up with him, he ‘fessed up and paid a settlement. No harm, no foul, right? Anybody can make a mistake, right?

Except that there are a couple of things that stand out in this situation.

First of all, the Treasury Secretary oversees the Internal Revenue Service. Shouldn’t the guy overseeing tax collection be able to, oh, I don’t know, do his own taxes without screwing it up?

Secondly, it turns out that the people who run the payroll at the IMF do know about this self employment tax loophole. For the US employees who have to pay the self employment tax, they add money to your salary to cover the 7.5% that the employer normally pays. The practice is called “grossing up,” as in they increase your gross pay by 7.5%.

Where it gets really interesting is that the gross up pay is paid out quarterly. So this raises the question: what did Geithner think those extra payments were for? Good behavior?

Think back sixteen years. When Bill Clinton was elected, his first pick for Attorney General was Zoe Baird. Ms. Baird, a high powered corporate attorney of considerable experience, was torpedoed when it came to light during the confirmation process that she had used an undocumented immigrant as household staff for several years, and that she had failed to pay the proper taxes for her employee. It was felt that the most senior law enforcement official in the US shouldn’t be someone who had broken the law.

Sixteen years later, a completely different political climate reigns. Mr. Geithner is almost certainly going to sail on to confirmation in the Senate. Still, it makes me wonder. How many other US employees of the IMF have gotten their taxes wrong this way?

Monday, January 12, 2009

Bernie Madoff's Victims

I’ve been reading a lot about Bernie Madoff in the news recently. Bernie is the Wall Street financier who has owned a securities trading firm for four decades. He was one of the pioneers of electronic trading, and was actually president of the NASDAQ organization for a couple of years. As a market maker, he was one of the most respected members of the Wall Street finance community.

He also ran a money management firm, noted for taking cash from wealthy individuals and other money management firms and producing consistent, steady returns of 1% to 2% a month.

Except that it now appears that Bernie wasn’t actually investing the money he was given. He was making up the posted gains, and using the money new investors gave him to pay cash distributions to older investors. A Ponzi scheme. The biggest, longest lasting Ponzi scheme in history.

So now I am reading stories from people who lost everything from a couple of hundred thousand dollars to a couple of million dollars up to institutions that have lost billions of dollars. Estimates of total losses have run as high as $50 billion dollars.

But here’s what I want to know: Can you truly lose money that you never had? For example, I read one account of an investor who put $25,000 into a fund that invested with Madoff in 1992. Even though the investor pulled out cash distributions every year, his investment had grown to $150,000. In his account, the investor said he had lost all $150,000.

The thing is, the investor never had $150,000. He only thought he had that much because Madoff told him he had that much. The most he ever had at risk was the original $25,000, and he had probably gotten most of that back in distributions over the years. So what is the true loss?

A Ponzi scheme is essentially a zero sum game. A zero sum game is one where the winnings of some of the players are offset by the losses of the other players. The individual running the scheme, in this case, Bernie Madoff, takes a cut off the top. Madoff’s skim, however, appears to be miniscule compared with the sums invested. I mean, the guy lived well, but not that well.

When all the forensic accounting is completed, the losses of later investors are going to be balanced with the gains of the earlier investors. And once that accounting is done, the losers are going to hire lawyers and try and get their money back from the winners.

Thousands of plaintiffs and defendants, all using lawyers to fight over money. Now that’s not a zero sum game. That’s a negative sum game.

Except for the lawyers.

Thursday, January 8, 2009

Happy New Year, Part II

In my last post I discussed the theme of deleveraging for 2009. By deleveraging, I mean reducing the ratio of debt to equity on both household and corporate balance sheets.

There are a number of ways an individual household can reduce leverage. Probably the most painful is to have your house foreclosed on. Since a home mortgage is typically the largest source of debt for a family, losing your home means losing most of your debt all at once. Not recommended, but if your mortgage payment is greater than market rent, moving into a rental will free up your cash flow.

A bankruptcy is less effective at reducing leverage than foreclosure. Most states protect your home equity during a bankruptcy filing. You can drop most of your credit card payments, but you still have the debt associated with your mortgage. Foreclosure and bankruptcy have got to be the two most painful ways of deleveraging.

The least painful way to reduce debt is to reduce current consumption and divert more of your cash flow into paying off debt. Whether paying off credit cards or making extra equity payments on a mortgage, either way you are reducing household debt.

Actually, it may be even less painful to increase income and put that extra money into debt retirement. Start up a sideline business or get a part-time second job. But in today’s market, those options may not be as readily available as they were even a year ago.

In the struggle to pay off debt, there are two schools of thought on which debts to pay of first. One school holds that the best idea is to focus most of your effort into paying down the debts with the highest interest rates. That way you lower the burden of finance charges faster. The other school of thought is to pay down the smallest debts first. This technique gives you small victories as you eliminate one debt after another.

Whichever technique you use, I’m more interested in the timing of the payoffs. Unless you are paying truly outrageous interest rates, the best response to an uncertain employment outlook is to build your cash position with additional savings.

Consider: both foreclosure and bankruptcy are not a function of the amount of debt carried. They are a function of cash flow. If you do not have enough cash to make all of your payments every month, you start to fall behind. It is the inability to make payments that drives people into bankruptcy. Exacerbating this is that most lenders pile on late fees and higher finance charges once you have late or missing payments.

Let’s say you are doubling up on the equity payment on your mortgage, and have been for years. The extra equity payments have shortened the term of the mortgage. You will pay it off in 15 years instead of 30. In the meantime, however, you have to keep making your payment every month.

Now you lose your job. If all your extra cash went towards paying down the mortgage, and you don’t have a substantial cushion, you are one month away from being delinquent on your mortgage. The fact that you made all those extra payments won’t cut any ice with the bank. They still want their payment every month.

So my plan is to continue making all my payments every month while I increase my cash reserve. Once I have enough extra money put away to extinguish a debt like a car loan, then I’ll pay it off all at once. It will require more discipline to hold onto the cash, rather than funneling the money directly to the lenders on a month by month basis. I may have to pay more in finance charges. But I’ll sleep better at night knowing I have the ability to ride out any unforeseen financial storms.

In a world of rising unemployment and falling real estate values, cash really is king.

Saturday, January 3, 2009

Happy New Year!

At the beginning of the New Year, I like many others, make resolutions for the coming twelve months. Sometimes these resolutions actually come to fruition (2008: start a blog), sometimes the hard realities of December bear no resemblance to the wishful thinking of January (2008: increase the value of my portfolio by 15%). Nonetheless, I find value in the exercise of goal setting. It helps define my priorities for the coming year.

Sometimes as you take stock at the end of one year, and you review progress against your goals, it becomes an exercise in shoulda, woulda, coulda. For example, I sure wish I'd gotten 100% into cash in the first half of 2008. Ah well. I'll just keep telling myself that I'm investing for the long haul. That makes it feel okay. Really, it does.

Anyway, I've decided that my financial theme for 2009 is deleverageing. My spell check doesn't like the term, so maybe deleverageing isn't in the dictionary yet. By the term the current financial crisis is in the history books, it will be.

In financial terms, leverage is a way of expressing the ratio of debt to equity. For example, if you buy a house with a 20% down payment, and take out a mortgage for the other 80%, you have leveraged your equity four to one. As you make your mortgage payments, your reduce the leverage as you build equity. This happens very slowly in the first years of the mortgage, than picks up speed as a larger and larger percentage of your mortgage payment is focused on paying down the principle balance.

The current crisis in the financial markets was brought on by excessive leverage during the housing bubble, both by consumers and institutions. Consumers bought houses with no money down (essentially infinite leverage), or they extracted all of the equity from their houses through home equity lines of credit. After all, if the value of housing had kept going up, they would have created equity out of thin air. Why not borrow against that? It seemed like a good idea at the time.

On the institutional side, banks were dumb enough to make those loans. The investment banks on Wall Street were dumb enough to repackage those loans and resell them, and institutional investors like insurance companies and pension funds were dumb enough to buy them. After all, if the home owners stopped paying their mortgages, the collateral (the houses) would be worth more than the original loans. Why not loan against that? It seemed like a good idea at the time.

It seemed like such a good idea that the Wall Street investment banks borrowed hundreds of billions of dollars to amplify the returns on the firm's capital. After all, bonuses were paid based on returns on capital. These guys were capitalists, says so right on the brochure. So when the housing market started to turn downward, a lot of the banks and investment banks were highly leveraged, 20 to 1 or even 30 to 1.

The upside of leverage is that when you are making gains, those gains are amplified by the amount of leverage. The downside of leverage is that when you are taking losses, the losses hit your capital by the same degree that gains boost it. So if you are leveraged 20 to 1, that means you have 20 dollars of debt for every dollar of equity. A 5% loss on the value of your assets is enough wipe out your equity.

Picture a bank holding most of it's assets in residential mortages. Foreclosure rates have more than doubled since 2007, and housing prices have dropped an average of 18% in the last year. Banks are taking losses of way more than 5% on their loan portfolios. When your debt is greater than the combination of your assets and your equity, that is the technical definition of insolvency, also known as bankruptcy. Ouch.

Financial institutions have spent the last year trying to raise capital, either by selling shares of preferred stock or by selling assets or by raising cash by cutting expenses like dividend payments. If leverage is the ratio of debt to equity, having more capital lowers leverage. For consumers, leverage is also being reduced. When you mail the keys to your house back to the bank, and move into a rental, you have reduced your personal leverage by the amount of your mortgage loan.

The bottom line is that when you reduce debt, you deleverage your financial position. So the process of reducing debt is deleverageing, however you spell it.

The thing about deleverageing is that it is a lot less painful when you do it willingly, before circumstances force you into it. It is a lot easier to tighten one's belt and build your rainy day fund, than it is to deal with foreclosure, or even escalating late payments because you missed a credit card payment.

Having established the theme of deleverageing for 2009, the next question is whether it is better to pay down debt or build up cash. I'll take up that issue in another post.