Greece’s fiscal problems have been much in the news recently. Essentially, the country is bankrupt. They have bond payments coming due this month, and they don’t have enough euros in the treasury to pay back the bond holders.
There is nothing unusual about that. Most governments don’t actually pay off their bond holders when the note comes due. What they do is issue new bonds, and just keep rolling the debt over. Greece’s problem is that they have hit their credit limit. The international financial markets are so nervous about how much debt has already been issued that they don’t want to allow Greece to continue digging the hole deeper.
This is not the first time a sovereign nation has run into this problem. Nations can’t handle their credit cards any better than the average American. The nation state playbook says that in a circumstance like this, you devalue your currency. Devaluation makes your exports cheaper, imports more expensive, and pays back the bond investors with a cheaper currency than they loaned you. The inflationary effects make everyone poorer, including the bondholders, who have to take a haircut on the value of their investment.
This isn’t an available option for Greece, because the Greeks don’t have their own currency anymore. They use the common European currency, the euro. If Greece defaults on its bonds, all of the countries in the Euro zone are in the splash zone. Hence the incentive for the other European Union countries to bail Greece out.
The other European nations, notably France and Germany, along with the International Monetary Fund, have agreed to be the lender of last resort to the Greek government. But there are conditions. They are requiring Greece’s government to reduce the government budget deficit from 13.9% of GDP to 3.9% over the next three years.
With their back against the wall, the Greeks are agreeing to the plan. They are cutting pensions, cutting salaries of government employees, and raising the retirement age. On the revenue side, consumption taxes are being increased one tenth, from 20% to 22%.
How big a cut is this going to be? Government spending makes up about 43% of the total Greek economy. The proposed austerity package of tax increases and budget cuts aims to get that down to about 35%. The government in Greece is going to have to shrink by about 20%. Overall, the average man on the street is going to get 10% poorer over the next couple of years, but the effect will be concentrated for government employees and retirees.
No wonder they’re protesting.
Showing posts with label credit crisis. Show all posts
Showing posts with label credit crisis. Show all posts
Monday, May 10, 2010
Tuesday, July 7, 2009
Getting your stories straight
USA Today ran two finance stories today with sharply contradictory messages. On the front page, the headline above the fold reads BANKS GET STINGY ON CREDIT. The story reported is that for the first four months of this year the number of new credit cards issued declined 38% compared with the same four months in 2008. Also, credit limits are slightly lower on the new cards that are issued. The average credit limit of $4594 is 3% lower than last year.
The tone of this story is that the new restraint on the part of credit card issuers is a bad thing. Spending pumps up the economy. Easy access to credit leads to spending. Therefore limiting access to credit delays the economic recovery.
In the Money section of the same paper, there is a related story with a completely different slant. Here the headline is US DEBT SHRINKING AT GLACIAL PACE. Total household debt peaked at $13.9 trillion in the third quarter of 2008, almost doubling since 2007. It has declined to $13.8 trillion during the first quarter of 2009, about a 1% drop.
This story points out that the US has just begun to deleverage. In the mid-80’s, household debt was 65% of disposable income. At the peak in 2007, household debt was 133% of disposable income. The perspective underlying this story is that until a lot more debt is either paid off or written off, consumers will not have the available income to resume spending in a way that will lift the economy.
So which is it? Is more debt good for the economy, or bad for the economy? From my perspective, it is an obvious answer. The economy came crashing down because of excessive debt. People paid way too much for houses they couldn’t afford. Then, to furnish those houses, they maxed out their credit cards. This was followed by tapping home equity lines of credit to pay off credit cards, which were then run up to the limit again.
It was like the financial equivalent of a giant game of musical chairs. Eventually the music stopped. Only in this game, all of the chairs had been pulled away. The good news is that the savings rate has increased from a negative number to 6.9%. This is a sign that people have stopped digging themselves into ever deeper holes of debt. But backfilling those holes will take time. The last thing we need to do is go back onto a credit fueled spending spree. That only starts the digging process all over again.
What was most surprising to me about these two stories is how they could have such different slants on the situation, coming out on the same day in the same paper. Don’t the editors read what the reporters are writing?
The tone of this story is that the new restraint on the part of credit card issuers is a bad thing. Spending pumps up the economy. Easy access to credit leads to spending. Therefore limiting access to credit delays the economic recovery.
In the Money section of the same paper, there is a related story with a completely different slant. Here the headline is US DEBT SHRINKING AT GLACIAL PACE. Total household debt peaked at $13.9 trillion in the third quarter of 2008, almost doubling since 2007. It has declined to $13.8 trillion during the first quarter of 2009, about a 1% drop.
This story points out that the US has just begun to deleverage. In the mid-80’s, household debt was 65% of disposable income. At the peak in 2007, household debt was 133% of disposable income. The perspective underlying this story is that until a lot more debt is either paid off or written off, consumers will not have the available income to resume spending in a way that will lift the economy.
So which is it? Is more debt good for the economy, or bad for the economy? From my perspective, it is an obvious answer. The economy came crashing down because of excessive debt. People paid way too much for houses they couldn’t afford. Then, to furnish those houses, they maxed out their credit cards. This was followed by tapping home equity lines of credit to pay off credit cards, which were then run up to the limit again.
It was like the financial equivalent of a giant game of musical chairs. Eventually the music stopped. Only in this game, all of the chairs had been pulled away. The good news is that the savings rate has increased from a negative number to 6.9%. This is a sign that people have stopped digging themselves into ever deeper holes of debt. But backfilling those holes will take time. The last thing we need to do is go back onto a credit fueled spending spree. That only starts the digging process all over again.
What was most surprising to me about these two stories is how they could have such different slants on the situation, coming out on the same day in the same paper. Don’t the editors read what the reporters are writing?
Monday, May 11, 2009
Pay Me Now or Pay Me Later
I hate slow pay. I hate it with a passion.
The world of business runs on a concept called trade credit. Trade credit basically means that you ship product to your customers before they actually pay for what they have bought. Similarly, if your suppliers extend trade credit, they let you have what you have ordered before money actually changes hands.
This is different then buying things with a credit card. When you use a credit card, the bank that issues the card transfers the money directly to the merchant, treating the balance due as an unsecured loan. The merchant gets paid right away, just as if you use cash, and therefore never takes on the risk of nonpayment. With trade credit, your vendors are supplying you with product solely based on your promise to pay up.
When I started in business, the standard terms for trade credit were Net 30 Days. That meant that one month after receiving product, you agreed to pay the net balance shown on the invoice. To manage your cash flow, you would hound your customers who went over the 30 day limit, knowing that you needed the money both to meet payroll and to keep your promises to your suppliers.
About ten years ago I started to see a change in these terms. Big companies started to demand extended terms. First sixty days, then 75 days, then even more then that. General Electric now has 120 day terms written into all of their contracts. Four months.
I think the move to extended terms was originally pushed by Wal Mart and the other big retailers, Lowe’s, Home Depot, Target and the like. Remember, the consumer pays for product before they take it out of the store. So if you turned your stock over fast enough, all of the cash required for your inventory was actually provided by the suppliers. For the big boys, it is a great idea. If you can get your vendors to pony up most of the working capital you need, that makes your return on equity look just a little bit better.
On the other hand, for a smaller company like the one I work for, this kind of trade credit policy puts you in a real bind. Our suppliers won’t extend 120 credit to us, either because they are so much bigger then us that we don’t have the leverage to force it, or because they are so much smaller that they couldn’t survive for that long.
For that matter, we don’t have enough cash to tie up four months worth of operating expenses in Accounts Receivable. So we are forced by our customers to borrow money for working capital.
I bring this up because our salesmen have heard rumors that next year GE is going to go to 150 days on their terms. They are a big enough customer that they will probably make it stick. After all, might makes right in situations like this.
But might does not necessarily make smart. By compelling their suppliers to focus on locating financing, and spending time keeping the bank placated, attention is necessarily shifted away from improving quality and delivery, and working on process improvements and product innovation. Not to mention, of course, that the interest charges you have to pay the bank reduce your profit margins.
But the real reason excessive slow pay is a bad idea is that it puts your supply chain in the hands of the bank. When you force your vendors to borrow money to meet payroll, the bank can shut your vendor down just by shutting off the line of credit.
Your vendor wants to keep you, the customer, happy. But your vendor’s bank does not care about you, the customer, at all. The bank cares about limiting its risk.
The more vendors you force to borrow money, and the more money you force them to borrow, the greater the odds that one of them will run into problems and be shut down. When your vendors shut down, you shut down.
Increasing leverage makes returns on equity look better, but it also increases systemic risk.
Isn’t that how the financial industry dug themselves into the hole?
The world of business runs on a concept called trade credit. Trade credit basically means that you ship product to your customers before they actually pay for what they have bought. Similarly, if your suppliers extend trade credit, they let you have what you have ordered before money actually changes hands.
This is different then buying things with a credit card. When you use a credit card, the bank that issues the card transfers the money directly to the merchant, treating the balance due as an unsecured loan. The merchant gets paid right away, just as if you use cash, and therefore never takes on the risk of nonpayment. With trade credit, your vendors are supplying you with product solely based on your promise to pay up.
When I started in business, the standard terms for trade credit were Net 30 Days. That meant that one month after receiving product, you agreed to pay the net balance shown on the invoice. To manage your cash flow, you would hound your customers who went over the 30 day limit, knowing that you needed the money both to meet payroll and to keep your promises to your suppliers.
About ten years ago I started to see a change in these terms. Big companies started to demand extended terms. First sixty days, then 75 days, then even more then that. General Electric now has 120 day terms written into all of their contracts. Four months.
I think the move to extended terms was originally pushed by Wal Mart and the other big retailers, Lowe’s, Home Depot, Target and the like. Remember, the consumer pays for product before they take it out of the store. So if you turned your stock over fast enough, all of the cash required for your inventory was actually provided by the suppliers. For the big boys, it is a great idea. If you can get your vendors to pony up most of the working capital you need, that makes your return on equity look just a little bit better.
On the other hand, for a smaller company like the one I work for, this kind of trade credit policy puts you in a real bind. Our suppliers won’t extend 120 credit to us, either because they are so much bigger then us that we don’t have the leverage to force it, or because they are so much smaller that they couldn’t survive for that long.
For that matter, we don’t have enough cash to tie up four months worth of operating expenses in Accounts Receivable. So we are forced by our customers to borrow money for working capital.
I bring this up because our salesmen have heard rumors that next year GE is going to go to 150 days on their terms. They are a big enough customer that they will probably make it stick. After all, might makes right in situations like this.
But might does not necessarily make smart. By compelling their suppliers to focus on locating financing, and spending time keeping the bank placated, attention is necessarily shifted away from improving quality and delivery, and working on process improvements and product innovation. Not to mention, of course, that the interest charges you have to pay the bank reduce your profit margins.
But the real reason excessive slow pay is a bad idea is that it puts your supply chain in the hands of the bank. When you force your vendors to borrow money to meet payroll, the bank can shut your vendor down just by shutting off the line of credit.
Your vendor wants to keep you, the customer, happy. But your vendor’s bank does not care about you, the customer, at all. The bank cares about limiting its risk.
The more vendors you force to borrow money, and the more money you force them to borrow, the greater the odds that one of them will run into problems and be shut down. When your vendors shut down, you shut down.
Increasing leverage makes returns on equity look better, but it also increases systemic risk.
Isn’t that how the financial industry dug themselves into the hole?
Sunday, April 19, 2009
General Growth Shrinks Down to Nothing
General Growth, the second largest shopping mall operator in America, filed for Chapter 11 bankruptcy last week. General Growth had grown through a series of acquisitions over the years. The largest of these was an $11 billion buyout of the Rouse Company in 2004.
GG had paid for these acquisitions through the mechanism of taking on ever increasing loads of debt. At the time of their bankruptcy filing, they had over $27 billion in outstanding loans.
The mall operator was taken down by two interlinked factors related to the recession. First, the current economic downturn has caused a shake out in the retailing industry. Merchants are closing stores, leaving blank fronts inside the malls. Unrented spaces mean that the cash flow available to pay debt is reduced.
The immediate cause of the bankruptcy was the general credit crunch. Banks were simply unwilling to roll over loans that had come due from the real estate operator. Faced with demands for cash, the management of General Growth threw up their hands and declared “Game Over.”
First of all, who lends money to a mall operator named General Growth? The mall industry has been shrinking for years. Malls are based on the concept that you park your car and stroll through the mall to do your shopping. Overweight Americans don’t want to stroll. They want to drive up to one store, get what they want (note the distinction between get what you want and get what you need), and then get back in the car and drive to the next big box retailer. “I had to drive around that parking lot four times before a good parking spot opened up. It’s a good thing gas prices have dropped since last year.”
I’m no retail genius, but even I know that the mall industry has been shrinking. It would be like loaning money to a company called Smoking Crack, Inc. “Sure, that sounds like a great investment!”
But it is even more amazing that the managers of the company bet the stockholder’s money on a strategy that included piling on debt until they were unable to get it refinanced. Without spectacular amounts of leverage, the returns in the mall business might not have been great, but they sure would have been better than being wiped out.
So, another company build on leverage bites the dust. And the trend for 2009 continues…
GG had paid for these acquisitions through the mechanism of taking on ever increasing loads of debt. At the time of their bankruptcy filing, they had over $27 billion in outstanding loans.
The mall operator was taken down by two interlinked factors related to the recession. First, the current economic downturn has caused a shake out in the retailing industry. Merchants are closing stores, leaving blank fronts inside the malls. Unrented spaces mean that the cash flow available to pay debt is reduced.
The immediate cause of the bankruptcy was the general credit crunch. Banks were simply unwilling to roll over loans that had come due from the real estate operator. Faced with demands for cash, the management of General Growth threw up their hands and declared “Game Over.”
First of all, who lends money to a mall operator named General Growth? The mall industry has been shrinking for years. Malls are based on the concept that you park your car and stroll through the mall to do your shopping. Overweight Americans don’t want to stroll. They want to drive up to one store, get what they want (note the distinction between get what you want and get what you need), and then get back in the car and drive to the next big box retailer. “I had to drive around that parking lot four times before a good parking spot opened up. It’s a good thing gas prices have dropped since last year.”
I’m no retail genius, but even I know that the mall industry has been shrinking. It would be like loaning money to a company called Smoking Crack, Inc. “Sure, that sounds like a great investment!”
But it is even more amazing that the managers of the company bet the stockholder’s money on a strategy that included piling on debt until they were unable to get it refinanced. Without spectacular amounts of leverage, the returns in the mall business might not have been great, but they sure would have been better than being wiped out.
So, another company build on leverage bites the dust. And the trend for 2009 continues…
Monday, April 13, 2009
Is it safe to go back in the water?
Last week Wells Fargo announced record earnings for the first quarter of 2009. The stock market soared on the news, and reports started to circulate that the worst was over for this recession.
No so fast!
Wells Fargo’s results were driven by fees from a wave of refinancing. The refi boom came about because the Fed has dropped interest rates to the floor. Mortgage rates have followed. As a result, people who could have been refinancing existing mortgages to take advantage of the lower rates.
Everyone who refinances has to pay fees to the bank for handling the transaction. This is great for the bank, but it is a short term phenomena. Mortgage rates are sitting at about 4.5% right now. They aren’t going to go much lower, if any. We’ve got about one quarter more of refinancing, then everyone who wants to take advantage of the new lower rates will have done so, and the fee income is going to dry up again.
The real issue is whether Wells Fargo has finished writing off all the bad loans in their real estate portfolio. Since real estate prices are continuing to fall, I’m guessing that more bad news is going to come out. After all, WF posted a loss in the 4th quarter of last year almost equal to what they earned this quarter.
We’re not out of the woods yet.
No so fast!
Wells Fargo’s results were driven by fees from a wave of refinancing. The refi boom came about because the Fed has dropped interest rates to the floor. Mortgage rates have followed. As a result, people who could have been refinancing existing mortgages to take advantage of the lower rates.
Everyone who refinances has to pay fees to the bank for handling the transaction. This is great for the bank, but it is a short term phenomena. Mortgage rates are sitting at about 4.5% right now. They aren’t going to go much lower, if any. We’ve got about one quarter more of refinancing, then everyone who wants to take advantage of the new lower rates will have done so, and the fee income is going to dry up again.
The real issue is whether Wells Fargo has finished writing off all the bad loans in their real estate portfolio. Since real estate prices are continuing to fall, I’m guessing that more bad news is going to come out. After all, WF posted a loss in the 4th quarter of last year almost equal to what they earned this quarter.
We’re not out of the woods yet.
Tuesday, March 24, 2009
Take this TARP...Part II
Goldman Sachs, the big Wall Street investment bank, recently announced that they were going to try and repay their share of the Federal TARP bailout money ahead of schedule. The previously announced plan was to repay the Treasury by the end of this year. They have now said they could pay back the government as early as the end of April.
I can’t help thinking this is partially due to the furor over the AIG bonuses. Watching the AIG financial traders get used as a metaphorical piñata by the politicians and media has got to be a powerful spur to get out from under the Federal thumb. Who can blame them: would you want to have to answer to Barney Franks?
As in the case of Northern Trust, I think much of the political grandstanding over the AIG bonuses was overwrought and silly. But I also think that the sooner the government gets out of the ownership of financial institutions, the better for the country. So if the posturing and outrage spurs the managers of companies to put their houses in order and regain their independence, in the long run we will be better for it.
It is an ill wind that blows no good.
I can’t help thinking this is partially due to the furor over the AIG bonuses. Watching the AIG financial traders get used as a metaphorical piñata by the politicians and media has got to be a powerful spur to get out from under the Federal thumb. Who can blame them: would you want to have to answer to Barney Franks?
As in the case of Northern Trust, I think much of the political grandstanding over the AIG bonuses was overwrought and silly. But I also think that the sooner the government gets out of the ownership of financial institutions, the better for the country. So if the posturing and outrage spurs the managers of companies to put their houses in order and regain their independence, in the long run we will be better for it.
It is an ill wind that blows no good.
Monday, March 23, 2009
AIG: Hangin' too good for em! Tax the b***s!
I’m outraged about the AIG bonuses. And right now I’m not talking about how $165 million in retention bonuses was paid out to the traders in the Financial Products unit; the same guys who wrecked the company. I’m still hacked off about that, but right now I’m outraged at the actions of the US Congress in regards to the situation.
In a state of high dudgeon, the House of Representatives passed a special bill last week that imposed a 95% tax on those bonuses. The US is looking at a trillion dollar deficit this year, and Congress is wasting their time going after a small group of traders who are getting retention bonuses when they should not even have been retained. Part of the taxpayer bailout of AIG should have been firing those guys. Instead, they were allowed to stick around until they qualified for bonuses.
The thing is, they were allowed to stick around to the end of the year. They had contracts, and those contracts have to be honored.
Now Congress, after the fact, is trying to get the money back. The US Constitution prohibits something call a Bill of Attainder. A Bill of Attainder is an act of the legislature that targets specific individuals and punishes them without a trial. Confiscatory taxation designed to hit only a small group of people arguably fits that definition.
What should have happened is that at the time of the original bailout, before the Treasury acquired 80% of AIG, all of the employment contracts should have been rendered subject to renegotiation as a precondition to receiving the money. Alas, no one thought of that during the press of events. Too bad, so sad.
Much as it pains my partisan soul, I have to give the Obama administration a pass on this one. By the time Obama was inaugurated in January, the retention bonuses had already been earned.
Instead of grandstanding and hyperventilating about how they are going to get that money back, our elected representatives would more constructively spend their time learning the ins and out of the financial system they are being asked to continue to bail out. Yes the AIG bonuses are outrageous, but in the great scheme of things they are also miniscule.
I would say that Congress has bigger fish to fry, but technically, whales are mammals, not fish.
In a state of high dudgeon, the House of Representatives passed a special bill last week that imposed a 95% tax on those bonuses. The US is looking at a trillion dollar deficit this year, and Congress is wasting their time going after a small group of traders who are getting retention bonuses when they should not even have been retained. Part of the taxpayer bailout of AIG should have been firing those guys. Instead, they were allowed to stick around until they qualified for bonuses.
The thing is, they were allowed to stick around to the end of the year. They had contracts, and those contracts have to be honored.
Now Congress, after the fact, is trying to get the money back. The US Constitution prohibits something call a Bill of Attainder. A Bill of Attainder is an act of the legislature that targets specific individuals and punishes them without a trial. Confiscatory taxation designed to hit only a small group of people arguably fits that definition.
What should have happened is that at the time of the original bailout, before the Treasury acquired 80% of AIG, all of the employment contracts should have been rendered subject to renegotiation as a precondition to receiving the money. Alas, no one thought of that during the press of events. Too bad, so sad.
Much as it pains my partisan soul, I have to give the Obama administration a pass on this one. By the time Obama was inaugurated in January, the retention bonuses had already been earned.
Instead of grandstanding and hyperventilating about how they are going to get that money back, our elected representatives would more constructively spend their time learning the ins and out of the financial system they are being asked to continue to bail out. Yes the AIG bonuses are outrageous, but in the great scheme of things they are also miniscule.
I would say that Congress has bigger fish to fry, but technically, whales are mammals, not fish.
Sunday, March 15, 2009
"...and negotiating for the company will be Bobo the chimp."
The big international insurance company AIG made the news again this weekend. No, they didn’t require another round of taxpayer funded bailout money. The $170 billion pumped in during the last three rounds seemed to have stabilized the patient for the time being.
The news this weekend was that AIG was going to pay out $450 million in “retention bonuses” to employees throughout the organization. These bonuses were apparently written into the employment contracts for executives at the various business units that make up AIG.
The amazing part about this is that $165 million of the retention bonus pool is allocated to the people at AIG’s financial products unit in London. These were the brainiacs who made all the bad deals that sunk AIG into such dire straits that they needed the $170 billion in the first place. Apparently the lawyers at AIG headquarters reviewed the employment contracts and concluded, “yup, we gotta pay ‘em.”
These guys in London inked deals that went bad to the tune of $60 billion in the last three months of 2008 alone. But they held their heads high and refused to quit, so by making it to the end of the year, they qualify for “retention bonuses.”
Who writes these contracts? This is the worst case of “head I win, tails you lose” I’ve seen all year.
According to news reports, the retention plan was set up early in 2008, before the realization set in about how bad the losses on the credit default swaps engineered at the financial products unit were going to be. AIG wanted to keep a number of executives from leaving, so the plan was set up to pay retention payments to senior people.
Call me crazy, but I’m not sure I’d want to keep the people around who wrecked the company and wiped out the shareholders. And the people who wrecked the company are still on the payroll, because they have a contract. For some reason, their business performance didn’t qualify as grounds for termination.
It kind of makes you wonder what you have to do to be fired for poor performance. Do you think being caught on videotape cutting a deal with Satan to sell him the souls of your customers would do it? Or would that qualify you for an additional bonus payment for “out of the box” thinking?
I wish I could get my hands on one of those contracts and see what it really says.
The news this weekend was that AIG was going to pay out $450 million in “retention bonuses” to employees throughout the organization. These bonuses were apparently written into the employment contracts for executives at the various business units that make up AIG.
The amazing part about this is that $165 million of the retention bonus pool is allocated to the people at AIG’s financial products unit in London. These were the brainiacs who made all the bad deals that sunk AIG into such dire straits that they needed the $170 billion in the first place. Apparently the lawyers at AIG headquarters reviewed the employment contracts and concluded, “yup, we gotta pay ‘em.”
These guys in London inked deals that went bad to the tune of $60 billion in the last three months of 2008 alone. But they held their heads high and refused to quit, so by making it to the end of the year, they qualify for “retention bonuses.”
Who writes these contracts? This is the worst case of “head I win, tails you lose” I’ve seen all year.
According to news reports, the retention plan was set up early in 2008, before the realization set in about how bad the losses on the credit default swaps engineered at the financial products unit were going to be. AIG wanted to keep a number of executives from leaving, so the plan was set up to pay retention payments to senior people.
Call me crazy, but I’m not sure I’d want to keep the people around who wrecked the company and wiped out the shareholders. And the people who wrecked the company are still on the payroll, because they have a contract. For some reason, their business performance didn’t qualify as grounds for termination.
It kind of makes you wonder what you have to do to be fired for poor performance. Do you think being caught on videotape cutting a deal with Satan to sell him the souls of your customers would do it? Or would that qualify you for an additional bonus payment for “out of the box” thinking?
I wish I could get my hands on one of those contracts and see what it really says.
Tuesday, March 10, 2009
We Bring Good Things to Light?
GE stock has fallen precipitously in value over the last year. It was trading at a little over $6 per share last week, having come down from a high of $40+ in 2007. This is the same GE that builds both jet engines and refrigerators, light bulbs and MRI scanners. GE even owns NBC and Universal Studios. They are a leader in globalization, noted for having a deep management bench and the ability to develop talent. GE is one of the few American companies with AAA bond rating. The bluest of the blue chips.
And yet, panic selling drove the price down 45% in one month. This, despite the fact that the company was profitable last year. What gives?
The problem is that GE has xx in assets, but has yy in liabilities. If GE has problems paying back those liabilities, that spells real trouble for the stockholders. In corporate finance, the owners of the liabilities (bondholders) always get paid before the owners of the equity (stockholders). The reason the stock price has fallen so far is that the judgement of the market is that GE’s liabilities won’t be paid back.
You may think “What’s the problem? They’ve got a lot more assets than liabilities.” Well, maybe yes, and maybe no.
GE is really two companies. There is General Electric, which is the collection of industrial businesses that makes all the stuff. They have twice as many assets as liabilities. Then there is GE Capital. GE Capital provided half of GE’s profits for 2007. The problems are in GE Capital portfolio. In the 2007 annual report, GE Capital had $646 billion in assets, and $587 billion in liabilities. If the assets are worth only 10% less than what GE said they were worth a year ago, that would be enough of a fall in value to wipe out GE Capital’s equity, forcing the company to put more cash into the business.
GE Capital uses the AAA rating to borrow money cheaply. They then use that money to make loans. A lot of the loans are equipment leases. You want to lease a jet engine or MRI scanner, GE Capital will help you do that. But they make a lot of other types of loans as well. For a financing company, the money borrowed is a liability, and the loans made are the assets.
The market is concerned about writedowns hidden in the loan portfolio. Another way of saying that is that the assets are worth a lot less than what GE has been saying, and GE will have to ‘fess up soon.
I decided to go looking through the annual report to see if I could spot any potential problems. In corporate annual reports, the pesky details that can cause trouble are usually buried in the notes that follow the financial statements at the back of the report. Opening up the report almost at random, I found Note 12: GECS Financing Receivables.
Inside Note 12 was a line item for a division called GE Money, listing Non-US Residential Mortgages: $73.759 billion. So GE owns a mortgage company that is holding almost $74 billion in mortgages. I’m guessing that most of the mortgages are in the UK.
Attached to the line items was a reference to subnote (A). In little, tiny print, subnote (A) included the following statement: “approximately 26% of this portfolio comprised loans with introductory, below market rates that are scheduled to adjust at future dates; with high loan-to-value ratios at inception; whose terms permitted interest-only payments; or whose terms resulted in negative amortization.”
Yikes. Let me translate that for you: “GE holds over $19 billion dollars of toxic subprime mortgages in a collapsing real estate market.” After those UK homeowners stop paying, GE will foreclose, and then sell the houses for half. My back of the envelope calculation is that GE will have to write down that sliver of their portfolio by about $10 billion dollars. The total reserve for losses in their Financing Receivables is only $4.3 billion.
GE recently eliminated 70% of their dividend. This contributed mightily to the free fall in the stock price, but it will free up $9 billion a year in cash to apply to other uses, like writing off foreclosed mortgages. I have a feeling that they are going to need the cash.
The 2008 annual report is due any day now. I can’t wait to read it.
And yet, panic selling drove the price down 45% in one month. This, despite the fact that the company was profitable last year. What gives?
The problem is that GE has xx in assets, but has yy in liabilities. If GE has problems paying back those liabilities, that spells real trouble for the stockholders. In corporate finance, the owners of the liabilities (bondholders) always get paid before the owners of the equity (stockholders). The reason the stock price has fallen so far is that the judgement of the market is that GE’s liabilities won’t be paid back.
You may think “What’s the problem? They’ve got a lot more assets than liabilities.” Well, maybe yes, and maybe no.
GE is really two companies. There is General Electric, which is the collection of industrial businesses that makes all the stuff. They have twice as many assets as liabilities. Then there is GE Capital. GE Capital provided half of GE’s profits for 2007. The problems are in GE Capital portfolio. In the 2007 annual report, GE Capital had $646 billion in assets, and $587 billion in liabilities. If the assets are worth only 10% less than what GE said they were worth a year ago, that would be enough of a fall in value to wipe out GE Capital’s equity, forcing the company to put more cash into the business.
GE Capital uses the AAA rating to borrow money cheaply. They then use that money to make loans. A lot of the loans are equipment leases. You want to lease a jet engine or MRI scanner, GE Capital will help you do that. But they make a lot of other types of loans as well. For a financing company, the money borrowed is a liability, and the loans made are the assets.
The market is concerned about writedowns hidden in the loan portfolio. Another way of saying that is that the assets are worth a lot less than what GE has been saying, and GE will have to ‘fess up soon.
I decided to go looking through the annual report to see if I could spot any potential problems. In corporate annual reports, the pesky details that can cause trouble are usually buried in the notes that follow the financial statements at the back of the report. Opening up the report almost at random, I found Note 12: GECS Financing Receivables.
Inside Note 12 was a line item for a division called GE Money, listing Non-US Residential Mortgages: $73.759 billion. So GE owns a mortgage company that is holding almost $74 billion in mortgages. I’m guessing that most of the mortgages are in the UK.
Attached to the line items was a reference to subnote (A). In little, tiny print, subnote (A) included the following statement: “approximately 26% of this portfolio comprised loans with introductory, below market rates that are scheduled to adjust at future dates; with high loan-to-value ratios at inception; whose terms permitted interest-only payments; or whose terms resulted in negative amortization.”
Yikes. Let me translate that for you: “GE holds over $19 billion dollars of toxic subprime mortgages in a collapsing real estate market.” After those UK homeowners stop paying, GE will foreclose, and then sell the houses for half. My back of the envelope calculation is that GE will have to write down that sliver of their portfolio by about $10 billion dollars. The total reserve for losses in their Financing Receivables is only $4.3 billion.
GE recently eliminated 70% of their dividend. This contributed mightily to the free fall in the stock price, but it will free up $9 billion a year in cash to apply to other uses, like writing off foreclosed mortgages. I have a feeling that they are going to need the cash.
The 2008 annual report is due any day now. I can’t wait to read it.
Monday, March 2, 2009
Northern Trust: "Take this TARP and Shove It..."
Two weekends ago Northern Trust sponsored a PGA tournament in LA. As part of their sponsorship, they flew hundreds of their clients and employees out to California for the event. Northern Trust’s guests were put up in fancy hotels, and treated to several parties, with big name entertainment such as the bands Chicago, Earth Wind, and Fire, and Sheryl Crow.
When news of this sponsorship broke, Congressman Barney Frank fired off an outraged letter, demanding that Northern Trust pay the Treasury back the amount that they spent on this event. His position was that since the bank had not refused Federal TARP money last year, it "demonstrates extraordinary levels of irresponsibility and arrogance" for the bank to spend money marketing to it’s clients in a way that Barney Frank disapproved of.
Last week Northern Trust defended itself by pointing out that it was profitable, and that it was funding a marketing plan out of those profits, not out of the TARP bailout money. They also pointed out that the Federal money was actually a loan, and that they had made the interest payments back to the Treasury on time.
Now the other shoe has dropped. This weekend Northern Trust announced that it would be returning the $1.6 billion given to it by the Treasury as soon as possible. In essence, they have told the Federal government “You can take your unsolicited bailout money, and your unsolicited advice on how we should run our business, and put them both where the sun don’t shine!”
Northern Trust does most of its business with institutions and high net worth individuals (AKA rich folks). Thy put the trust in trust funds. The execs at NT must have figured that if they went with the sackcloth and ashes marketing advocated by the new Puritans in Congress and the media, they stood to lose a lot of business. As long as they had the Federal money on their books, they were going to continue being attacked for following a strategy that has made them one of the banks that don’t need a bailout. So to preserve their successful business model, they decided to return the money.
One question pops up for me. Just how much money do you have to have in a bank to get treated like a Northern Trust client? I keep what I consider a fair chunk of money on deposit at my bank, and I don’t get freebies like getting flown out to a California golf tournament, and being put up at the Ritz Carleton. My bank won’t even give me a coupon for the get away weekend at the local Red Roof Inn.
Or how about the Sheryl Crow concert? Shoot, I’d be happy with a Sheryl Crow CD! No, the only freebie I’ve gotten from my bank was a pad of Post-it notes, and I had to distract the banker to get those (“Look, it’s Hailey’s comet!” Point with the left hand, snatch with the right).
When I grow up, I want to be a Northern Trust client.
When news of this sponsorship broke, Congressman Barney Frank fired off an outraged letter, demanding that Northern Trust pay the Treasury back the amount that they spent on this event. His position was that since the bank had not refused Federal TARP money last year, it "demonstrates extraordinary levels of irresponsibility and arrogance" for the bank to spend money marketing to it’s clients in a way that Barney Frank disapproved of.
Last week Northern Trust defended itself by pointing out that it was profitable, and that it was funding a marketing plan out of those profits, not out of the TARP bailout money. They also pointed out that the Federal money was actually a loan, and that they had made the interest payments back to the Treasury on time.
Now the other shoe has dropped. This weekend Northern Trust announced that it would be returning the $1.6 billion given to it by the Treasury as soon as possible. In essence, they have told the Federal government “You can take your unsolicited bailout money, and your unsolicited advice on how we should run our business, and put them both where the sun don’t shine!”
Northern Trust does most of its business with institutions and high net worth individuals (AKA rich folks). Thy put the trust in trust funds. The execs at NT must have figured that if they went with the sackcloth and ashes marketing advocated by the new Puritans in Congress and the media, they stood to lose a lot of business. As long as they had the Federal money on their books, they were going to continue being attacked for following a strategy that has made them one of the banks that don’t need a bailout. So to preserve their successful business model, they decided to return the money.
One question pops up for me. Just how much money do you have to have in a bank to get treated like a Northern Trust client? I keep what I consider a fair chunk of money on deposit at my bank, and I don’t get freebies like getting flown out to a California golf tournament, and being put up at the Ritz Carleton. My bank won’t even give me a coupon for the get away weekend at the local Red Roof Inn.
Or how about the Sheryl Crow concert? Shoot, I’d be happy with a Sheryl Crow CD! No, the only freebie I’ve gotten from my bank was a pad of Post-it notes, and I had to distract the banker to get those (“Look, it’s Hailey’s comet!” Point with the left hand, snatch with the right).
When I grow up, I want to be a Northern Trust client.
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.
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.
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.
Saturday, November 22, 2008
Be Calm
From all indications, the US economy is in bad shape. Unemployment is rising, as more companies announce layoffs. The fall in stock prices has gotten to the level that many of us have stopped looking at our 401K balances. The credit markets are still largely frozen up, making it difficult for even profitable companies to get financing for their operations. It is clear that we are in a recession, and by all indications it will be a bad one.
In the face of all this bad news, the cries for a new stimulus package from Washington have become louder and more insistent. Paul Krugman, the Nobel winning economist and New York Times columnist, is calling for an immediate fiscal stimulus of $300 to $600 billion. Gail Collins, another New York Times columnist, is calling on President Bush to resign as the only way to save the country. "Orderly transfer of power be damned! Save us, Obama, save us!" Any impediment to handing out the fat envelopes of government cash, such as the Constitution, is considered as perilous in this time of crisis.
Two things are being missed in the panicked rush to increase the national debt in the name of keeping the economy going.
First, it's not that bad out there. The unemployment rate has risen, that's true. But 93% of us still have jobs. Banks have had to write off hundreds of billions of dollars worth of bad mortgages, and a number of banks have failed, that's true. But not a single depositor has lost his savings. Credit has gotten scarcer and more expensive, that's true. But my credit card still works and I expect it to keep working, as long as I keep paying off the bill. Standards may be a bit higher, but banks are still making loans to individuals with good credit ratings. Corporate profits are down, but aside from financial services and the domestic auto makers, companies in most sectors are not losing money.
Perform a little thought experiment: when you drive past Wal-Mart, is the parking lot still full of cars? If you go out to eat at a restaurant, is the place half empty, or do you have to wait for a table? My experience has been that the economy is still functioning. It may be harder to make a buck, but rumors of a new Great Depression are greatly exaggerated.
The other factor that has been missed by the pundits is that gas prices have dropped in half over the last couple of months. Gasoline that was at $4 a gallon over the summer now costs under $2 at the pump. For the average household, this frees up between $50 and $100 a week. Between now and the end of the year that could be worth up to $500, with another chunk of budgetary relief in January. And another in February, and so on. Over the next few months, lower gas prices will but as much money back into the economy as any proposed stimulus package.
Money that isn't literally burned is availible for keeping mortgages current, and paying down credit card debt, and shopping for Christmas presents. All activities that will reduce the level of financial panic. We just have to be patient.
In the face of all this bad news, the cries for a new stimulus package from Washington have become louder and more insistent. Paul Krugman, the Nobel winning economist and New York Times columnist, is calling for an immediate fiscal stimulus of $300 to $600 billion. Gail Collins, another New York Times columnist, is calling on President Bush to resign as the only way to save the country. "Orderly transfer of power be damned! Save us, Obama, save us!" Any impediment to handing out the fat envelopes of government cash, such as the Constitution, is considered as perilous in this time of crisis.
Two things are being missed in the panicked rush to increase the national debt in the name of keeping the economy going.
First, it's not that bad out there. The unemployment rate has risen, that's true. But 93% of us still have jobs. Banks have had to write off hundreds of billions of dollars worth of bad mortgages, and a number of banks have failed, that's true. But not a single depositor has lost his savings. Credit has gotten scarcer and more expensive, that's true. But my credit card still works and I expect it to keep working, as long as I keep paying off the bill. Standards may be a bit higher, but banks are still making loans to individuals with good credit ratings. Corporate profits are down, but aside from financial services and the domestic auto makers, companies in most sectors are not losing money.
Perform a little thought experiment: when you drive past Wal-Mart, is the parking lot still full of cars? If you go out to eat at a restaurant, is the place half empty, or do you have to wait for a table? My experience has been that the economy is still functioning. It may be harder to make a buck, but rumors of a new Great Depression are greatly exaggerated.
The other factor that has been missed by the pundits is that gas prices have dropped in half over the last couple of months. Gasoline that was at $4 a gallon over the summer now costs under $2 at the pump. For the average household, this frees up between $50 and $100 a week. Between now and the end of the year that could be worth up to $500, with another chunk of budgetary relief in January. And another in February, and so on. Over the next few months, lower gas prices will but as much money back into the economy as any proposed stimulus package.
Money that isn't literally burned is availible for keeping mortgages current, and paying down credit card debt, and shopping for Christmas presents. All activities that will reduce the level of financial panic. We just have to be patient.
Monday, November 17, 2008
Buzzing with Excitement
Since Congress passed the $700 billion bailout authorization called TARP (Troubled Asset Relief Program) in October, the predictable rush to the trough has occurred. What I didn't anticipate, however, was how fast other players than banks would get their hands out for a share of Federal largesse.
Originally sold as a plan to buy up illiquid mortgages and mortgage backed securities, TARP quickly morphed into direct equity injections into major banks. Seeing how easy it was, insurance company AIG bellied up to the bar for a second round, having already received an $80 billion Federal loan.
Not to be outdone, the cities of Philidelphia, Atlanta, and Phoenix sent a letter to Treasury Secretary Paulson, asserting their rightful claim to a Federal handout. San Jose, the home of Silicon Valley, is waiting to see how that is handled before submitting their request for $15 billion.
This was closely followed by the domestic automotive manufacturers. Not satisfied with the first $25 billion in loan guarantees they got as a separate line item in the TARP authorization, Ford, Chysler, GM are threatening economic armageddon if they do not get at least another $25 billion.
This morning a group of automotive supplier companies applied for their fair share of the bailout money. In a strange way, this latest request almost makes sense. The big 3 car companies are threatening to take their supplier base down with them if they have to declare bankruptcy. The auto suppliers are just trying to cut out the middleman, getting the money directly from the Treasury instead of getting it from the car companies.
I guess I shouldn't be surprised with how fast players far removed from the financial industry are rushing in to get a chunk of the $700 billion TARP bailout fund. When you've got that big a honeypot, you're going to pull in a lot of flies.
Originally sold as a plan to buy up illiquid mortgages and mortgage backed securities, TARP quickly morphed into direct equity injections into major banks. Seeing how easy it was, insurance company AIG bellied up to the bar for a second round, having already received an $80 billion Federal loan.
Not to be outdone, the cities of Philidelphia, Atlanta, and Phoenix sent a letter to Treasury Secretary Paulson, asserting their rightful claim to a Federal handout. San Jose, the home of Silicon Valley, is waiting to see how that is handled before submitting their request for $15 billion.
This was closely followed by the domestic automotive manufacturers. Not satisfied with the first $25 billion in loan guarantees they got as a separate line item in the TARP authorization, Ford, Chysler, GM are threatening economic armageddon if they do not get at least another $25 billion.
This morning a group of automotive supplier companies applied for their fair share of the bailout money. In a strange way, this latest request almost makes sense. The big 3 car companies are threatening to take their supplier base down with them if they have to declare bankruptcy. The auto suppliers are just trying to cut out the middleman, getting the money directly from the Treasury instead of getting it from the car companies.
I guess I shouldn't be surprised with how fast players far removed from the financial industry are rushing in to get a chunk of the $700 billion TARP bailout fund. When you've got that big a honeypot, you're going to pull in a lot of flies.
Tuesday, October 14, 2008
New Ideas for Spending Money
Where do they come up with this stuff?
In the face of a plunging stock market and moribund credit markets, both Presidential candidates are reaching deeper into their goodie bags to come up with new bribes, er, enticements to try and stimulate the economy. Sure, because $700 billion to buy up banks and mortgages wasn’t enough.
Last week John McCain fired off a salvo. He proposed rescinding the requirement that owners of IRA’s and 401K’s have to start taking withdrawals from retirement accounts starting at age 70 ½. Why force people to sell assets into a down market, when that just increases the downward pressure on stock values? Actually, I think this is a pretty good idea, but then again, I’ve never heard a good argument for why mandatory withdrawals from retirement accounts were necessary in the first place.
After meeting with his economic advisors over the weekend, McCain apparently felt that anything else they proposed was too gimmicky, so he hasn’t come out with anything new this week. Of course, there is one more presidential debate coming up, so maybe he’s saving up for that.
In the meantime, Barack Obama came out with multiple gimmicks, er, policy proposals this week. First, he wants to mail out a $1000 check to everyone whose household income was less than $150,000. He also wants to extend unemployment benefits for another 13 weeks. This looks like a straightforward increase in welfare to me, pure and simple.
Senator Obama wants to impose a three month moratorium on foreclosures for any bank that accepts the Federal bailout money. You have to wonder what the economic point of this is. Does he anticipate that people will start paying their mortgages again after a three month grace period? Wouldn’t an increase in the number of foreclosures in process (loans go delinquent, but none ever get resolved) put even more stress on the banks that taxpayer money is going to bail out? The political point is a little more self evident: “Vote for me, folks, and I’ll give you three months free rent!”
Then there is the idea of removing penalties for 401K withdrawals. This allows you to get the tax break for contributing to a retirement plan, without actually having to forego the immediate consumption. Americans don’t save enough for retirement now, so let’s make it easier to consume instead of invest. This is the triumph of short term gratification over long term planning. Times may be tough now, but they will be even tougher when you are too old to continue working.
My personal favorite among Senator Obama’s new proposals is the tax credit for adding employees to the payroll. He has proposed a $3000 tax credit be given to businesses for every person they hire. This is basically offering a bribe to go out and hire people, but it is not even an effective bribe. In my hiring and firing, if I need to hire people, I hire them, and $3000 from the government isn’t nearly enough to sway my opinion. A new employee costs at least $20,000 a year. Unless you have enough business to justify that expense, a $3000 dollar subsidy doesn’t begin to cover that cost.
As a conservative, I long for the days when every problem didn’t automatically become the concern of the US government. Both parties seem to be caught up in the game of seeing who can offer more tax revenue to the citizenry. I’ll be happy in three weeks when the Pander fest known as the general election campaign is over.
In the face of a plunging stock market and moribund credit markets, both Presidential candidates are reaching deeper into their goodie bags to come up with new bribes, er, enticements to try and stimulate the economy. Sure, because $700 billion to buy up banks and mortgages wasn’t enough.
Last week John McCain fired off a salvo. He proposed rescinding the requirement that owners of IRA’s and 401K’s have to start taking withdrawals from retirement accounts starting at age 70 ½. Why force people to sell assets into a down market, when that just increases the downward pressure on stock values? Actually, I think this is a pretty good idea, but then again, I’ve never heard a good argument for why mandatory withdrawals from retirement accounts were necessary in the first place.
After meeting with his economic advisors over the weekend, McCain apparently felt that anything else they proposed was too gimmicky, so he hasn’t come out with anything new this week. Of course, there is one more presidential debate coming up, so maybe he’s saving up for that.
In the meantime, Barack Obama came out with multiple gimmicks, er, policy proposals this week. First, he wants to mail out a $1000 check to everyone whose household income was less than $150,000. He also wants to extend unemployment benefits for another 13 weeks. This looks like a straightforward increase in welfare to me, pure and simple.
Senator Obama wants to impose a three month moratorium on foreclosures for any bank that accepts the Federal bailout money. You have to wonder what the economic point of this is. Does he anticipate that people will start paying their mortgages again after a three month grace period? Wouldn’t an increase in the number of foreclosures in process (loans go delinquent, but none ever get resolved) put even more stress on the banks that taxpayer money is going to bail out? The political point is a little more self evident: “Vote for me, folks, and I’ll give you three months free rent!”
Then there is the idea of removing penalties for 401K withdrawals. This allows you to get the tax break for contributing to a retirement plan, without actually having to forego the immediate consumption. Americans don’t save enough for retirement now, so let’s make it easier to consume instead of invest. This is the triumph of short term gratification over long term planning. Times may be tough now, but they will be even tougher when you are too old to continue working.
My personal favorite among Senator Obama’s new proposals is the tax credit for adding employees to the payroll. He has proposed a $3000 tax credit be given to businesses for every person they hire. This is basically offering a bribe to go out and hire people, but it is not even an effective bribe. In my hiring and firing, if I need to hire people, I hire them, and $3000 from the government isn’t nearly enough to sway my opinion. A new employee costs at least $20,000 a year. Unless you have enough business to justify that expense, a $3000 dollar subsidy doesn’t begin to cover that cost.
As a conservative, I long for the days when every problem didn’t automatically become the concern of the US government. Both parties seem to be caught up in the game of seeing who can offer more tax revenue to the citizenry. I’ll be happy in three weeks when the Pander fest known as the general election campaign is over.
Wednesday, October 8, 2008
If at first you don't succeed...leave it alone.
The crisis in the nation’s, and the world’s, credit markets continues to persist. From reading news reports, I hear that credit is “frozen,” and that “banks are afraid to lend to one another.” The standard line being used is that without access to credit, businesses cannot buy inventory or payroll, consumers cannot buy cars or houses, and the entire economy is in danger of grinding to a halt.
In the face of the credit market freeze, the Federal Reserve and the Treasury are announcing new actions almost every day to try and get the buyers of securities off the sidelines (there is no shortage of people wanting to sell IOU’s, just not a lot of people buying them these days).
In the last week the Fed has taken the following actions:
-It has started buying unsecured commercial paper. These are basically short-term loans made to individual companies for funding operations. They are usually not backed by any collateral.
-Fed Chairman Ben Bernanke promised to cut interest rates in a speech on Tuesday. That’s usually good for cheering up the markets.
-This morning, the Fed did cut interest rates, along with six other central banks around the world, in a coordinated action. Okay, now we know all of the central bankers are serious about restarting the stalled credit markets.
-The latest proposal that has been floated is a plan for the Fed to buy ownership stakes in banks.
All of this of course, is on top of the $700 billion Treasury bailout that passed Congress last week, also known as the mother of all interventions.
The first thing that strikes me about all of this is the emphasis on making loans and borrowing money as the engine of the economy. Wasn’t it too much borrowing, and lending to people who couldn’t pay the money back that got us into this mess?
The other thing that strikes me is the frenetic nature of the government’s actions. They want an immediate reaction, and when the market doesn’t oblige, they cough up another plan to see if that will give them an immediate reaction.
In the manufacturing arena, one reaction to problems is called "overadjusting the process." You take a part coming off the machine, measure it, and then tweak the machine. Then you do it again, and again, and again. The problem with that is that you never let the process stabilize to normal capability. Sometimes you have to resist the temptation to keep pulling on the levers and knobs, and just let the machine run for a while to determine your true process capability.
It feels like governments are trying to do the same thing. Every day a new program or intervention is announced, without giving the markets time to settle down and get used to the last adjustment. It probably doesn't help that it is an election year. My favorite metaphor for this is “pulling the plant out of the soil to check on the growth of the roots.”
There are a lot of people who work in the credit markets. Leave 'em alone to do their jobs, and eventually they will figure out how to muddle through. Interest rates will spike higher for awhile, even for ultrasafe borrowers like the state of California and AT&T. But as investors figure out that California is not going to default, trading volume will go up, and rates will come back down.
I have a lot of faith in letting people muddle through. It is not always efficient, and it is almost never pretty, but in my experience, letting people do their jobs seems to work.
In the face of the credit market freeze, the Federal Reserve and the Treasury are announcing new actions almost every day to try and get the buyers of securities off the sidelines (there is no shortage of people wanting to sell IOU’s, just not a lot of people buying them these days).
In the last week the Fed has taken the following actions:
-It has started buying unsecured commercial paper. These are basically short-term loans made to individual companies for funding operations. They are usually not backed by any collateral.
-Fed Chairman Ben Bernanke promised to cut interest rates in a speech on Tuesday. That’s usually good for cheering up the markets.
-This morning, the Fed did cut interest rates, along with six other central banks around the world, in a coordinated action. Okay, now we know all of the central bankers are serious about restarting the stalled credit markets.
-The latest proposal that has been floated is a plan for the Fed to buy ownership stakes in banks.
All of this of course, is on top of the $700 billion Treasury bailout that passed Congress last week, also known as the mother of all interventions.
The first thing that strikes me about all of this is the emphasis on making loans and borrowing money as the engine of the economy. Wasn’t it too much borrowing, and lending to people who couldn’t pay the money back that got us into this mess?
The other thing that strikes me is the frenetic nature of the government’s actions. They want an immediate reaction, and when the market doesn’t oblige, they cough up another plan to see if that will give them an immediate reaction.
In the manufacturing arena, one reaction to problems is called "overadjusting the process." You take a part coming off the machine, measure it, and then tweak the machine. Then you do it again, and again, and again. The problem with that is that you never let the process stabilize to normal capability. Sometimes you have to resist the temptation to keep pulling on the levers and knobs, and just let the machine run for a while to determine your true process capability.
It feels like governments are trying to do the same thing. Every day a new program or intervention is announced, without giving the markets time to settle down and get used to the last adjustment. It probably doesn't help that it is an election year. My favorite metaphor for this is “pulling the plant out of the soil to check on the growth of the roots.”
There are a lot of people who work in the credit markets. Leave 'em alone to do their jobs, and eventually they will figure out how to muddle through. Interest rates will spike higher for awhile, even for ultrasafe borrowers like the state of California and AT&T. But as investors figure out that California is not going to default, trading volume will go up, and rates will come back down.
I have a lot of faith in letting people muddle through. It is not always efficient, and it is almost never pretty, but in my experience, letting people do their jobs seems to work.
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.
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.
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.
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.
Monday, July 28, 2008
Bad News, Good News
I noticed something interesting in the news today. I was reading an article about the housing market, detailing that housing prices nationwide have dropped about 18% in the last year. The news article went on to state that more bad news was expected, as housing prices were expected to drop an additional 15-20% before leveling off at the end of 2009.
Why is it bad news when housing prices drop? Shelter is a basic human need. Housing is a product that we all use, and many of us would like more of. If housing prices fall, than buyers who were priced out of the market can now buy. Other buyers can now afford more house. From this perspective a drop in housing prices is good news.
“Oh, but what about the poor house sellers,” you may say. “Now they aren’t making any money when they sell their property.” Well, when big screen TV’s drop in price by 50% in a year, I don’t hear any boohooing over the fate of the poor TV manufacturers. What I hear is “Now I’m gonna get me a 54” wide screen. In HD. When those linemen hit that quarterback, I’m gonna see his ribs crack! A bigger TV is my right as an American. I heard it says so in the Constitution.”
Anyone who has lived in their house for five years or more isn’t going to be hurt by the drop in housing prices. Anyone looking to buy their first house is going to be helped by the drop in housing prices.
But what about the people losing their houses due to foreclosure? Well, they aren’t losing their houses because prices are dropping. They are losing their houses because they are not paying the mortgage. In many cases, they can’t afford the mortgage because the house was too expensive for their income.
The history of the housing boom over the last six years was people taking on more and more debt to buy ever more expensive houses. They were able to take on this debt because of mortgage products such as “liar’s loans” and negative amortization loans. The current process of price correction is mostly painful to the lenders, who are suffering the losses from loaning more money than people can afford to pay.
Housing prices are going to continue to slide until someone with the median household income can afford the mortgage payments on the median priced house. The faster that happens, the faster the housing sector, and the economy as a whole, will recover.
And that will be good news for everyone.
Why is it bad news when housing prices drop? Shelter is a basic human need. Housing is a product that we all use, and many of us would like more of. If housing prices fall, than buyers who were priced out of the market can now buy. Other buyers can now afford more house. From this perspective a drop in housing prices is good news.
“Oh, but what about the poor house sellers,” you may say. “Now they aren’t making any money when they sell their property.” Well, when big screen TV’s drop in price by 50% in a year, I don’t hear any boohooing over the fate of the poor TV manufacturers. What I hear is “Now I’m gonna get me a 54” wide screen. In HD. When those linemen hit that quarterback, I’m gonna see his ribs crack! A bigger TV is my right as an American. I heard it says so in the Constitution.”
Anyone who has lived in their house for five years or more isn’t going to be hurt by the drop in housing prices. Anyone looking to buy their first house is going to be helped by the drop in housing prices.
But what about the people losing their houses due to foreclosure? Well, they aren’t losing their houses because prices are dropping. They are losing their houses because they are not paying the mortgage. In many cases, they can’t afford the mortgage because the house was too expensive for their income.
The history of the housing boom over the last six years was people taking on more and more debt to buy ever more expensive houses. They were able to take on this debt because of mortgage products such as “liar’s loans” and negative amortization loans. The current process of price correction is mostly painful to the lenders, who are suffering the losses from loaning more money than people can afford to pay.
Housing prices are going to continue to slide until someone with the median household income can afford the mortgage payments on the median priced house. The faster that happens, the faster the housing sector, and the economy as a whole, will recover.
And that will be good news for everyone.
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