Car Wars, Part II

I have a clarification on my previous post regarding the new Federal automotive fuel efficiency standards. The 35 mpg requirement is for passenger cars and light trucks combined. The requirement for passenger cars is that the corporate average hits 42 miles per gallon.

I was curious as to how many cars currently on the market meet that standard. So I visited the official EPA fuel efficiency website (www.fueleconomy.gov). They have a searchable database where you can look for cars that meet differing levels of fuel efficiency. Do a search at meet or exceed 40 mpg, and you come up with two, count ‘em two, models. If you want a car that meets the 2016 standard today, you can get a Toyota Prius or a Honda Civic Hybrid.

It kind of reminds me of Henry Ford’s old dictate regarding the Model T. “You can have it in any color you want, as long as it’s black.”

Typically, cars are developed in what’s called a platform. The platform includes the chassis, the suspension, the powertrain; basically, all of the guts and structure between the seats and the body panels. Usually, more than one model of car is built off of the platform. For example, the Honda CR-V is built off the Civic platform. The Ford Fusion and the Mercury Milan also share a platform.

Developing a new platform takes between three and five years. Not only does the platform have to be engineered, but a lot of the subassemblies will also be new designs. Then the tools to build the new parts have to be designed and built. Once the new parts are made, then the assembly processes to make the subassemblies have to be designed and built. I have seen times where getting just one part for a new automotive subassembly took over 18 months between the first quotation to delivery of production parts.

Because of the enormous cost of developing a new platform, particularly once you get to the stage of building production tools, car companies usually bring only one platform to market in any one year.

To arrive at the mandated targets will require new platform development for almost every platform over the next 8 years. If you listen carefully, you can hear faint screams of agony coming from all directions. Those are the screams of product planners and design engineers from all over the world being told about the new North American standards they will have to meet, and the timetable for meeting them.

Car Wars

I have been hearing on the news today about the new deal to raise automotive fuel efficiency standards. The average passenger car mileage will increase from the current 27.5 miles per gallon to 35.5 miles per gallon in 2016. From the news coverage I’ve seen so far, it is not clear if that 35.5 mpg figure also applies to light trucks. Last year Congress passed a law requiring light trucks to hit fuel efficiency standards of 27.5 mpg by 2020, but that is now superceded by this new EPA rule.

For car makers, fuel efficiency is governed by a concept known by the acronym CAFÉ: Corporate Average Fuel Efficiency. The concept is pretty simple. The average fuel efficiency of all of the cars a manufacturer sells has to hit the government’s target. If you sell one Ford Fusion (26.5 mpg) and one Ford Fusion Hybrid (38.5 mpg), your CAFÉ rating is 32.5 mpg.

If you are Ford Motor, and you want to sell a muscle car like a Mustang (22 mpg) you have to sell another car that gets 49 miles to the gallon to hit the new standard. The latest version of the Toyota Prius only gets 44 mpg, so even that would have to increase by 11% to average out with a Mustang.

The new fuel efficiency standards represent a 30% increase over a seven year time period. To hit these targets, what all of the car companies are going to have to do is predictable. Cars are going to get (much) smaller, lighter, and less powerful. They are also going to become much more expensive.

A lot more cars are going to be hybrids. Since every hybrid has dual drive systems, one gas and one electric, there are a lot more components per car than a standard powertrain. More components, more cost.

For cars with more powerful engines, the prices will also go up. Why? Well, how else can the car companies convince you to buy a car that would lose a collision with a dog, when what you really want is a big honkin’ pickup truck? After all, the evidence of the marketplace is clear. Given a choice, Americans like to drive SUV’s and pickup trucks. In 2007, the top three best selling vehicles in North America were all full size trucks.

In the news coverage so far, everyone has been all smiley and happy, singing kumbaya over how great this is. So far, nobody has bothered to ask any automotive design engineers what they think about this. Those poor bastards are probably sitting in bars, trying to drink themselves into a catatonic stupor.

Tomorrow morning, they are going to have to wake up with a hangover, go in to work, and start trying to figure out how to retool 80% of the industry capacity to build small cars on lines configured to make big trucks and SUV’s. They have to do this during a major recession, with forecasted sales volume at 60% or less of what is was just a couple of years ago. And, oh yeah, the head of California’s pollution control board announced plans today to start work on the next major ratcheting up of fuel efficiency standards.

Work in the auto industry? I’d rather take on a career juggling chain saws. Flaming chain saws.

Third

How does Nancy Pelosi stay on as Speaker of the House? She's a pit bull partisan politico, schooled in old school urban machine politics. That extraordinary dedication to partisanship was obviously useful as House Minority Leader, making plans for her party to recapture control of the House of Representatives. But the Speaker of the House, isn't she at least nominally supposed to be for American interests, and not just the interests of the Democrats Party?

Last year, in passing the $700 billion bank bailout legislation, she had a chance to reach across the aisle and get bipartisan support. Whether you thought the bank bailout was a good idea or not, members of both parties thought it was a necessary action for the time. It was considered important to get bipartisan support for the commitment of so much money, so suddenly. So Speaker Nancy showed up to make a speech on the House floor in support of the legislation.

Now, I'm no speech writer, but if I was I would have put together a message somewhere along these lines:
"Ladies and gentlemen of the House. I have come before you today to speak in support of the legislation on the floor today. $700 billion dollars is a lot of money, but we are in the middle of an unprecedented economic crisis. Our banking system has seized up, and is in danger of collapsing. The experts we have consulted have agreed that if we do not do something to turn the situation around, our economy will undergo a calamity which will hurt all Americans.

"That is why I am asking all of you, both Republican and Democrat, to support this bill. As members of opposing political parties, we can have very real differences, both practical and philosophical, on a range of issues. But as Americans, we can put those differences aside, and work together when the chips are down to find solutions for the critical issues that this country faces. In this time of crisis, let us show a united face to the world."

She could have made a speech like that. Instead, we got this:


Now, after inveighing against the evil Republican Party for allowing war criminals to torture innocent civilians, it turns out that Speaker Pelosi had been repeatedly briefed by the CIA on what interrogation tchniques were planned for use, as well as what was actually being done to terrorists that had been captured. At the time, she never raised a note of protest.

When this information came to light, first she denied ever having this information. Then she agreed, yes, she did have the information, but only because a staffer had attended the briefing and had told her. Then, she said the CIA had lied about briefing her. Then she said the CIA misleads Congress all the time. She's got more twists and turns then a snake. Here's a news story on her press conference:


After watching this story, you have to believe that Nancy Pelosi has no commitment to the truth at all, only what she can spin to her political advantage. You know what the scary part of that is? She is third in line for the Presidency, right after Joe "Don't fly on airplanes, they're deathtraps!" Biden.

I really hope President Obama's stop smoking program is working.

Reserve Currency: I'll Reserve Judgement On That

Nouriel Roubini came out with an Op-Ed piece in the New York Times this week. In it, he raises a warning flag. The Chinese, who fund the US government deficit by being the biggest buyers of Treaury bonds, and who have a gigantic stockpile of dollars, are starting to make noises that they don’t want the dollar to be the world’s reserve currency anymore.

In the post-World War II economic system, the dollar became the world’s reserve currency. That means that for globally traded commodities, the deals are priced in terms of dollars. World oil prices are in dollars per barrel.

It also means that for a number of currencies, if you want to change over to another currency, you have to use dollars to complete the two halves of the transaction. For example, to convert Danish kronar into Thai baht, you first trade your kronar for dollars, then trade the dollars for baht.

If you want to be part of the world trading system, you have to keep a stockpile of dollars on hand to fund your buying and selling.

Because everybody has to have dollars, that keeps demand for greenbacks high. This allows the government to keep interest rates low in financing the deficit. It also allows American consumers to run up massive trade deficits, since exporting countries have to accept US currency. Our status as the world’s reserve currency keps the dollar strong, leading to low interest rates and inexpensive imports.

Mr. Roubini’s warning is that unless we get our fiscal house in order, the Chinese currency, the renminbi, will supplant the dollar over the next ten years. Historically, reserve currencies have always come from creditor nations, not borrower nations. If the renmenbi surplants the dollar, our currency will fall preciitously in value. This will cause a spike in interest rates as the government will have to entice investors into continuing to fund our deficits. Also, commodity prices will inevitably rise in dollar terms.

I hate to argue against anyone who is advocating more fiscal restraint, but I don’t find Mr. Roubini’s nightmare scenario to be particularly frightening.

First, to function as a reserve currency, the renminbi would have to be widely traded on currency markets, and before that could happen the Chinese would have to allow it to float, or move up and down in value, vis a vis other currencies. But the Chinese keep the value of their money pegged against the dollar. It is only in the last couple of years that even limited trading of the currency has been allowed.

It is precisely because the renminbi is pegged against the dollar that the US continues to run such a massive trade deficit with China. Otherwise the dollar would already have dropped in value against the renminbi, making Chinese imports more expensive. And the Chinese get something out of the deal. US demand for cheap Chinese imports is driving the extremely rapid industrialization of the Chinese economy.

In addition to the practical difficulties (many of which Mr. Roubini himself lists out), as a manufacturing manager I think the benefits of a falling dollar would vastly outwiegh the costs. Yes, commodity prices would increase. But for the last ten years the Chinese have used an artificially low currency to take market share from companies like mine. Instead of continuing to fight one long rear guard action against off-shore competitors, we could use our advantages of lower freight costs, higher productivity, and shorter lead time to take back business that has been lost. Maybe we could even expand into new markets and products.

If being the reserve currency has allowed Americans, both collectively and individually, to be irresponsible, than losing that status would be a change for the better. It is the difference between empowerment and enablement.

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?

Mystery of the Week

The big business story this last week was Chrysler Corporation filing for Chapter 11 bankruptcy. The goal is to have a quick, “surgical” bankruptcy, and emerge from court in a matter of weeks, not months.

When they come out of Chapter 11, the rough outline of the ownership structure will be the UAW holding about 50%, the bondholders holding about 10%, Italy’s Gruppo Fiat having up to a 35% stake, and the US government holding the remainder.

Here’s my question: What is Fiat doing for their share of the equity? Two things Fiat isn’t doing is ponying up any cash up front, or guaranteeing any of Chrysler’s existing debt.

I haven’t researched the deal very deeply. But on the surface it looks like Fiat will pick up a big share of the reconstituted Chrysler in exchange for—nothing!

Nice work if you can get it.

The More Things Change...

Kenyan politics are a mess. The political parties are largely linked to tribal groups in the country, and partisanship is vastly fiercer than here. Last year arguments over a disputed election dissolved into violence that convulsed the country for weeks and left a number of people dead.

Eventually a coalition government was formed and the violence burned itself out. But the parties involved in the coalition are still squabbling, and there are fears that the tensions simmering under the surface could break out again.

In response to this situation, a number of women’s groups in Kenya have called for a one week sexual boycott. The idea is that until the men start talking to each other instead of fighting each other, their wives will withhold their favors.

Just thinking about this idea brings a smile to your face. The concept of women using their sexual power to bring the men in their lives to heel seems rife with comic possibilities. Maybe it has already been done. Wasn’t there a movie along those lines…?

Actually, the idea is much older than that. The same concept forms the plot of Lysistrata, an ancient Greek play, written by the playwright Aristophanes in the 411 BCE. In his version, the city-states of Sparta and Athens are at war. The women of both cities cut the men off until they agree to make peace. The play is, of course, a satire. By poking fun at the men and women of Sparta and Athens, Aristophanes points out the absurdity of our behavior in both sexual politics and state politics. At the heart of the story is an incongruous concept: sex makes us crazy, but that craziness can make us behave more sanely with regard to larger conflicts.

Twenty-four hundred years ago Aristophanes looked at people and politics, and came up with an idea that resonates through the ages, right up to the present day.

That is why I am a conservative. The raw material of society is people. The human animal. Our motivations and desires are the same as they were millennia ago. The institutions, mores, and practices that persist over time do so for a reason: they work. Why they work may not be obvious to us, but we hazard the foundations of society when we make ill-considered alterations to institutions that have developed and held up over long periods.

I believe the current mania for “change” is ill-considered. History is littered with the wreckage of attempted utopian schemes. Until you change people, you better be careful when trying to change society. It has been over two millennia, and we are still waiting.

Even with a filibuster proof majority in the Senate, you cannot repeal the Law of Unintended Consequences.

Waterboarding and other unpleasantness

Some thirty years ago, I was a cadet attending ROTC summer training camp in Ft. Benning, Georgia. One day of the training was dedicated to adventure training. Rappeling, zip lines, biting the heads off chickens. That sort of thing.

At one point during the day, a group of cadets sat down with one of the training sergeants, a grizzled old Viet Nam vet. Somehow the discussion turned to the subject of questioning prisoners of war. The sergeant said that during the war, they would take two blindfolded VC up in a helicopter and start questioning them. Then they would tie a rope around one of them and throw him out of the chopper. The other would hear the screams as the man was pushed out, which was enough to get him to start answering questions.

Then the veteran said “If you really want information, you take the 9 volt battery out of the walkie-talkie handset, and press both terminals against the man’s temple. Bzzt! When he gets finished singing God Bless America, he’ll tell you anything you want to know.”

At this point he stopped and looked at the group of college students surrounding him, and saw the absolutely shocked faces. It was silent for a moment. Then, with dead sincerity, the sergeant said “That’s not torture. That’s interrogation.”

With the current media pyrotechnics about the Bush administrations “advanced interrogation” policies, it is worth noting this is not the first time we, as a society, have attempted to define the issue of what constitutes torture, and what is merely tough questioning. I think the question does not lend itself to bright and shining boundaries.

Pulling someone’s fingernails off with pliers? Yes, that’s torture. Sleep deprivation? Maybe. Now we’re in the grey area. Making a suspect wear women’s underwear, or having a woman lead him around with a dog leash? Please, you pay extra for that in Vegas.

But in struggling with these issues as policy is set, I have a suggestion. A modest proposal. Call it a version of sauce for the gander.

Have your attorneys draft memos outlining the limits of what is acceptable. This is just what the Bush administration did. Then take those same attorneys and subject them to the same interrogation techniques they proposed. If they say waterboarding is legal, waterboard ‘em. If they say exposure to cold is legal, stick ‘em in a meat locker. At the end of the process, is they still sign off on the memos, you have your policy.

Think of it as a new version of the Golden Rule. Not, “Do unto others as you would have done to yourself.” Not, “Do unto others as they would do unto you, but do it first.” No, not even the classic, “Whoever has the gold makes the rules.”

This version of the Golden Rule is “Don’t do anything unto others that you wouldn’t be willing to have done to yourself.”

Green Shoots and Other Images

Last week, Fed Chairman Ben Bernanke said he detected “green shoots” among the economic indicators he tracks. A nice metaphor for seeing signs of recovery from the current economic malaise. Beautifully timed to coincide with the annual rebirth of springtime.

At my company, we are also seeing some “green shoots” of our own. After dropping to a level less than half of what it was a year ago, orders from customers have rebounded somewhat. March financial results put us into the black for the year to date, April’s results will be better still, and the sales forecast for May/June is comfortable, if not stupendous.

It is infinitely less stressful to be focused on how much profit we can make, as opposed to having concerns over whether the month will show a profit or a loss. We have shifted over to the positive problem of “How do we make shipments on time with the resources we have?” as opposed to the negative problem of “Who is the next person to get laid off?” I’ve even had to call a few people back off layoff.

My problem is that I can’t confine myself to the springtime “green shoots” metaphor. I come back to other metaphors. Grimmer metaphors.

“We’re not out of the woods yet.” “The other shoe has yet to drop.” “The light at the end of a tunnel is an oncoming train.” “The economy is executing a head fake. It gets you moving one way, then whammo, it turns and goes the other.” “It’s always darkest just before it really goes pitch black.”

My gut feeling is that we are going to hear more bad news before the economy really recovers. So I am keeping cost controls in place, eliminating unnecessary expenses, and watching every hour of overtime like a hawk. I would say “plan for the worst, and hope for the best,” but I think hope is for suckers.

Some say the glass if half full. Some say the glass is half empty. I say the glass has a crack, and the water is running out.

Maybe that's why I don't get invited out much.

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…

Tax Season is Over

The ides of April are behind us. The gust of wind that stirred the hair on the back of your neck yesterday was the collective sigh of relief from all the tax filers sending in their tax returns just ahead of the deadline. Following that was a minor breeze coming from the paid tax preparers who are standing down after frantic activity of the last few weeks. Tax season is over.

When I signed on with H & R Block to do taxes last year, I figured that getting customers was the easiest part of the business. After all, the only service with a comparable level of built-in demand is the funeral home industry. Taxes are inevitable for everybody, right?

Well, taxes may be inevitable, but paying someone else to do them for you is not. H & R Block reported that through March 15, the number of returns prepared were down 6.2% versus the same period a year ago. The news was even worse at Jackson Hewitt, the second largest tax preparation chain. They are forecasting a drop of 12% for the number of returns prepared for the 2009 tax season.

USA Today ran a story on this with the headline “Downturn has taxpayers filing solo.” The implication is that the recession has driven more tax filers to using at home software for their taxes to save money.

I think trying to tie this trend to the current recession is a lot of hogwash. More people are filing taxes using home computers because it is cheaper and easier. That is an attractive proposition all the time, whether there is a recession or not.

When I prepare someone’s taxes at an H & R Block office, I have to be paid (not bloody much pay, but money does change hands). Also, rent on the bricks and mortar office continues all year round, even though tax season only lasts three months. HRB maintains the computers the paid preparers work on as well.

With the home software, the cost of producing another copy of the program is a tiny fraction of those costs. If you use the on-line version of the tax software, even those costs are eliminated. It’s no surprise that the price of home preparation kicks the crap out of the price of a paid preparer. And you can do your taxes any time, day or night, in your underwear, should you so desire.

As home computers with high-speed internet connections have become ubiquitous, more and more people are choosing the less expensive, more convenient home tax prep over paid services. The new model of computers and internet is hollowing out the market for tax preparers. This is the same process that killed the travel agent business. With the exception of cruise specialists, there are no more travel agents, and there used to be at least one in every small town.

Is tax preparation going to the same route to extinction?

Probably not. The difference is that not everyone flies on the airlines, but everyone has to file a tax return. They also have to die, but that’s a different story.

Even though tax law is getting more complicated, doing your taxes yourself is getting easier as the software gets better, particularly if your taxes aren’t particularly complicated. This means that for paid tax services, the middle of the market is getting carved out.

Two groups are left over: early season filers and late season filers. The early season filers tend to be lower income. They are either computer illiterate, or they want access to the financial products that tax prep firms can offer (refund anticipation loans). The late season filers will be the people with complicated taxes (farms, partnerships, business owners). The late filers will need more tax expertise and judgement applied than they can get from a computer program.

The total market for tax preparation services will continue to shrink. But even if they close offices, the services will still have to cover a lot of overhead. I will predict that even as the industry shrinks, the prices charged will continue to increase. Of course, raising prices will accelerate customers switching to the do it yourself model.

I may do taxes with H & R Block again next year. But I wouldn’t buy their stock as a long term investment.

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.

Depression? What Depression?

My latest bedtime reading is a book called The Coming Great Depression by Harry S. Dent. I keep it on my nightstand, and read a few pages every evening before I go to sleep.

The Coming Great Depression? Sweet dreams, buddy!

Dent is primarily a demographer, and he uses demographic trends as a tool for forecasting the economy. His major point is that there is a strong correlation between birthrates and asset prices (stocks and housing), with a forty year time lag. Put another way, if the birthrate goes up this year, in forty years the stock market will go up as well.

The logic behind this observed correlation is simple. People in their late thirties and early forties are at their peak productive years in the workforce. Also, those are the years of peak consumption, as people raise families, move up to bigger houses, spend on their children’s education, etc.

The primary prediction of the book is that the current downturn is only the start of a longer down cycle. The down cycle will play out over the next 10 to 15 years. The bottom of the trough will occur in 2012 or 2013, with the next boom cycle starting in 2022.

After the post WWII baby boom generation, birth rates fell and we had what is called the baby bust generation that followed. What Dent calls the Echo Boom generation was born in the eighties, a time of increasing birth rates. The dearth of baby busters will cause the drop off in the economy, and the Echo Boomers will ignite the next growth cycle as they hit their peak productive and consuming years.

The author throws in a lot of other cycle analysis to support his arguments. He mentions commodity cycles, technology cycles, political cycles and others. The periodicity of these cycles range from 18 to 250 years in length. I’m not sure I buy the additional arguments. I mean, please. A 250 year cycle that he can predict will bottom out in the next ten years? It just sounds like looking for arguments to support a predetermined prediction.

The central demographic argument is compelling, however.

If we are headed into an economic trough that will last 10 to 15 years, than equity investing is a losing game until the next up cycle starts. Better to focus on building up your cash position and acquire high rated bonds.

The good news for me is that if Dent is right, the next upswing in asset prices will occur just as I am getting ready for retirement. A rising market will fund my golden years.

Of course, Dent also wrote a book called Dow 32,000 a few years back, at the height of the tech boom, and we know how that turned out.

I’ll take it all with a grain of salt.

Crisis? What crisis?

A funny thing happened last week. I bought a car.

A small sport utility, actually. I leased the vehicle three years ago, and since it had low milage, I bought it when the lease expired. Plunked a couple thou down to keep the payment low and signed up for a 24 month payout.

Okay, you're still waiting for the comedy part to kick in, I know.

The funny part was how easy it was to get the loan. I walked into the dealership, signed some papers, and bang-zoom, drove off with the car. They'll send me the first statement at the end of this month.

Hahaha...wait, no that still isn't funny.

All right, so maybe it wasn't funny, at least not in the ha ha sense. More like it was funny in the peculiar sense.

You see, I keep reading about how the credit market is frozen up. I keep reading about how "we need to get the banks out loaning money again." But I didn't have a problem getting a loan. From where I'm standing, there is no problem borrowing money.

In all fairness, the interest rate was higher than I wanted to pay. My last car loan was five years ago, and at that time the best rate was 5%. This loan was at 7 percent. Given that the Fed funds rate is lower than it was five years ago, my new car loan is actually more profitable for the bank than the old loan was.

Also, I have a sterling credit rating, and I put a chunk of money down on the transaction. The odds of this loan going nipples up are vanishingly remote.

So maybe the problem is not that the banks aren't loaning money. Maybe the problem is that the banks aren't loaning money to poor credit risks.

Can you blame them? After all, it was loaning money to people who couldn't afford to pay it back that got the banks in trouble in the first place.

Quiznos Blinks

In the fast food sub sandwich category, the two biggest players are Subway and Quiznos. Due to a huge head start and relentless franchising, Subway is the dominant company in the marketplace. Their advertising has traditionally focused on differentiating their products from other fast food categories such as burgers and fried chicken.

Subway ads typically emphasize the fresh baked bread and the vegetable fixings piled on their sandwiches. They have positioned themselves as a lighter alternative to other fast food restaurants. Their spokesperson, Jared, has built an entire career around a friendly personality and the fact that he lost a lot of weight by eating Subway food.

Quiznos, on the other hand, has played off the category leader Subway. Quiznos ads have pointed out how much more meat is on their subs, and stressed the oven toasting. “If you want a sub,” they seem to say, “shouldn’t it be our sub and not theirs?”

As a consumer of both chain’s sandwiches, I can attest Quiznos does make a superior sub. What the Quiznos ads forget to mention is that it is also a more expensive sub. The price differential for the premium Quiznos product is $2-$3 more than Subway would charge.

Recently, Subway began a promotion centering around the concept of “the $5 foot long.” It started with selected foot long sandwiches being discounted down to a $5 dollar price. The promotion was so successful (aided by an incredibly catchy ad campaign) that the $5 foot long concept has been extended to all of their sandwiches.




The motivating idea behind the campaign is simple: more food for less money. It is the same animating concept behind McDonalds dollar menu.

Now Quiznos is responding with their own foot long product. The ads for the ciabatta bread sub emphasize the fact that it sells for only $4. In fact, the ad ends by repeating the price three times, albeit with a humorous twist. The new Quiznos ads are clearly a reaction to the Subway campaign. The message is “our sub is cheaper than their sub.”

The ads are funny and memorable. They feature the toasting oven as one of the characters in the ad. The oven’s voice is intended to resemble the HAL 9000 computer in 2001: A space Odyssey.




There are two ways to establish the value proposition in the mind of the consumer. One way is to emphasize the superior features or quality of your brand compared to the competition. The other way is to emphasize a lower price.

With their new ads launching this new product, Quiznos has abandoned the superiority strategy of brand building. They are now trying to sell a cheaper sandwich than Subway. Once you start competing solely on price, it is tough to build your brand up as a premium product.

In the long run, this new direction will hurt Quiznos more than the short term market share gain helps them.

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.

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.

BankTracker: How bad is it at my bank?

I have found a new toy. The BankTracker website has been set up to use publicly available data to rate the health of banks. The site takes information that banks are required to report to the FDIC every quarter, and creates a ratio of troubled assets to capital and reserves.

The troubled assets are defined as loans that have not received a payment in 90 days, loans that are no longer accruing interest (usually this means loans that have not received a payment in 60 days), and the category of other real estate, which means property that the bank has already foreclosed on. The foreclosed property is carried on the books as having a value equal to the outstanding balance of the loan at the time of foreclosure.

The troubled assets are then divided by the combination of Tier 1 capital and loss reserves to come up with a ratio. On the BankTracker website, the ratio is expressed as the percentage of troubled loans to capital. For example, if a bank had $100 million in capital and $10 million in troubled loans, the website reports the ratio as 10. If the website reported the ratio as 130, that would mean that troubled loans were equivalent in value to 130% of the banks capital.

So go ahead and look up your bank and see where they stand. I did, and my bank’s ratio was about 30. Their problem loans add up to about 30% of their capital. Not that bad, although the median for all banks was about 10. Still, my bank has enough capital to ride out the current mess, as long as the number of problem loans doesn’t get worse.

Even banks with ratios over 100 can still survive. If a bank has problem loans in excess of the amount of capital they carry, and cannot recover any of the value of those loans, the bank is technically insolvent. But that doesn’t take into account the recovery value of the assets. Take the other owned real estate (foreclosed properties). If the bank sells those properties for 50 cents on the dollar, they only write off half the value of the property.

For all of the problem loans, they will move from non accruing status to 90 days late, into foreclosure. After foreclosure, they will be other owned real estate. Eventually, the foreclosed houses will sell, and whatever fraction of the loan value the bank recovers will be added to capital.

I don’t know what criteria the FDIC uses to determine their problem bank list. But I would guess that anyone with a problem loan to capital ratio exceeding 150% would be an excellent candidate.

"...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.

Orchestra Tuning (Off-topic Post)

I went to a concert by our local symphony orchestra this evening. Before they began playing the first piece on the program, the musicians did what they do at all symphonies, all over the world. They tuned up their instruments.

Is there any more wonderfully expectant sound in the world than a symphony tuning up? It is a sound latent with all the potential that the future holds.

It is the sound of predawn lightening of darkness, just before the sun breaks over the horizon. It is the sound of the first cup of coffee in the morning, before the day's business begins. It is the sound of the mad scramble to get dressed and ready for an evening out, just before you step out the door.

Often times, I enjoy those moments of anticipation when the orchestra tunes up as much as some parts of the actual program. Judging by the videos that others have posted on YouTube, I'm not the only one.