Beer Wars

One of the big stories in the business press this last week has been that the Belgian headquartered beer maker InBev has come out with an offer to buy American beer maker Anheuser-Busch, maker of Budweiser and Michelob. Rumors of this deal have been circulating for several months now, resulting in a rise in Anheuser-Busch’s stock price, which as recently as March was trading for around $45 per share. InBev’s offer is at $65 a share.

The first thing to note is that this deal is almost certainly going to go through. InBev has the financing in place to make an all cash offer. On the day the offer was announced, it was at a price 10% above the closing price of Anheuser-Busch stock the day before the announcement. So the holders of Anheuser-Busch stock (the stock symbol is the cutesy BUD, by the way) collectively have a choice: take $65 a share for their stock, or watch the stock price slide back down into the low $50’s is the deal falls through. Hmmm, $65 or $55. Which one would I take? An old saying that involves wishing in one hand springs to mind right now.

Anheuser-Busch is a family run corporation. The current CEO is August Busch IV, who follows August Busch III. But AB is not a family owned company. The Busch family owns only 4% of the stock. They may have stocked the board of directors with their friends, but if they reject the offer, the board members will have a hard time explaining why they turned down InBev’s offer.

Anheuser-Busch is an acquisition target because of their very success. AB’s market share of the US beer market peaked at 52% a few years back. It has since dropped back to about 50%. If they got any bigger, it would attract attention from the Dept. of Justice Antitrust division. So they have no room to grow in the US market. But what the public stock markets demand above all else is earnings growth. As long as AB was growing, they would have a high stock price. Once growth cooled off, the stock price would sag. The single minded focus on the US market meant that they were slow to grow internationally. Low growth, combined with a lack of globalization, made Anheuser-Busch a target. The weak US dollar makes it a relative bargain.

But not that much of a bargain. Although InBev gets to show earnings growth by folding AB’s earnings in with their current operations, they have to justify paying a premium for Anheuser-Busch to their stockholders. The new owners are unlikely to increase sales, given that they would already control 50% of the market. Brewing is a pretty mature industry, so it’s difficult to see where InBev could squeeze any cost out of manufacturing or distribution. They could save money by cutting back on advertising and brand building in the short run (so long to the Clydesdale commercials at the Superbowl), but longer term that will lead to a loss of market share, and lower earnings.

So aside from increasing InBev’s earnings in the short run, I don’t see any logic for this deal in the long run. This may be why InBev’s stock price has been dropping on the Belgian stock exchange.

If this deal does close, I can predict two consequences: One, a less interesting Superbowl come next February. Two, celebrations by the folks who run Miller, Coors, and Sam Adams.

Ed McMahon

“Call no man happy, until he’s dead.”—Herodotus

Every so often real life intervenes in an argument, bringing a concrete example to an abstract argument so spot on that you could not make up a more telling example. Such an event can be pulled from last week’s news stories.

For those who missed the story, Ed McMahon’s house in Beverly Hills is being foreclosed on. Yes, that Ed McMahon. “Here’s Johnny!” “Send in your reply to Publisher’s Clearing House. You may already be a winner.” That guy.

Ed McMahon earned millions annually as a top ranked television personality and pitchman. Make that: he earned millions annually for decades. He is now over $644 thousand in arrears on a $4.6 million mortgage is took out only a few years ago.

When asked about why he is in arrears, his response is that it is because of his inability to work for the last eighteen months due to a neck injury.

The dude is 85 years old! Who the heck goes through life thinking that having to work in your eighties to keep from getting evicted is a workable game plan?

I have been arguing that true wealth is not related to your lifestyle, or to how much you earn. True wealth starts when you have the financial security to continue with your current lifestyle, even if you can no longer continue working. Exhibit number oneof how not to do this is Ed McMahon. I rest my case.

The Three Zones of Wealth

In my last post I talked about wealth, and how you could define being wealthy. Being wealthy is not defined by your earned income, and is certainly not defined by your lifestyle. With the collapse of the housing bubble, we are seeing plenty of people who are not only losing their jobs, but whose lifestyles were supercharged by pulling equity out of their homes and spending it. The lifestyle was never sustainable over the long term, and the job loss just accelerated the crash.

For me, wealth means passive income. Loosely defined, passive income is money that comes to you with little or no work on your part. Another way of putting it is with the old saying “Have your money work for you, instead of you working for your money.”

Just because you have passive income doesn’t mean you’re wealthy, however. You have to have enough of it. I’ve got both interest and dividend income that I list on my tax return, but I’m a long way short of being able to retire.

And that brings me to what I really want to write about today. I view wealth as happening in three zones, each of which defines a different way of looking at what it means to be wealthy.

The first of these zones is what I call retirement wealthy. Sometimes I hear this being described as financial independence. You enter this zone when you have enough passive income to pay for your current lifestyle. Once your dividends (or royalties, or rent, or bond interest) are enough to cover your expenses, you’ve got a choice: keep working for income, or retire and do what you want to do. I think this is what most people would define as being rich.

To achieve this state, you have to work both offense and defense. Offense, in terms of increasing your passive income (maxing out your 401K, e.g.) and defense, in terms of decreasing your living expenses (drive used cars, clip coupons).

The next zone of wealth starts where considerations of defense can fade away. You want to go to Tahiti for a week? Charter the jet! Seventy-two inch TV catch your eye? Buy it! This is the level of wealth where you have people to handle the mundane details of daily life. You don’t sit around the house all day waiting for the cable guy. That’s what the housekeeper is for.

Once you have entered the first zone of wealth, the longer you keep working, the closer you get to the second zone. After all, if you are not spending all of your passive income, then it will continue to compound on you. Money is the only animal that will only breed in captivity.

The third zone of wealth is what I call Future Old Money. I saw an interview with the country singer Garth Brooks once. One of the things he said was “I have more money than my children’s children will be able to spend.” Future old money. Fifty years from now, Garth’s grandkids will be toasting him at their dinner parties for making their lives of leisure possible.
Most personal finance writers concentrate on the first zone of wealth. After all, that is the zone that all of us can reach. It only takes time, discipline, and a modicum of knowledge. And most of the focus is on what I call defense, reducing expenses, if only to free up capital to invest.

To get into the second and third zones, however, you’ve got to win big. Even if we saw a way to do that, most of us don’t have enough appetite for risk to get there. I certainly don't.

The Nature of Wealth

Last week I was in Nashville, and the friends I was with took us on a tour of Belle Meade, which is the high rent district of Nashville. We passed mansion after mansion. Acres of perfectly groomed landscaping. Then we passed the Belle Meade Country Club. My friends insisted that only “old money” could belong. No parvenu with only a couple of hit country albums need apply.

This started me thinking on the subject of wealth (admittedly, a topic never too far from my thoughts).

How do define wealth? How would you know if you are wealthy? If you are not yet wealthy, but hope to be, how do you define the goal?

A lot of people would define it in terms of your possessions and entertainment. If you have the biggest house, the fanciest car, the most toys, you’re wealthy. Similarly, if you fly to Europe on vacation, or dine out at the most expensive restaurants, you’re wealthy.

I’m not sure I agree with that stance. Consider the real estate bubble, now collapsing. There were plenty of people, especially in the more overheated markets of California and Florida, who repeatedly refinanced their houses, cashing out the equity. They then spent the cash on the very things listed above. But now that the boom has come to a halt, those people are losing their lifestyle, along with the ability to refinance.

If your lifestyle has that little security, I would not consider that as true wealth.

Other people might define wealth in terms of the income that someone earns. “He’s a doctor, they’re all rich.” “CEO’s make the big bucks.”

I think the problem with that definition is that you have to stay on the treadmill to keep earning that money. It’s kind of like a shark: if you stop swimming, you sink to the bottom and die.

So for me, wealth is an issue of how much passive income you have. Passive income is money that comes to you without your having to work for it. The source of the money is something you own, or even who you are. Dividends. Profits from a business that someone else manages. Interest on bonds. Even capital gains from selling appreciated assets (after all, somebody had to make money in California real estate). All of those are examples of passive income.

Passive income can also come from pensions and social security. Even though you had to work to pay into the system, you aren’t working for the money now. As long as you can manage to stay warmer than room temperature, they are going to continue sending you checks.

So, by my definition, if you want to be wealthy, you need to develop sources of passive income.

Card Wars

I realized something today. I don’t know the interest rate on either of my two credit cards. I use an American Express card for most purchases, and I have a Visa for the places that do not accept Amex.

The topic came up because I was talking about personal finance with a coworker at lunch today. We were discussing how people can get in over their heads with credit cards, and how that can force people into bankruptcy. She told me that she didn’t understand that, because she had a low rate on her credit card. “It’s only 2.9%, but I don’t even pay that because I pay off my balance every month.”

I also pay off my balances in full every month. And because I have been doing that for as long as I can remember, the interest rate on the card is irrelevant to me. What is relevant to me is that I get air line miles from my credit card.

The important thing to remember about the credit card industry is that they make money from two income sources. First, they make money from the interest charges paid by cardholders. But a more reliable source of income is the fees they charge merchants to process the transaction. These charges can be upwards of 2% of the cost of the item being charged.

So let’s say you’re American Express. Most Amex users are businesses who pay their bills in full every month. When I charge something using my card, Amex pays the merchant 98% of the purchase price right away. I pay Amex 100% back, on average a month after I buy the item. If you are getting 2% a month for the use of your money, that becomes a 24% rate of return on an annual basis.

Since American Express is raising capital in the public markets, their cost of capital is (just a guess) around 6% a year. With borrowing money at 6%, and getting a return of 24%, the differential is an 18% return. If you are making that kind of return, you can offer considerable rewards as part of your marketing plan.

But not considerable cash back. If Amex offered 1% cash back, that would lower the differential to 6% a year, which doesn’t leave a lot left over after operating and marketing costs are taken out. So the card companies that offer that kind of cash back are depending on the first source of income: interest charges paid by cardholders.

So far, I know of only one credit card company that would let me check out the tradeoffs involved in getting rewards such as cash back. So I checked out the Capital One Card Lab, which you can find here. With excellent credit, a menu of options pops up. Choosing one option, like 1% cash back, removes other options, like some of the interest rate choices.

Ohhhh, a game! Let’s play!

After playing a few rounds, I settled in on 2% cash back on gas & groceries, with no annual fee. If I agreed to a 20% APR, they’ll set the APR at zero for the first year. So I could use their money for a year, while my cash was earning interest in a money market account. All I have to do is remember to pay it off in full at the end of the year, and every month thereafter, and I never have to pay that 20%.

A 2% reduction in gas and grocery costs, paid for by someone else? This is a game I just might play.

Politicians are the same all over the world.

There was an article in the New York Times today, regarding the reaction by Indian economists and politicians to comments made by President Bush about the increase in global food prices. In a news conference in Missouri on May 2, part of the President's answer to one question was the following, referring to the growing middle class in India:

“When you start getting wealth, you start demanding better nutrition and better food, and so demand is high, and that causes the price to go up.”

This has apparently ignited a storm of criticism in India. You can read the article here. The comments cited by the Times ranged from insulting President Bush's intelligence (nothing new there) to claims that Americans are causing food shortages in Africa by overeating. This puts me in mind of those dinner time conversations growing up. You know the one:

"Billy, you clean your plate. Think of the starving children in Africa." "But ma, I already weigh 190 pounds, and I'm only 12."

That the Indians have taken umbrage with the President's remarks shows that they have collapsed the distinction between explaining an event, and placing blame for the same event. Globally, grain prices have risen significantly in the last year or so. Why?

Part of the answer is that demand for grain is up. Not from Americans. We're huge overeaters, but we've been the most obese people in the world for at least a decade now. Well, with the rapid development in China and India over the last decade, meat consumption in those countries has gone up, right along with rising incomes. Not to American levels, but higher than it has been. The increase in meat consumption helps explain why global demand for grain has increased.

The situation in India and China has changed, and knowing that helps our understanding of the situation. That's a long way from blaming them. Americans are the last people in the world to blame anyone for wanting to eat better. If anything, we're more likely to start sharing recipes. Still, the Indians are insulted, and their politicians have turned around and started blaming us for the rise in food prices.

And in an odd way, that gives me some hope for a better world. Their politicians are just as capable of knee jerk reactions that make them sound like idiots as ours are. Maybe by focusing on our similarities (even the embarassing ones) instead of our differences, we can build bridges of understanding to other parts of the world. This incident may help us to realize that despite our surface differences, we're really all the same inside.

Nah!

Pennies From Heaven: An Update

In the weeks since I first posted about picking up pennies off the ground, I've managed to find one penny lying around. Then on Friday I picked up a dime outside of the movie theater, and Saturday morning I spotted a quarter in a public park. That got me thinking about the subject again.

For the last month I'm up about forty cents. Clearly picking up change is not going to make a meaningful difference in one's financial status, whether you make the effort to bend over and grab, or not. So if there is going to be any value to the practice, it lies in the metaphorical realm. That is to say, that picking up loose change becomes a shorthand expression, an encapsulation if you will, of your entire outlook towards your finances. By defining who you are, the metaphor can then influence your financial behavior in other areas of your life.

The simplest way of expressing the metaphor is "I'm so cheap I pick up pennies in the street." Viewed that way, the practice becomes a physical reminder of the importance of frugality. If the memory of the effort expended to gain every penny is actually imprinted in into your muscles, you are less likely to be extravagent with your dollars.

I want to take the metaphor to another level, however, and view the practice as a expression of how we look for opportunity. I think there is a risk for searching for pennies on the ground. That risk is that we can become focused on looking on the ground, to the exclusion of keeping our eyes looking at where we want to go.

I prefer to take a more positive take on the situation. I like to think that although my focus remains on where I'm going, I have expanded my attention to take in more of what's going on around me. This expanded focus allows me to spot opportunities that might otherwise seem to humble to be worth pursuing. Sometimes those opportunities pay off bigger than you expect.

Like looking for pennies, and spotting a quarter.

Energy Saving Tip: Wash Your Car

I washed and waxed my car this weekend for the first time in months. The weather finally cooperated, with clear skies and a warm sunny day. When I finished, I felt extra virtuous: not only did the car need a bath, but I improved my fuel efficiency at the same time.

Here's the science part: A dirty car has a rougher surface finish than a clean, freshly waxed car. That rougher surface finish creates more wind resistance, forcing the engine to work harder to overcome the drag. Hence, washing your car gives you better mileage.

Frankly, I'm not sure that the gain is all that significant. You probably get a much bigger mileage boost by driving with the windows closed. Driving with the windows down turns your car into a giant wind scoop, which can increase drag by up to 10%. But every little bit helps.

Besides, I was going to wash the car anyway. I think that one of the keys to saving money is to find ways to save by moving in a direction you were headed anyway. If you see a coupon for something you use regularly, cut it out. You don't have to be looking for pennies on the ground, but if you spot one, pick it up. (I picked up a penny today on the floor of my gym.) Saving money doesn't always have to be about sacrifice or struggle. Sometimes it can be about spending a pleasant hour or two outdoors on a spring day.

By the way, my ride looks great.

Great Moments in "Duh"

Here’s a headline from today’s New York Times:
As Pump Prices Soar, Buyers Flock to Small Cars

Repeat after me: “When man bites dog, that’s news. When dog bites man, that’s not news.”

There was one piece of interesting information in the article, however. Last April, four cylinder engines outsold six cylinder engines in the US. What is interesting is that the milestone was reached, not that the market share of smaller engines increased.

The market share effect is simply a rational response to changed market conditions. When gas prices go up and consume a larger share of income, people find ways to consume less gas. In the short run, they try and drive less. You eliminate unnecessary trips; combine multiple errands into one drive. These are behavioral changes.

Longer term, people make bigger structural changes, like buying smaller cars that get better mileage. For many families, the cars they drive are either the first or second largest concentration of capital they have, after their houses. As that capital is fully depreciated, and comes up for replacement, people are buying more efficient vehicles.

Despite all the complaining about high gas prices, however, I haven’t seen any increase in carpooling. This indicates to me that people are more willing to devote higher percentages of their income to gas, rather than make that big a behavioral change. At least so far.

So when we see a shift in the number of carpoolers, that will be news.

Pennies from Heaven

As I was walking from my car into the grocery store this afternoon I saw a penny lying on the pavement. I picked it up, and that started me thinking: What a country! The streets may not be paved with gold, but they are paved with copper clad zinc slugs!

Yes, I am one of those people that picks up pennies that other people have dropped. I know that most people will not bother. Not worth the effort, they say. Heck, obviously the people who were the owners of the coins didn’t think it was worthwhile to retrieve the pennies they dropped.

My feeling is that it is a worthwhile activity. Taking a second or two to bend down and gather money up off the street is a way of reminding myself of the importance of frugality. If I will expend the effort to bend down and pick up a penny, than I should work that much harder to save real money by avoiding unnecessary expenses and getting better deals.

In addition to being a physical reminder of the need for fiscal vigilance, a sort of metaphorical value, I also receive real value from this habit. They may only be pennies, but it’s still money, after all.

If it takes me two seconds to bend down, pick up the penny, and regain my stride, that works out to a pay rate of $18 per hour. My compensation at work is at a higher rate than that, but it’s more money than I would otherwise make while running errands.

This makes me curious about how much money I can actually pull off the streets. So as part of this blog, I am going to start keeping track of how many pennies I pick up. Last week, there was one in the parking lot at work, three coming out of the movie theater on Friday night, and then the one going into the grocery store this afternoon. So far I’m up to 5 cents.

Mmmm. Maybe I shouldn’t quit my day job just yet.

Shoulda, woulda, coulda...

Watching the early returns from Pennsylvania, Hillary Clinton is projected to win the Democratic primary. No big surprise there. The real question is whether she will win over Barack Obama by a big enough margin to convince Democratic Party superdelegates that they should back her instead of him at the convention later this year. At this point Hillary is extremely unlikely to catch up Barack in the number of ordinary delegates going into the convention.

We may actually see a real live political convention, complete with back room deals, before this is all over. As opposed to the 100% scripted and choreographed lovefests that have taken place every four years for the last few decades.

But tonight I actually want to shift the focus to Florida and Michigan. Last year the state Democratic party apparatus in both states decided to move up their primary without getting approval from national party headquarters. To punish the renegades, and to keep the other states in line, the national party stripped both states of their delegates to the national convention. To hold with party discipline, the candidates agreed not to campaign in either state (well, Hillary did show up in Florida, put she pulled out as soon as she came under sniper fire). Barack Obama was not even on the ballot in Michigan. So the fourth and the eighth largest states were shut out of the nominating process.

So why did both Florida and Michigan decide to move their primaries? They did it because the conventional wisdom (which is not the same thing as convention wisdom) was that Super Tuesday would sew up the nomination, back on February 5. After a candidate wins enough primaries to mathematically guarantee the nomination, any primaries after that are moot, and the winning candidate essentially coasts until the general election campaign starts after both parties have their nominating conventions. You haven't seen John McCain buying a lot of television ads in Pennsylvania this month, have you?

Both Florida and Michigan wanted to be "relevant" in the primary season. The party leadership in both states wanted the candidates to campaign (i.e. spend money) in their states, so they risked, and incurred, the wrath of the national headquarters.

The irony here, of course, is that the conventional wisdom was dead wrong. The Democratic nomination wasn't sewed up on Super Tuesday. Not even close. So if Florida and Michigan had left their primaries until March, as originally scheduled, they would have been crucial battleground states for the Democratic nomination. As such, they would have received a ton of attention, and money, from both Clinton and Obama.

Instead, that attention and money have been poured into Pennsylvania for the last month and a half.

For the state party leaders in both states, I guess that it's appropriate that the symbol of the Democratic Party is a donkey.

A Modest Proposal

My company drug tests all applicants for employment. That includes contract employees that we hire through a labor staffing service (that’s a fancy way of saying we use a lot of temps). If you fail the drug test, you don’t start work.

We also require periodic random drug screens. For the temps, you only get one bite of the apple. You fail a random test, you do not pass GO; you do not collect $200 dollars. Your assignment ends and the temp service fires you.

For our regular full-time employees, the policy is more lenient. If you fail one drug test, you get the option of being suspended while you go through drug rehab counseling. By the way, the employee has to pay for the cost of rehab. If the employee does not pay for rehab, or gets a second positive drug test, we fire them.

If someone is terminated for failing a drug test, they are not eligible for unemployment benefits. It’s treated the same way as if you had quit your job. One other place employees are drug tested is right after any workplace accident. A positive drug test there leads to a denial of worker’s compensation benefits. “Stitch yourself up there, buddy. Bet you wish you hadn’t done those lines of coke this weekend, huh?”

The laws allow the stoppage of benefits to drug users. The laws allow it because as a democratic society, we have collectively decided that the use of illegal narcotics is harmful to society as a whole. So we allow significant negative consequences to befall people caught using while they are employed. And drug testing in the first place is allowed because of free association. Nobody holds a gun to your head and tells you to go to work for a company that drug tests. The individual’s freedom of choice is preserved.

My question is this: If drug use disqualifies you from unemployment and worker’s comp benefits, why shouldn’t it disqualify from other types of benefits? Welfare benefits or disability benefits, for example. If random drug screening was a condition of receiving benefits, that would have to make a dent in the demand for illegal drugs, wouldn’t it?

I would like to hear what the arguments are against such a proposal. If we tried to put a policy like this into place, somebody would scream that it wasn’t fair. But I don’t see it as unfair.

If you are going to take taxpayer money, surely the taxpayers have an interest in making sure you are following the rules that society sets up. After all, nobody holds a gun to your head and makes you sign up for welfare.

It’s your choice.

The Law of Unintended Consequences

I think that one of the unwritten laws that govern economic activity is this: Whatever you pay for, you get more of.

By this I mean that once you establish a market for anything, suppliers will come forward to meet the demand for that product or service. If all of the supply is bought up, those suppliers will go out and produce more, operating on the assumption that if someone paid for it before, someone will pay for it again.

Jay Leno once did an ad campaign for Frito-Lay that expressed this concept better than I can. The tagline for the ads was “Crunch all you want. We’ll make more.”

Ordinarily, I have no objections to free markets and how they operate. Indeed, I’ve spent most of my adult life working under this principle. Finding ways to reduce the cost of what someone wants to pay for. Trying to anticipate when the next order is coming. Planning to increase capacity to supply more. Of course, I’ve always worked in legal industries. What makes free markets work is the buyers freely giving up their money to acquire what the sellers are selling.

But what about markets where the buyer has to buy, as long as the sellers are out there? Remember: Whatever you pay for, you get more of. If you keep paying, over time you’ll get more suppliers.

Welfare markets work like that. Aid to unwed mothers originally started out as a way of ameliorating poverty and protecting children. But what the government is paying for is women who aren’t married to have children. Not surprisingly, the number of women with children born out of wedlock has exploded in the past few decades.

Another area where the payer has no choice but to pay is in health care. Third parties pay for most of the health care in this country. The consumers of health care, the patients, don’t write the checks. The government, through Medicare and Medicaid, and private insurance companies, are how most Americans finance their health care. Health insurance is a pretty heavily regulated industry. And one of the regulations says that insurers have to pay for procedures, tests, and drugs that are “medically necessary.”

Not the cheapest way possible. Not the most cost effective. Whatever the doctor deems medically necessary, that’s what the insurer has to pay for.

So let’s suppose you are a supplier to the health care industry, like a medical device manufacturer, or a pharmaceutical manufacturer. Do you bend your efforts to reducing costs, or do you work to develop new treatments, and then work towards getting doctors to recommend those new methods? The latter does lead to progress in medical technology, but it also drives costs ever upward. Upward to the point that increasing numbers of people cannot afford insurance coverage.

“Crunch all you want. We’ll make more.”

Feet of Clay

The ongoing turmoil in the US credit markets appears to have snared another victim. General Electric announced 1st quarter earnings that were sharply lower than what they had led investors to expect as little as a month ago. The gunslingers, oops, sorry, the professional investors who work on Wall Street don’t like surprises, and they hammered the stock. The price for a share of GE dropped 12% on Friday, which was the largest one-day decline for GE in over twenty years. The last time GE stock dropped so much was in the stock market crash of October 1987, when the Dow Jones Industrial average dropped 25% in a single day.

The damage to earnings was apparently not caused by the industrial and high tech businesses, which are doing well. Companies all over the world are still buying jet engines, power plants, and MRI scanners. The financial services businesses in the GE portfolio did not provide the profits that had been estimated.

The guys who run GE know that Wall Street punishes surprises on the downside. So there are only two possible explanations for missing their earnings targets by so much:
1. Senior management does not know what is going on inside the company. That is, losses in GE Capital were piling up, but no one wanted to take the write off, or tell the higher ups about the losses.
2. Things turned around so much in the last two weeks of March that they overwhelmed the progress of the previous ten weeks.

Jeffrey Immelt, the CEO of GE, choose what was behind Door #2, saying: “the extraordinary disruption in the capital markets in March affected our ability to complete asset sales and resulted in higher mark-to-market losses and impairments."

These results are important because GE, due to the size and breadth of their operations, is considered a bellwether for the US, and indeed, the global economy.

Also, GE is considered an unusually well managed company, with excellent risk control. In the annual report for last year, much was made of the fact that GE had no debt that was secured by sub-prime mortgages as collateral.

If GE is having problems in the financial markets, than other banks and investment companies will be having problems as well. Even with all the announced write downs and loans made by the Federal Reserve, we’re not out of the woods yet.

I keep reading the terms Bear Stearns and bailout used in the same sentence, or at least in the same paragraph. Usually the gist of these news stories is that Wall Street (i.e. Bear Stearns) got a bailout, therefore fairness demands that Main Street (i.e. the poor schlemiels who paid too much for their house) also get bailed out. I've got two problems with the folks who make this argument.

First of all, next month the Federal government is going to mail out checks of up to $1200 to almost everyone in America who filed a tax return. People who have not paid taxes in years, like many Social Security recipients, are being advised to file for 2007, in order to reserve their place at the public feeding trough. The cost of this government largesse will total $150 billion. Surely that's enough of a bailout to satisfy the most ardent of parachutist, isn't it?

But more to the point, it is hard to see how the Bear Stearns deal could be considered a Federal bailout in the first place. To make the deal go, the Fed gave $30 billion to JP Morgan Chase, the acquirer. In exchange, the Fed received a portfolio of Bear Stearns assets with a book value of $30 billion. For political reasons, the cash given to JP Morgan was called a loan, and the Bear Stearns assets were called collateral. Frankly, these assets are certainly not worth the book value in today's market. However, the Fed does not have to sell the assets on any timetable. In the fullness of time the Fed may be able to recover most of the money they put into the deal. There will almost certainly be an eventual loss, however, and that loss will be borne by the taxpayers.

The Fed took this action not to bailout Bear Stearns, but to keep the financial markets from freezing up in the panic that would have accompanied a bankruptcy filing by the fifth largest US investment bank. That panic would have hurt a number of large financial institutions. Institutions like the pension funds that pay pensions to retirees. Institutions like the insurance companies that pay to rebuild your house if it burns down. Institutions like municipal governments that issue bonds to build roads and sewage systems. Institutions that serve local Main Street interests.

Meanwhile, what happened to stockholders of Bear Stearns stock? Many of these stockholders were Bear Stearns' employees. As a matter of fact, the employees owned about 30% of the company. In January 2007 the stock was worth $170 per share. The Friday before the deal with JP Morgan, the stock was still worth $30 per share. The latest offer from JP Morgan was $10 a share.

So. over the weekend, two thirds of their equity was wiped out. Adding insult to injury, large numbers of the former owner/employees are facing pink slips in the very near future.

Calling this a bailout is like saying that what Henry the Eigth did to Anne Boleyn was a haircut.

Sometimes It's Just Hail

I'm a contrarian by nature. Hand me silver, and all I see is the lining to a cloud. As far as I'm concerned, there is no glass so overbrimming that evaporative losses won't eventually make it half empty. When things look bleak, I remind myself that it is always darkest just before it gets really dark. But although I discount good news, I also take news that the world is coming to an end with a grain of salt.

A case in point came in today. Swiss banking giant UBS announced that it was writing off $19 billion in assets related to subprime mortgages in the US. This is on top of the $18 billion that they wrote off less than six months ago. UBS is seeking to raise $15 billion in fresh capital to shore up their balance sheet, and oh yes, they've pitched their chairman out the airlock for orchestrating this debacle. "Can you breathe vacuum, Herr Chairman?"

The headline for this story is obvious: "UBS Writes Off $19 Billion." I think the critical item comes a little deeper than the lead paragraph, however. The asset write off came as part of UBS's announcement of first quarter earnings. For the first quarter of 2008, UBS lost $12 billion, including the write off. A little simple math tells us that without the subprime mortgage problems, the bank would have earned $7 billion in the last three months.

That is the real story here. The banks taking the hits that have shaken the global financial system are large diverse organizations with multiple lines of business that are still very profitable. In time, they will work their way out of the mess that they created, and will begin providing a return for their investors again.

We're not out of the woods yet. Housing prices are going to fall further, and we are going to see further write downs on securities backed by unpaid mortgages. We haven't seen the full effect of the collapse of the housing bubble, as it plays out on the wider economy. There will be a lot of pain, and a lot of bad headlines still to come.

But the sky isn't really falling. At least, not today.

Caught with Her Hand in the Cookie Jar

Hilary Clinton is getting a lot of flak for making a speech were she claimed that on a trip to Bosnia, her plane landed under sniper fire, and she had to make a run for the motorcade. Unfortunately, television coverage of the event shows nothing of the kind. Hilary and Chelsea wave frm the plane, saunter down the ramp, and go through a welcoming session right there on the tarmac, complete with little girl handing over a bouquet of flowers. About the only attack taking place is possibly an allergy attack from the pollen.

Today HRC admitted that she "misspoke." To paraphrase, I guess that depends upon what the definition of "misspoke" is.

Okay, look. Yesterday my production manager and I had a disagreement about whether total employment at our company had peaked at 98 employees or 101 employees in 2007. After pulling payroll records, I had to agree that I was wrong when I claimed only 98, instead of the correct 101. That's misspeaking.

If I had claimed that the extra 3 employees didn't count, because they were actually extraterrestial aliens who had landed a flying suacer at the company picnic and applied for jobs, that would be a little more than misspeaking. That would be making up events out of whole cloth.

If Hilary had said that she came under sniper fire in Bosnia, but it was actually Dafur, that would be misspeaking. But other than the start of deer season in Arkansas, when is it even remotely possible that she was shot at? And if she hasn't been shot at, how could she have come up with the story that she had?

Also interesting is that in a later interview she claimed "Last week for the first time in twelve years or so, I misspoke." She actually knows that its her first mistake in 12 years. I can't even be sure what I had for dinner last Wednesday, but she's sure that she hasn't made a false claim in over a decade. It makes you wonder what she could have said that made such a strong impression.

"Don't worry, Bill. I forgive you."

Bad Law I, Starbucks 0

Here's a quiz for you: Next time you pop into Starbucks for an infusion of caffeine and ambience, take a fast look at the staff working the store. Now, quick: who's the boss? Is it the person running the expresso machine, the person running the register, or the person grinding coffee in the back? Thinking back on my recent visits to my favorite coffee emporium, I honestly couldn't tell you. Sometimes I've gone in and found only one person working the store. I guess that he's the one in charge on those occasions.

This matters because in California, there is a law that says that members of management cannot share in pooled tips. Last week a judge in San Diego ruled that Starbucks had violated this law because they had allowed shift supervisors to share in the tip pool. The judge slapped the company with a fine of...$100 MILLION dollars (when I say that I'm tempted to touch my pinkie to the corner of my mouth, ala Dr. Evil).

I think this decision is wrong for a couple of reasons. First of all, it perpetuates the us versus them view of the workplace that runs contrary to the way a lot of top performing organizations function these days. Think back to your experience of Starbucks. If you cannot tell who the boss is, it's because everyone is working. There's no foreman there behind the counter. Think of a football team. The quarterback may run the plays, and he may get paid better than the linebackers. But no one ever gets confused that the quarterback isn't playing the game as a member of the team.

I don't know many specifics about how Starbucks runs their stores, but I suspect that the shift supervisors are not really what I would consider management anyway. Managers have hire and fire authority. Managers schedule the associate's work shifts, and formally review the other team member's work performance. If the Starbucks shift supervisor does not do these things, it is hard to consider that person as a manager.

Finally, this judge's decision irritates me because it takes away my ability to make up my own mind. When I'm standing there with a latte in one hand and my change in the other, thinking about whether to put the change in the tip jar or back in my pocket, just who am I tipping? More often than not, I'm rewarding the worker who jumped in where needed to keep the line moving, or the worker who showed the newbie how to run the coffee grinder. Before last week, I didn't even know that Starbucks had shift supervisors, but I'll bet there the ones who set the tone for the whole experience.

And this judge just ruled that I shouldn't be allowed to tip them.

Let's hope Starbucks wins on appeal.

Bear Stearns: RIP, Part II

In my last post I talked about the collapse of Bear Stearns in terms of liquidity. What happened was an old fashioned run on the bank. But the other half of the story was leverage.

Leverage is a measure of the ratio of debt to equity, equity being the cash money that investors put in to a company. The use of debt allows you to "lever up" the rate of return on equity. Let's work through an example to illustrate how this works.

Suppose you buy a slightly run down house in a decent neighborhood for $110,000. You put another $10,000 into fixing the house up over six months, then list the house for sale. Six months after that you sell the house for $135,000. So your profit is $15,000 (you put in $120,000 total, and got out $135,000). The rate of return on equity is profit/equity, or in this example, .125 or 12 1/2%. Which is okay, but not spectacular. Don't quit your day job.

Now let's see what leverage can do for you.

Work the same example, but assume we buy the house with $10,000 down and an interest only loan of $100,000 at 7%. Same $10,000 to fix the house, same $135,000 sale at the end of the year. The first thing you do is pay off your loan, so reduce the sales price by $107,000. Your profit is lower, because you got $28,000 less the $20,000 you put into the house. So your total profit is only $8000, versus $15,000 in our first example. But look at rate of return on equity. In this case, return is 8/20, or 40%. Houchee mama! By using 5 to 1 leverage, we've increased our rate of return by a factor of three. Why wouldn't you want to use leverage? Let's play this game again!

Well, the problem is that leverage can work against you as well as for you. Remember, the guy who holds the debt always gets paid back first. Let's run our second example again, only this time we'll assume that the real estate market is tanking, so instead of selling the house for 12.5% more than we put in, we sell for $107,000, or about 11% less than what we put in. We pay back our loan for $107,000, leaving us with...zip, nada, bubkus. Your equity of $20,000 got wiped out. Game over.

That's with 5 to 1 leverage. Bear Stearns had $11.5 billion worth of stockholder's equity. They had leveraged that to control $395 billion worth of assets on their balance sheet. When you are leveraged at 34 to 1, it only takes a three percent drop in value to wipe out your equity. Game over.

Bear Stearns: RIP

The big business news this Monday is the acquisition of Bear Stearns by J P Morgan Chase over the weekend. At the close of the market last Friday, Bear Stearns was valued at $30/ share. When the deal was announced on Sunday, Morgan was only paying $2 per share. In addition, the Federal Reserve agreed to loan Morgan $30 billion dollars, taking as collateral mortgage backed bonds in Bear's portfolio. Basically, the Fed (by which I mean the taxpayers) took the bonds most likely to go into default off JP Morgan's hands.

This looks like a steal for JP Morgan. They're paying $2 a share for a company with a book value of $80 a share. Even if it is written down by half, the assets would still be worth 20 times what Morgan is paying for them. The real estate held by Bear Stearns alone is worth about four times the purchase price.

Bear Stearns was one of the five largest US investment banks. The employees owned 30% of the stock. Their stake is now valued at less than $5500 per person. The Chairman of Bear Stearns, John Cayce, was one of the richest Wall Street executives, with holding in BS stock worth oven $1 billion less than a year ago. What could have convinced the management of Bear Stearns to take a deal that essentially wiped them out?

In a word: liquidity.

Liquidity is a measure of how easy it is to convert assets into cash. Cash is always the most liquid asset of all. Normally, stocks are almost as liquid as cash. Call your broker, tell him to sell, and you can have cash within a couple of hours. If you have a store that has inventory, you will usually liquidate the inventory every couple of months. Anyone who has ever tried to sell a house in a down market knows that real estate can be one of the most illiquid forms of asset.

Bear Stearns ran their financial trading operations using a lot of borrowed money. Some of the money was given to the firm by it's clients. Some by other banks. What happened last week was that these parties started to pull their loans from Bear Stearns. In order to keep operations going, Bear Stearns would have had to sell assets from their portfolio. The problem is that right now, no one is buying mortgage backed assets. That market will probably come back in a few months, but Bear Stearns needed money right now.

Basically, the brightest minds in finance became part of a panic driven run on a bank. And a Wall Street titan that survived the Great Depression is no more.