By William Patalon III
Wall Street created the U.S. housing bubble and now it’s missing the real estate rebound.
And Andrew Waite understands why.
Waite is the publisher of the Personal Real Estate Investor, a glossy magazine that focuses on investors who buy houses or condos to manage for income or to fix up and sell for a profit. But he’s not some industry cheerleader whose statements are nothing but spin.
He’s a true expert on the U.S. housing sector who goes out of his way to "educate" journalists about the true state of the American housing market, and who criticizes most of the "indicators" in use as useless and irrelevant. Plus, as a onetime Wall Street venture-capitalist who subsequently joined Silicon Valley’s Sand Hill Road private equity crowd, Waite really understands how the Wall Street investment game is played - and, in the case of the U.S. housing market, the missteps Wall Street made and why.
"Wall Street analysts and economists do not understand the housing industry," Waite told Money Morning in a recent interview. "While stocks and bonds are relatively simple to analyze, housing is anything but. Unlike stocks, housing is a non-tradable asset."
But through the creation of mortgage-backed securities, Wall Street tried to transform housing into a tradable asset. That lack of understanding set the stage for the housing bubble. And it’s the same miscalculation that is keeping the big-money crowd from understanding that the housing market may have already bottomed - and may well be on its way back up.
Let’s look at both miscues.
Building a Bubble
Stocks and bonds are "tradable assets." They trade on central exchanges - in a very efficient manner - and play well into the kind of mathematical averaging that paves the way for all sorts of indices (the Standard & Poor’s 500 Index), and sub-indices (the Dow Jones Transportation Index).
That’s not the case with housing, which is very granular in nature - meaning how housing does in one neighborhood differs greatly from how it does in another. Housing is a "non-traded" asset because it is hard to trade - and when it does trade does so in a highly inefficient market.
As Waite says, housing is referred to as "real" property for a reason: Unlike stocks or bonds, which are paper representations of the underlying asset, housing is the asset itself. People live in houses, and most don’t buy them as investments - they buy them to live in. The typical house is owned for five to seven years, and only about 5% of the U.S. housing stock turns over in a single year. In a "normal" period - by that, I mean a stretch that’s not artificially souped up by the unrealistically loose credit that led up to the subprime-mortgage debacle - prices escalate perhaps 3% to 4% annually. And there aren’t the whipsaw pricing patterns that we see with stocks.
Even so, as part of its mission to transform housing into a tradable asset, Wall Street designed a reporting system that, true to form, was badly flawed, Waite says. The measures applied to the market - sample size, methodology, and statistical presentation - work well for assets that are dynamically traded, as stocks are. But they don’t work for housing:
* Stocks are analyzed by looking at the underlying company’s fundamentals, meaning the conclusions reached are very much tied to the specific earnings power of that firm.
* Housing, by comparison, is analyzed make "illogical" generalizations about the market that fail to reflect reality.
* Stocks are analyzed in a forward-looking fashion, being all about earnings projections and expectations.
* Housing analysis ends up being backward looking (45 days to 180 days), meaning the conclusions that are reached are likely outdated by the time we see them.
* Housing ends up being treated like a commodity, with "five-star" neighborhoods (where sales are brisk and the asking price is now being exceeded as prospective purchasers bid the values up in hopes of landing the house) being "averaged in" with "disastrous" one-star neighborhoods.
Says Waite: "Housing indexes and statistics emanating from Wall Street take a cynical view of housing … and they misrepresent the actual value of housing by ignoring the critically obvious point - most housing purchases are ‘buy, occupy and hold’," and aren’t a speculative play aimed at short-term profits.
By misfiring so badly, Wall Street established an environment in which housing prices were expected to escalate at better-than-their-historical norms, fanning the speculative flames. The easy credit made available by the mortgage-backed debt market only made matters worse. Banks made loans, and Wall Street bundled those loans into an asset-backed security - giving the banks back the cash that they could then use to make their next round of loans. Because the loans were "averaged" out, the resultant securities were given the highest credit ratings by the ratings agencies - which was more than the securities deserved.
It was a recipe for disaster - or, at least, for a bubble.
Wall Street never saw it coming.
Anatomy of a Rebound
Wall Street has also failed to understand the dynamics of a housing market recovery - which is already in the works, Waite says.
And he should know. The portion of the real estate market that Waite’s magazine caters to - the real estate investor - is significant. In fact, a groundbreaking study commissioned by the magazine, and conducted by real-estate researcher REALTrends Inc., in concert with Harris Interactive, found that real estate investors account for 22% to 28% of all home sales (existing and new) each year - a total of 1.5 million to 1.64 million houses each year. That’s a big piece of a $300 billion industry, so it provides a very solid sample.
According to Waite, the housing market bottomed last year. But that bottoming takes place in stages. Housing values continue to decline. But values can’t bottom, solidify, and then head north until sales volumes increase, Waite says.
"First you get volume, and then you get valuations," Waite says.
And it doesn’t get better across the board all at once: Sales will improve in a "predictable sequence" that start with the very best neighborhoods, work their way down to the really good neighborhoods, and finally reach the plain old good developments.
As noted, Waite says the very best neighborhoods are already seeing strongly improved sales, with actual bidding battles taking place as prospective buyers willingly pay more than the asking price in order to land the choicest properties.
As those markets sell out, and the credit spigots open, demand will move from the very best neighborhoods down to the "pretty good" residential properties, Waite says.
Three reports released over the course of three straight days the last week of March seem to support Waite’s view.
Sales of new homes rose 4.7% in February - the first increase in seven months, the U.S. Commerce Department reported March 26. The day before that report came out a government gauge of home prices posted its first gain in almost a year. And the third of that "hat trick" of upbeat reports issued that same week said that sales of previously owned homes - the biggest share of the market - also increased in February.
The plunge in housing prices is also starting to have an effect. In a second report issued March 26, the California Association of Realtors said that existing-home sales in the state were up 83% in February from the previous year. The reason: The median home price was down roughly 40%, which is helping shrink inventories to about a six months’ supply from 15 months in 2008.
If Waite’s theory is correct, as sales of new and existing homes pick up on a month-to-month basis, prices will follow.
But true to form, Wall Street is demanding proof.
The data "have allayed some fears that the housing market would continue to freefall," Omair Sharif, an economist with RBS Greenwich Capital, told The Wall Street Journal. "But it’s way too early to say if we’ve hit bottom."
But Waite fervently believes that bottom has already been hit and that it’s all uphill - over the long haul - from here.
"Wall Street would have you believe that putting money into a house is as sophisticated as putting money in a mattress," he said. "But as it continues to prove, nothing could be further from the truth."
Friday, April 10, 2009
Monday, March 30, 2009
The Three Ways China May Deal With Growing U.S. Debt
By William Patalon III
And Jason Simpkins
Although there’s a veritable laundry list of obstacles that could blunt the U.S. government’s ongoing economic turnaround efforts, its single-biggest challenge may come from its single-biggest creditor - China.
When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao’s concerns about the United States’ quickly growing debt load.
“We have lent a huge amount of money to the United States,” Premier Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”
China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries - about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China’s nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government - including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).
However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.’s U.S. Treasury Master Index.
China’s leaders “are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China there has been a lot of debate about whether they should continue to buy Treasuries.”
And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China’s concerns about this country’s growing deficits - and its creditworthiness - are escalating in kind.
Depending upon how it did so, were China to stop buying U.S. debt - or even worse, to start dumping it - the economic fallout could be widespread, and perhaps even catastrophic:
* The U.S. dollar would drop 15%-20%.
* U.S. stocks would get hammered.
* Inflation would spike and interest rates on Treasuries would jump into the 8% range.
* And the economy would end up flat on its back - where it would stay, with no rebound on the horizon.
Detailing the Deficit
During the first five months of the 2009 fiscal year, which began Oct.1, the U.S. budget deficit hit a record $764.5 billion. Last month, President Obama outlined a $3.94 trillion budget plan that would take the deficit to $1.75 trillion by the time the fiscal year ends Sept. 30. The plan then calls for a $1.17 trillion deficit for fiscal 2010.
As currently projected, the U.S. budget deficit is forecast to run at about 12% of gross domestic product (GDP) - even worse than the perennially anemic Japan, where the deficit is running at 11%. And the debt picture is certain to get worse.
The Treasury Department has the government’s printing presses running overtime just to finance the $787 billion stimulus passed by Congress earlier this year. And in order to pay for all the stimulus, bailout and fix-it plans that are being put in place to arrest the U.S. economic decline, the U.S. government is assuming a murderous amount of debt: Over the next decade, the Congressional Budget Office projects that the White House budget will run $9.3 trillion in deficits.
That’s $2.3 trillion more than the Obama administration had forecast. But even the CBO projection could prove way too low: It assumes that the U.S. economy - after declining 1.5% this year - will turn around an advance at a racy 4.1% clip in both 2010 and 2011, a forecast that seems far too rosy, given the depths that the U.S. economy appears to have reached.
And that brings us to China.
Enter the (Red) Dragon
During the past several years, government-operated “sovereign-wealth funds” (SWFs) from virtually every major economic powerhouse around the world had been on a global shopping spree, buying up assets and bidding up prices as they did so.
China was no exception.
So when worldwide financial-asset prices began to slide - and then to nosedive - China abandoned many of its riskier holdings, choosing to boost its stockpile of U.S. Treasury securities. That underscores one marketplace truism: Despite Premier Wen’s reservations, the market for U.S. debt is the only market large enough, liquid enough, and stable enough to accommodate China’s large-scale investments.
That’s forced China to engage in a kind of global investor activism - although, so far, most of that activism has been aimed at one country: The United States.
About one-fifth of China’s currency reserves were tied up in Fannie and Freddie debt last fall when the two mortgage firms were placed under government conservatorship, The Washington Post reported.
In fact, as Money Morning detailed back in September as part of its ongoing investigation of the bailout of the U.S. banking system, that U.S. government decision to take control of Fannie and Freddie was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds.
China clearly made its risk concerns known at that time, adding to the sense of urgency U.S. officials felt to make a move. Today, as U.S. debt continues to mount at an obscene rate, financial and economic risks also escalate. This could lead to a spike in inflation and interest rates - a double-whammy that could cause any recovery that’s under way to sputter and stall. That duo of higher inflation and interest rates could also hammer bond values, including the Treasuries held in such large quantities by China. So it’s no wonder the risk concerns China articulated back at the time of the Fannie and Freddie takeovers go double or triple now.
Indeed, when Premier Wen unveiled the spending measures earlier this month, he made the point of saying that China should seek to “fend off risks” by further diversifying its reserves.
“We have already adopted a guiding management policy of diversifying our foreign exchange reserves, and at present our foreign exchange reserves are safe overall,” Wen said. “Our first principle in managing foreign currency is averting risk. We have always adhered to the principles of foreign currency security, liquidity and maintaining value, and implemented a strategy of diversification.”
When it comes to U.S. government debt, that strategy will take one of three forms, and will have the following potential effects:
1. Quietly threatening to stop purchasing (or even threatening to “dump”) U.S. Treasuries, a form of “back-channel” communications that can generate results (just look at how China forced the U.S. government to place Fannie and Freddie in conservatorship). Because this is back channel, it stays out of the marketplace, so long as the U.S. government finds some ways to appease Chinese investors by somehow reducing risk.
2. Quietly slowing or stopping its purchases of U.S. government debt. If China does this effectively and systematically, the fact that it’s cutting back on purchases doesn’t surface until the plan is executed. If China is able to pull this off - and it faces long odds to do so - the fact that it’s cutting back on U.S. debt doesn’t roil the markets too badly, especially if it doesn’t leak out until after the fact.
3. Publicly dumping U.S. debt. Self-explanatory in nature - and also the most unlikely, if it wants to maintain its “friendly” status with the United States - this is the worst-case scenario, and is the one that ends up with the dollar and the stock market getting stomped. If China chooses this route, it’s also essentially cutting off its nose to spite its face. The reason: By publicly dumping U.S. debt, the Treasury market will also take a beating - meaning China’s remaining U.S. debt holdings would take a haircut of 20% to 30%.
The Marketplace Realities
International demand for long-term U.S. financial assets actually fell in January, reflecting China’s smallest net purchase since May, Bloomberg reported.
International investors sold a net $8.4 billion in U.S. corporate debt in January, the report showed. Net foreign purchases of Treasury notes and bonds were a net $10.7 billion in for the month, after purchases of $15 billion a month earlier.
Few analysts believe China will abandon its Treasury holdings altogether, as that would hammer the dollar, hurt the value of its debt holdings and ruin its political relationship with the United States.
Besides, it’s becoming increasingly clear that Beijing wants a voice in Washington.
Yu Yongding, a former advisor to the Bank of China said last month that China should seek guarantees from the U.S. government that its holdings won’t be diminished by “reckless policies.”
Premier Wen echoed that request last week when he called on the United States to “honor its promises and guarantee the safety of China’s assets.”
“I think what they’re trying to say right now is, ‘Don’t take any steps that would impair our ability to access your market,’” Auggie Tantillo, executive director of the American Manufacturing Trade Action Coalition, told The Post. “The Chinese are starting to flex their muscles, they are becoming more powerful commercially and economically, and they want us to know it.”
The very possibility that China and other foreign countries would stop buying U.S. bonds already was enough to prompt the U.S. government to take control of foundering mortgage giants Fannie Mae and Freddie Mac.
And Jason Simpkins
Although there’s a veritable laundry list of obstacles that could blunt the U.S. government’s ongoing economic turnaround efforts, its single-biggest challenge may come from its single-biggest creditor - China.
When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao’s concerns about the United States’ quickly growing debt load.
“We have lent a huge amount of money to the United States,” Premier Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”
China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries - about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China’s nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government - including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).
However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.’s U.S. Treasury Master Index.
China’s leaders “are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China there has been a lot of debate about whether they should continue to buy Treasuries.”
And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China’s concerns about this country’s growing deficits - and its creditworthiness - are escalating in kind.
Depending upon how it did so, were China to stop buying U.S. debt - or even worse, to start dumping it - the economic fallout could be widespread, and perhaps even catastrophic:
* The U.S. dollar would drop 15%-20%.
* U.S. stocks would get hammered.
* Inflation would spike and interest rates on Treasuries would jump into the 8% range.
* And the economy would end up flat on its back - where it would stay, with no rebound on the horizon.
Detailing the Deficit
During the first five months of the 2009 fiscal year, which began Oct.1, the U.S. budget deficit hit a record $764.5 billion. Last month, President Obama outlined a $3.94 trillion budget plan that would take the deficit to $1.75 trillion by the time the fiscal year ends Sept. 30. The plan then calls for a $1.17 trillion deficit for fiscal 2010.
As currently projected, the U.S. budget deficit is forecast to run at about 12% of gross domestic product (GDP) - even worse than the perennially anemic Japan, where the deficit is running at 11%. And the debt picture is certain to get worse.
The Treasury Department has the government’s printing presses running overtime just to finance the $787 billion stimulus passed by Congress earlier this year. And in order to pay for all the stimulus, bailout and fix-it plans that are being put in place to arrest the U.S. economic decline, the U.S. government is assuming a murderous amount of debt: Over the next decade, the Congressional Budget Office projects that the White House budget will run $9.3 trillion in deficits.
That’s $2.3 trillion more than the Obama administration had forecast. But even the CBO projection could prove way too low: It assumes that the U.S. economy - after declining 1.5% this year - will turn around an advance at a racy 4.1% clip in both 2010 and 2011, a forecast that seems far too rosy, given the depths that the U.S. economy appears to have reached.
And that brings us to China.
Enter the (Red) Dragon
During the past several years, government-operated “sovereign-wealth funds” (SWFs) from virtually every major economic powerhouse around the world had been on a global shopping spree, buying up assets and bidding up prices as they did so.
China was no exception.
So when worldwide financial-asset prices began to slide - and then to nosedive - China abandoned many of its riskier holdings, choosing to boost its stockpile of U.S. Treasury securities. That underscores one marketplace truism: Despite Premier Wen’s reservations, the market for U.S. debt is the only market large enough, liquid enough, and stable enough to accommodate China’s large-scale investments.
That’s forced China to engage in a kind of global investor activism - although, so far, most of that activism has been aimed at one country: The United States.
About one-fifth of China’s currency reserves were tied up in Fannie and Freddie debt last fall when the two mortgage firms were placed under government conservatorship, The Washington Post reported.
In fact, as Money Morning detailed back in September as part of its ongoing investigation of the bailout of the U.S. banking system, that U.S. government decision to take control of Fannie and Freddie was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds.
China clearly made its risk concerns known at that time, adding to the sense of urgency U.S. officials felt to make a move. Today, as U.S. debt continues to mount at an obscene rate, financial and economic risks also escalate. This could lead to a spike in inflation and interest rates - a double-whammy that could cause any recovery that’s under way to sputter and stall. That duo of higher inflation and interest rates could also hammer bond values, including the Treasuries held in such large quantities by China. So it’s no wonder the risk concerns China articulated back at the time of the Fannie and Freddie takeovers go double or triple now.
Indeed, when Premier Wen unveiled the spending measures earlier this month, he made the point of saying that China should seek to “fend off risks” by further diversifying its reserves.
“We have already adopted a guiding management policy of diversifying our foreign exchange reserves, and at present our foreign exchange reserves are safe overall,” Wen said. “Our first principle in managing foreign currency is averting risk. We have always adhered to the principles of foreign currency security, liquidity and maintaining value, and implemented a strategy of diversification.”
When it comes to U.S. government debt, that strategy will take one of three forms, and will have the following potential effects:
1. Quietly threatening to stop purchasing (or even threatening to “dump”) U.S. Treasuries, a form of “back-channel” communications that can generate results (just look at how China forced the U.S. government to place Fannie and Freddie in conservatorship). Because this is back channel, it stays out of the marketplace, so long as the U.S. government finds some ways to appease Chinese investors by somehow reducing risk.
2. Quietly slowing or stopping its purchases of U.S. government debt. If China does this effectively and systematically, the fact that it’s cutting back on purchases doesn’t surface until the plan is executed. If China is able to pull this off - and it faces long odds to do so - the fact that it’s cutting back on U.S. debt doesn’t roil the markets too badly, especially if it doesn’t leak out until after the fact.
3. Publicly dumping U.S. debt. Self-explanatory in nature - and also the most unlikely, if it wants to maintain its “friendly” status with the United States - this is the worst-case scenario, and is the one that ends up with the dollar and the stock market getting stomped. If China chooses this route, it’s also essentially cutting off its nose to spite its face. The reason: By publicly dumping U.S. debt, the Treasury market will also take a beating - meaning China’s remaining U.S. debt holdings would take a haircut of 20% to 30%.
The Marketplace Realities
International demand for long-term U.S. financial assets actually fell in January, reflecting China’s smallest net purchase since May, Bloomberg reported.
International investors sold a net $8.4 billion in U.S. corporate debt in January, the report showed. Net foreign purchases of Treasury notes and bonds were a net $10.7 billion in for the month, after purchases of $15 billion a month earlier.
Few analysts believe China will abandon its Treasury holdings altogether, as that would hammer the dollar, hurt the value of its debt holdings and ruin its political relationship with the United States.
Besides, it’s becoming increasingly clear that Beijing wants a voice in Washington.
Yu Yongding, a former advisor to the Bank of China said last month that China should seek guarantees from the U.S. government that its holdings won’t be diminished by “reckless policies.”
Premier Wen echoed that request last week when he called on the United States to “honor its promises and guarantee the safety of China’s assets.”
“I think what they’re trying to say right now is, ‘Don’t take any steps that would impair our ability to access your market,’” Auggie Tantillo, executive director of the American Manufacturing Trade Action Coalition, told The Post. “The Chinese are starting to flex their muscles, they are becoming more powerful commercially and economically, and they want us to know it.”
The very possibility that China and other foreign countries would stop buying U.S. bonds already was enough to prompt the U.S. government to take control of foundering mortgage giants Fannie Mae and Freddie Mac.
Saturday, March 21, 2009
Business for Hard Times
By JON RAPPOPORT www.nomorefakenews.com
I know people don’t have time to read long articles these days. They’re too busy tallying up their massive profits in the stock market, selling their homes for astronomical prices, and deciding which yacht or private plane to buy---but if you can bear with me, you might glean a few data-McNuggets re how the financial world works.
And you could learn something about how to start a business that will make you rich without turning a profit.
I know. That sounds like a contradiction.
Have patience. Read on.
The first thing you have to do is find a wonderful product that people can afford. And I have one.
number 9 dream. Never heard of it? A novel. David Mitchell wrote it in 2001. Sensational reviews in England. I bought all 418 pages of it at Book Tales in downtown Encinitas for two bucks, used. That’s a little over half a cent a page.
And on page five and six, we have this:
“I sip my coffee foam. My mug rim has traces of lipstick. I construct a legal case to argue that sipping from this part of the bowl constitutes a kiss with a stranger. That would increase my tally of kissed girls to three, still less than the national average. I look around the Jupiter Café for a potential kissee, and settle on the waitress of the living, wise, moonlit viola neck. A tendril of hair has fallen loose, and brushes her nape. It tickles. I compare the fuchsia pink on the mug with the pink of her lipstick. Circumstantial evidence, at any distance. Who knows how many times the cup has been dishwashed, fusing the lipstick atoms with the porcelain molecules? And a sophisticated Tokyoite like her has enough admirers to fill a pocket computer. Case dismissed.”
I paid roughly an eighth of a cent for that paragraph. Not bad. (If you cajole people, some of them will give you pennies.)
The whole book has, so far, taken up three hours of my time. I’m moving through it slowly. I’m on page 87. Three hours, at a total cost of, let’s call it, 43 cents.
If I go to the movies, I’m paying at least ten dollars by the time I’m out of there, not even counting mileage in the car, and I’ve usually logged only two hours of screen time. And nobody on the screen is saying, “the waitress of the living, wise, moonlit viola neck.”
The Encinitas public library is a well-designed low-slung building with lots of big windows. You can even sit outside on an elevated deck and read. Of course, you can check books out of libraries for nothing, but I don’t count that, because I like owning a book and keeping it around for years. I like underlining passages and making notes in the margins. So I use the very nice bookstore the Encinitas library maintains next to its front door.
For two dollars, I bought a hardbound 1963 Grove Press edition of Henry Miller’s Black Spring. And I got this brief chunk of poetry for what I estimate was a fifth of a cent:
“The tide washes up in front of the curved tracks and splits like glass combs. Under the wet headlines are the diaphanous legs of the amoebas scrambling on to the running boards, the fine, sturdy tennis legs wrapped in cellophane, their white veins showing through the golden calves and muscles of ivory. The city is panting with a five o’clock sweat. From the tops of skyscrapers plumes of smoke soft as Cleopatra’s feathers. The air beats thick, the bats are flapping, the cements softens, the iron rails flatten under the broad flanges of the trolley wheels.”
A fifth of a cent.
Maybe these two passages smack of literature, for you. And for you, literature is crap--although at these prices nobody should be arguing. But all right. At the outdoor racks of used paperbacks at the Cardiff Public Library, I picked up Elmore Leonard’s Pagan Babies, a sensational crime novel set in Rwanda and Detroit, for 25 cents. Another three hours of reading. I haven’t seen three hours of television or movies in the last few years that stack up to Pagan Babies.
In a small shopping plaza off San Eliho, in Cardiff, there is a thrift shop. I found a few Jack Higgins thrillers there. Wonderful spy-crime writer. I bought an old Physician’s Desk Reference for four dollars. And one of the Isaac Asimov Foundation novels for fifty cents.
Marvelous. Wonderful. Such a fantastic product. Used books.
So I got to thinking…and the thinking produced this business----
I rented an old storefront in Encinitas. It had broken windows and cracked floors. I made some shelves and went to garage sales and bought old books by the foot and stuck them on the shelves.
I taped a big sign on the broken window: FREE BOOKS.
When people came in, I told them this wasn’t precisely true, but they could take as many books as they wanted if they signed an IOU. As long as they could legibly write their names, phone numbers, and addresses on a piece of paper or a rag or a stick of wood, they could have books. They could pay me later.
Well, this took off like a rocket.
I found two partners who had a modest amount of cash. We rented and opened eight such bookstores in the San Diego area and they all started doing gangbusters business.
Eventually, we took over 11267 bookstores from coast to coast and we did the “free book” thing with all of them. We got on Larry King and Nightline and Today.
We went to a bank, a big bank. We told them we had packages of IOUs. Bundles. Tons. We would be willing to sell them.
Wow.
We walked out of there with the kind of cash I had previously only dreamed of.
The bank manager called me three weeks later and told me he’d sold those packages and bundles and tons of IOUs to a guy in Belgium. And a month after that, the Belgium banker sold the tons to the investment honcho at AIG. After that, I don’t know what happened.
But I’m now living in a mansion on a Greek island and I have a 300-foot yacht.
I figured I should hire a security company, you know, to protect my assets, and a veteran with Special Forces training recommended bringing in a hundred dogs, three hundred armed guards---and he built electrified fences around the property. It all seemed a bit excessive to me, but he assured me this was the way to go.
I’m now writing my memoirs. The first line is:
“I never made a penny, but I made 400 million dollars.”
This is why America was created. This is the meaning of liberty.
I know people don’t have time to read long articles these days. They’re too busy tallying up their massive profits in the stock market, selling their homes for astronomical prices, and deciding which yacht or private plane to buy---but if you can bear with me, you might glean a few data-McNuggets re how the financial world works.
And you could learn something about how to start a business that will make you rich without turning a profit.
I know. That sounds like a contradiction.
Have patience. Read on.
The first thing you have to do is find a wonderful product that people can afford. And I have one.
number 9 dream. Never heard of it? A novel. David Mitchell wrote it in 2001. Sensational reviews in England. I bought all 418 pages of it at Book Tales in downtown Encinitas for two bucks, used. That’s a little over half a cent a page.
And on page five and six, we have this:
“I sip my coffee foam. My mug rim has traces of lipstick. I construct a legal case to argue that sipping from this part of the bowl constitutes a kiss with a stranger. That would increase my tally of kissed girls to three, still less than the national average. I look around the Jupiter Café for a potential kissee, and settle on the waitress of the living, wise, moonlit viola neck. A tendril of hair has fallen loose, and brushes her nape. It tickles. I compare the fuchsia pink on the mug with the pink of her lipstick. Circumstantial evidence, at any distance. Who knows how many times the cup has been dishwashed, fusing the lipstick atoms with the porcelain molecules? And a sophisticated Tokyoite like her has enough admirers to fill a pocket computer. Case dismissed.”
I paid roughly an eighth of a cent for that paragraph. Not bad. (If you cajole people, some of them will give you pennies.)
The whole book has, so far, taken up three hours of my time. I’m moving through it slowly. I’m on page 87. Three hours, at a total cost of, let’s call it, 43 cents.
If I go to the movies, I’m paying at least ten dollars by the time I’m out of there, not even counting mileage in the car, and I’ve usually logged only two hours of screen time. And nobody on the screen is saying, “the waitress of the living, wise, moonlit viola neck.”
The Encinitas public library is a well-designed low-slung building with lots of big windows. You can even sit outside on an elevated deck and read. Of course, you can check books out of libraries for nothing, but I don’t count that, because I like owning a book and keeping it around for years. I like underlining passages and making notes in the margins. So I use the very nice bookstore the Encinitas library maintains next to its front door.
For two dollars, I bought a hardbound 1963 Grove Press edition of Henry Miller’s Black Spring. And I got this brief chunk of poetry for what I estimate was a fifth of a cent:
“The tide washes up in front of the curved tracks and splits like glass combs. Under the wet headlines are the diaphanous legs of the amoebas scrambling on to the running boards, the fine, sturdy tennis legs wrapped in cellophane, their white veins showing through the golden calves and muscles of ivory. The city is panting with a five o’clock sweat. From the tops of skyscrapers plumes of smoke soft as Cleopatra’s feathers. The air beats thick, the bats are flapping, the cements softens, the iron rails flatten under the broad flanges of the trolley wheels.”
A fifth of a cent.
Maybe these two passages smack of literature, for you. And for you, literature is crap--although at these prices nobody should be arguing. But all right. At the outdoor racks of used paperbacks at the Cardiff Public Library, I picked up Elmore Leonard’s Pagan Babies, a sensational crime novel set in Rwanda and Detroit, for 25 cents. Another three hours of reading. I haven’t seen three hours of television or movies in the last few years that stack up to Pagan Babies.
In a small shopping plaza off San Eliho, in Cardiff, there is a thrift shop. I found a few Jack Higgins thrillers there. Wonderful spy-crime writer. I bought an old Physician’s Desk Reference for four dollars. And one of the Isaac Asimov Foundation novels for fifty cents.
Marvelous. Wonderful. Such a fantastic product. Used books.
So I got to thinking…and the thinking produced this business----
I rented an old storefront in Encinitas. It had broken windows and cracked floors. I made some shelves and went to garage sales and bought old books by the foot and stuck them on the shelves.
I taped a big sign on the broken window: FREE BOOKS.
When people came in, I told them this wasn’t precisely true, but they could take as many books as they wanted if they signed an IOU. As long as they could legibly write their names, phone numbers, and addresses on a piece of paper or a rag or a stick of wood, they could have books. They could pay me later.
Well, this took off like a rocket.
I found two partners who had a modest amount of cash. We rented and opened eight such bookstores in the San Diego area and they all started doing gangbusters business.
Eventually, we took over 11267 bookstores from coast to coast and we did the “free book” thing with all of them. We got on Larry King and Nightline and Today.
We went to a bank, a big bank. We told them we had packages of IOUs. Bundles. Tons. We would be willing to sell them.
Wow.
We walked out of there with the kind of cash I had previously only dreamed of.
The bank manager called me three weeks later and told me he’d sold those packages and bundles and tons of IOUs to a guy in Belgium. And a month after that, the Belgium banker sold the tons to the investment honcho at AIG. After that, I don’t know what happened.
But I’m now living in a mansion on a Greek island and I have a 300-foot yacht.
I figured I should hire a security company, you know, to protect my assets, and a veteran with Special Forces training recommended bringing in a hundred dogs, three hundred armed guards---and he built electrified fences around the property. It all seemed a bit excessive to me, but he assured me this was the way to go.
I’m now writing my memoirs. The first line is:
“I never made a penny, but I made 400 million dollars.”
This is why America was created. This is the meaning of liberty.
Tuesday, March 10, 2009
Has Anybody Seen the Bottom Yet?
By Martin Hutchinson
Last week’s economic data told us two things. First, this recession is almost certainly going to be the worst since World War II. Second, the pit isn’t bottomless; there are faint signs of a landing - although it is still some considerable way further down.
For investors, the prospect of a not-quite-bottomless pit in the United States is unexciting, to say the least, so it’s worth looking internationally for areas where the news is rather better.
Friday’s unemployment number for February was just about as bad as everybody feared, with non-farm payrolls losing 651,000 jobs. But the real news was the revisions made in the non-farm payroll numbers for December and January, boosting the job-losses for those months to 684,000 and 655,000, respectively.
This had the perverse effect of making February look better by comparison, since it was now the second month in which the number of jobs lost had slightly declined. Job losses have now been holding approximately constant for each of the last four months at about 650,000; thus, it doesn’t appear as though the economic decline is getting any steeper.
Other reports confirmed that the decline is not steepening, and even suggest that a turn may be on the way. The Institute of Supply Management manufacturing and non-manufacturing indices for February were both approximately flat - unchanged - from the previous month, suggesting again that the rate of economic destruction is constant at worst.
In the short term, help is on the way, partly from the continual gradual easing of credit conditions, assisted last week by the unveiling of a $1 trillion Treasury Asset-backed Securitized Loan Fund, which will help to restart the securitization market for consumer loans of all kinds.
Healthy banks will not welcome this new competition, since it will cut into their margins. Even so, when this new program starts in the spring, it will combine with two other government initiatives to create a trifecta of heavy-hitting stimulus programs that, in combination, should provide the U.S. economy with a shot of adrenaline - the results of which could start to show themselves by the May/June timeframe.
Those other two initiatives are:
The modest tax cuts for consumers in the lower and middle incomes.
And the first of the outlays from the $787 billion package passed and signed into law last month.
That’s where the bottom may be coming into view. If the downward slope is not getting any steeper - and we can expect some upward force in a few months - then there must be a good chance that the economic bottom is only a few months away.
Should that prove to be the case, the recession will have lasted about 18 months - about as long as the most severe recessions since World War II - and will have produced a drop in gross domestic product (GDP) of about 5%, slightly worse than the 1974 and 1982 recessions, which had previously been the post-war period’s deepest.
Still, this recession’s 5% drop in GDP will not seriously match up against the Great Depression’s 25% GDP drop, or against various other fairly severe recessions experienced in other advanced economies during the last 50 years.
Recovery is a different matter. Once the recession has fully bottomed out, perhaps in the third or fourth quarter of this year, the economic recovery from the bottom will be hampered by two factors:
First, the federal budget deficits will be continuing at a level of more than $1 trillion per annum - equal, perhaps, to 10% of GDP. Thanks to a manifestation known as the "crowding out effect," government financing of these huge deficits will tend to drive private borrowers out of the credit markets and restrict funds availability for business expansion.
Second, the huge increases in money supply in the last six months - the St. Louis Fed’s "Money of Zero Maturity" broad money index (the best broad money-supply measure left over since the central bank stopped reporting M3 money-supply statistics in March 2006) has been rising at an annual rate of over 20% since October - will almost certainly cause a resurgence in inflation once the economy has bottomed out. Combined with the afore-mentioned budget deficits, this surge in inflation will probably cause a steep uptick in interest rates unlike anything we’ve seen since the late 1970s. With rising interest rates and rising inflation, economic recovery will be very sluggish indeed, with full recovery delayed for several years.
If the recovery of the U.S. economy is exceptionally sluggish and delayed, it is unlikely that stock market returns will be satisfactory: Indeed, the U.S. market may remain at or below its current depressed levels for several years.
On the other hand, economies that have not incurred such huge budget deficits - or taken such huge risks with inflation - may find that their recovery arrives at the normal pace: Those markets could be rising rapidly from their recessionary low points by the middle of next year.
This suggests that the major East Asian countries, which have ample liquidity and generally positive trade balances, will be particularly well-positioned to be able to expand through domestic growth, boosting their companies’ profits and stock prices, accordingly. The best-run countries of Latin America - particularly Colombia, Brazil and Chile - may also benefit from Asian growth, without suffering high inflation or financing difficulties, since they have reacted to the global recession much more conservatively than the United States or Europe.
So, there you have the good news and bad news, all in an economic nutshell. And that brings us to the bottom line. Let’s look at all three:
The good news: We may be only a few months away from the bottom of the U.S. recession, which may be only a moderate distance below where the economy is right now.
The bad news: Any recovery that does manifest itself is likely to be very sluggish indeed.
The bottom line: Look to Asia and Latin America (particularly Colombia, Brazil and Chile) for the next investment bull markets.
Last week’s economic data told us two things. First, this recession is almost certainly going to be the worst since World War II. Second, the pit isn’t bottomless; there are faint signs of a landing - although it is still some considerable way further down.
For investors, the prospect of a not-quite-bottomless pit in the United States is unexciting, to say the least, so it’s worth looking internationally for areas where the news is rather better.
Friday’s unemployment number for February was just about as bad as everybody feared, with non-farm payrolls losing 651,000 jobs. But the real news was the revisions made in the non-farm payroll numbers for December and January, boosting the job-losses for those months to 684,000 and 655,000, respectively.
This had the perverse effect of making February look better by comparison, since it was now the second month in which the number of jobs lost had slightly declined. Job losses have now been holding approximately constant for each of the last four months at about 650,000; thus, it doesn’t appear as though the economic decline is getting any steeper.
Other reports confirmed that the decline is not steepening, and even suggest that a turn may be on the way. The Institute of Supply Management manufacturing and non-manufacturing indices for February were both approximately flat - unchanged - from the previous month, suggesting again that the rate of economic destruction is constant at worst.
In the short term, help is on the way, partly from the continual gradual easing of credit conditions, assisted last week by the unveiling of a $1 trillion Treasury Asset-backed Securitized Loan Fund, which will help to restart the securitization market for consumer loans of all kinds.
Healthy banks will not welcome this new competition, since it will cut into their margins. Even so, when this new program starts in the spring, it will combine with two other government initiatives to create a trifecta of heavy-hitting stimulus programs that, in combination, should provide the U.S. economy with a shot of adrenaline - the results of which could start to show themselves by the May/June timeframe.
Those other two initiatives are:
The modest tax cuts for consumers in the lower and middle incomes.
And the first of the outlays from the $787 billion package passed and signed into law last month.
That’s where the bottom may be coming into view. If the downward slope is not getting any steeper - and we can expect some upward force in a few months - then there must be a good chance that the economic bottom is only a few months away.
Should that prove to be the case, the recession will have lasted about 18 months - about as long as the most severe recessions since World War II - and will have produced a drop in gross domestic product (GDP) of about 5%, slightly worse than the 1974 and 1982 recessions, which had previously been the post-war period’s deepest.
Still, this recession’s 5% drop in GDP will not seriously match up against the Great Depression’s 25% GDP drop, or against various other fairly severe recessions experienced in other advanced economies during the last 50 years.
Recovery is a different matter. Once the recession has fully bottomed out, perhaps in the third or fourth quarter of this year, the economic recovery from the bottom will be hampered by two factors:
First, the federal budget deficits will be continuing at a level of more than $1 trillion per annum - equal, perhaps, to 10% of GDP. Thanks to a manifestation known as the "crowding out effect," government financing of these huge deficits will tend to drive private borrowers out of the credit markets and restrict funds availability for business expansion.
Second, the huge increases in money supply in the last six months - the St. Louis Fed’s "Money of Zero Maturity" broad money index (the best broad money-supply measure left over since the central bank stopped reporting M3 money-supply statistics in March 2006) has been rising at an annual rate of over 20% since October - will almost certainly cause a resurgence in inflation once the economy has bottomed out. Combined with the afore-mentioned budget deficits, this surge in inflation will probably cause a steep uptick in interest rates unlike anything we’ve seen since the late 1970s. With rising interest rates and rising inflation, economic recovery will be very sluggish indeed, with full recovery delayed for several years.
If the recovery of the U.S. economy is exceptionally sluggish and delayed, it is unlikely that stock market returns will be satisfactory: Indeed, the U.S. market may remain at or below its current depressed levels for several years.
On the other hand, economies that have not incurred such huge budget deficits - or taken such huge risks with inflation - may find that their recovery arrives at the normal pace: Those markets could be rising rapidly from their recessionary low points by the middle of next year.
This suggests that the major East Asian countries, which have ample liquidity and generally positive trade balances, will be particularly well-positioned to be able to expand through domestic growth, boosting their companies’ profits and stock prices, accordingly. The best-run countries of Latin America - particularly Colombia, Brazil and Chile - may also benefit from Asian growth, without suffering high inflation or financing difficulties, since they have reacted to the global recession much more conservatively than the United States or Europe.
So, there you have the good news and bad news, all in an economic nutshell. And that brings us to the bottom line. Let’s look at all three:
The good news: We may be only a few months away from the bottom of the U.S. recession, which may be only a moderate distance below where the economy is right now.
The bad news: Any recovery that does manifest itself is likely to be very sluggish indeed.
The bottom line: Look to Asia and Latin America (particularly Colombia, Brazil and Chile) for the next investment bull markets.
Wednesday, March 4, 2009
Bank of Canada lowers overnight rate target by 1/2 percentage point to 1/2 per cent
Bank of Canada lowers overnight rate target by 1/2 percentage point to 1/2 per cent
OTTAWA – The Bank of Canada today announced that it is lowering its target for the overnight rate by one-half of a percentage point to 1/2 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 3/4 per cent.
The outlook for the global economy has continued to deteriorate since the Bank's January Monetary Policy Report Update, with weaker-than-expected activity in major economies. The nature of the U.S. recession, with very weak auto and housing sectors, is particularly challenging for Canada.
Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries. The timely implementation of ambitious plans in some major countries to address toxic assets and recapitalize financial institutions will be critical in this regard.
National accounts data for the fourth quarter of 2008 and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January. Potential delays in stabilizing the global financial system, along with larger-than-anticipated confidence and wealth effects on domestic demand, could mean that the output gap will not begin to close until early 2010. These factors imply a slightly lower profile for core inflation than was projected in the January MPRU.
The effects of the recent aggressive monetary and fiscal policy actions in Canada and other major economies will begin to be felt in the second half of this year and will build through 2010. Once the global financial system stabilizes and global growth recovers, the underlying strength of the Canadian economy and financial sector should ensure a more rapid recovery in Canada than in most other industrialized economies.
The Bank's decision to lower its policy rate by 50 basis points today brings the cumulative monetary policy easing to 400 basis points since December 2007. Consistent with returning total CPI inflation to 2 per cent, the target for the overnight rate can be expected to remain at this level or lower at least until there are clear signs that excess supply in the economy is being taken up.
Given the low level of the target for the overnight rate, the Bank is refining the approach it would take to provide additional monetary stimulus, if required, through credit and quantitative easing. In its April Monetary Policy Report, the Bank will outline a framework for the possible use of such measures.
The Bank will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve its 2 per cent inflation target over the medium term.
Information note:
The next scheduled date for announcing the overnight rate target is 21 April 2009. A full update of the Bank's outlook for the economy and inflation, including risks to the projection, will be published in the Monetary Policy Report on 23 April 2009.
OTTAWA – The Bank of Canada today announced that it is lowering its target for the overnight rate by one-half of a percentage point to 1/2 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 3/4 per cent.
The outlook for the global economy has continued to deteriorate since the Bank's January Monetary Policy Report Update, with weaker-than-expected activity in major economies. The nature of the U.S. recession, with very weak auto and housing sectors, is particularly challenging for Canada.
Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries. The timely implementation of ambitious plans in some major countries to address toxic assets and recapitalize financial institutions will be critical in this regard.
National accounts data for the fourth quarter of 2008 and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January. Potential delays in stabilizing the global financial system, along with larger-than-anticipated confidence and wealth effects on domestic demand, could mean that the output gap will not begin to close until early 2010. These factors imply a slightly lower profile for core inflation than was projected in the January MPRU.
The effects of the recent aggressive monetary and fiscal policy actions in Canada and other major economies will begin to be felt in the second half of this year and will build through 2010. Once the global financial system stabilizes and global growth recovers, the underlying strength of the Canadian economy and financial sector should ensure a more rapid recovery in Canada than in most other industrialized economies.
The Bank's decision to lower its policy rate by 50 basis points today brings the cumulative monetary policy easing to 400 basis points since December 2007. Consistent with returning total CPI inflation to 2 per cent, the target for the overnight rate can be expected to remain at this level or lower at least until there are clear signs that excess supply in the economy is being taken up.
Given the low level of the target for the overnight rate, the Bank is refining the approach it would take to provide additional monetary stimulus, if required, through credit and quantitative easing. In its April Monetary Policy Report, the Bank will outline a framework for the possible use of such measures.
The Bank will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve its 2 per cent inflation target over the medium term.
Information note:
The next scheduled date for announcing the overnight rate target is 21 April 2009. A full update of the Bank's outlook for the economy and inflation, including risks to the projection, will be published in the Monetary Policy Report on 23 April 2009.
Wednesday, February 18, 2009
Is President Obama Creating a Better Banking System by Capping Executive Pay?
Is President Obama Creating a Better Banking System by Capping Executive Pay?
By Martin Hutchinson Contributing
By revamping the banking sector’s compensation system, and creating a salary cap of $500,000 for the top executives at institutions that accepted federal bailout money, new U.S. President Barack Obama could be launching a reform movement that helps make the American financial system worthwhile to invest in again.
For the last 30 years, Wall Street has had a problem with its remuneration system. Base pay was only around $150,000 even for a partner/managing director - not enough to live on for senior Wall Street bankers with a Manhattan lifestyle - while bonuses were 10, 20 or even 100 times that amount.
This promoted a culture in which risk-seeking behavior was encouraged - even rewarded - which is why the notorious office politics and 1egendary 100-hour workweeks became the Wall Street norm. Needless to say, shareholders in such institutions got a pretty raw deal; the universal assumption was that their returns would be whatever crumbs were left over after management had paid itself gargantuan bonuses.
It becomes easy to see, then, just why President Obama’s limitation will have an interesting effect. Some financial-services businesses - consumer lending, mortgage banking, routine business banking (including much large ticket lending) and retail brokerage - work very well at the operating level with a $500,000 salary cap. There are plenty of practitioners available with lots of experience in these businesses, whose remuneration, except at the very top, never soared to “Wall Street” levels.
Meanwhile, other businesses will become more or less impossible, except at a routine level. For example, if you try to engage in big-ticket trading, while paying traders $200,000 to $300,000 a year, and your competitors pay traders $2 million to $3 million a year, you will get your lunch handed to you on a fairly regular basis. The top Wall Street traders mostly got that way by developing an intimate knowledge of some major portion of the market’s deal flow, and that knowledge is worth millions to somebody, even if a particular bank’s salary structure is capped. Similarly, the top block traders in equities, the top merger specialists, and others, will not stick around for less than $500,000 a year.
After a year or so, a bank subject to a salary cap will be a very different creature. At the top, it will have primarily administrators, paid substantially more than their government counterparts, who will run a perfectly competent operation, but who will not be capable of broad strategic insight or aggressiveness, be it offensive (acquisitions) or defensive (major cost cutting).
The organization will compete only in those financial-service businesses that have become routinized. However, such businesses represent perhaps 90% of all financial-service transactions, so being limited in this way will not put the firm at a huge disadvantage. More importantly, each company’s risk management function will become very simple, since nobody will benefit significantly by taking on much more than modest risks.
Had regulators prevented the mortgage finance institutions Fannie Mae (FNM) and Freddie Mac (FRE) from paying their top managements $10 million a year, they would have been successful and low-risk models of this type (and we would all be much better off today).
With simpler risk management than their unrestricted competition, and much cheaper management at the top, these new banks will be highly competitive in the businesses in which they operate. Given such parameters, it is likely that their unrestricted competitors will either have to reshape themselves to match them, or get out of the commoditized businesses and concentrate only on high value added, high-risk markets.
This would be completely appropriate.
If the largest banks are to be considered “too big to fail” and must be bailed out from time to time with taxpayer money, then they must be prevented from taking large risks. By restricting their management’s remuneration, Obama will also have restricted the taxpayer’s downside risk, while at the same time providing more cost-efficient services in these commoditized business areas.
The high-risk and complex businesses will migrate to other houses, whether hedge funds or investment-banking “boutiques” - the former specializing in operations requiring large amounts of risk capital, and the latter specializing in operations requiring high-level financial creativity and connections.
If the authorities are wise, they will impose a size limitation on these operations, so that they are unable to become large enough to endanger the financial system or require taxpayer bailout. Naturally, pay for executives in these companies will be unlimited, in good years far higher than in the commoditized behemoths.
In general, the ordinary investor would be foolish to invest in the new hedge funds and investment banking boutiques. Insiders at those operations will always have an advantage over their outside investors, and will tend to treat their capital sources as “dumb money,” suitable only for extracting large management fees. The largest institutions, with an ongoing relationship with these houses, will be their primary sources of outside capital, but many of them will rely heavily on reinvestment of partner earnings, as Wall Street houses did before 1970.
For retail investors, the huge salary-capped behemoths will be ideal “widows-and-orphans” investments. They will not grow much, so will pay out most of their earnings as dividends. They will also not take large risks, so their earnings will fluctuate only moderately in any but the deepest recession. Because of their attractiveness as investments, they will have a very low cost of capital, another cost advantage enabling them to repel encroachments by more aggressive houses.
In general, as a believer in the free market, I strongly deprecate limitations on executive pay. But when the institution concerned is “too big to fail” the argument for such limitations is very strong indeed.
By Martin Hutchinson Contributing
By revamping the banking sector’s compensation system, and creating a salary cap of $500,000 for the top executives at institutions that accepted federal bailout money, new U.S. President Barack Obama could be launching a reform movement that helps make the American financial system worthwhile to invest in again.
For the last 30 years, Wall Street has had a problem with its remuneration system. Base pay was only around $150,000 even for a partner/managing director - not enough to live on for senior Wall Street bankers with a Manhattan lifestyle - while bonuses were 10, 20 or even 100 times that amount.
This promoted a culture in which risk-seeking behavior was encouraged - even rewarded - which is why the notorious office politics and 1egendary 100-hour workweeks became the Wall Street norm. Needless to say, shareholders in such institutions got a pretty raw deal; the universal assumption was that their returns would be whatever crumbs were left over after management had paid itself gargantuan bonuses.
It becomes easy to see, then, just why President Obama’s limitation will have an interesting effect. Some financial-services businesses - consumer lending, mortgage banking, routine business banking (including much large ticket lending) and retail brokerage - work very well at the operating level with a $500,000 salary cap. There are plenty of practitioners available with lots of experience in these businesses, whose remuneration, except at the very top, never soared to “Wall Street” levels.
Meanwhile, other businesses will become more or less impossible, except at a routine level. For example, if you try to engage in big-ticket trading, while paying traders $200,000 to $300,000 a year, and your competitors pay traders $2 million to $3 million a year, you will get your lunch handed to you on a fairly regular basis. The top Wall Street traders mostly got that way by developing an intimate knowledge of some major portion of the market’s deal flow, and that knowledge is worth millions to somebody, even if a particular bank’s salary structure is capped. Similarly, the top block traders in equities, the top merger specialists, and others, will not stick around for less than $500,000 a year.
After a year or so, a bank subject to a salary cap will be a very different creature. At the top, it will have primarily administrators, paid substantially more than their government counterparts, who will run a perfectly competent operation, but who will not be capable of broad strategic insight or aggressiveness, be it offensive (acquisitions) or defensive (major cost cutting).
The organization will compete only in those financial-service businesses that have become routinized. However, such businesses represent perhaps 90% of all financial-service transactions, so being limited in this way will not put the firm at a huge disadvantage. More importantly, each company’s risk management function will become very simple, since nobody will benefit significantly by taking on much more than modest risks.
Had regulators prevented the mortgage finance institutions Fannie Mae (FNM) and Freddie Mac (FRE) from paying their top managements $10 million a year, they would have been successful and low-risk models of this type (and we would all be much better off today).
With simpler risk management than their unrestricted competition, and much cheaper management at the top, these new banks will be highly competitive in the businesses in which they operate. Given such parameters, it is likely that their unrestricted competitors will either have to reshape themselves to match them, or get out of the commoditized businesses and concentrate only on high value added, high-risk markets.
This would be completely appropriate.
If the largest banks are to be considered “too big to fail” and must be bailed out from time to time with taxpayer money, then they must be prevented from taking large risks. By restricting their management’s remuneration, Obama will also have restricted the taxpayer’s downside risk, while at the same time providing more cost-efficient services in these commoditized business areas.
The high-risk and complex businesses will migrate to other houses, whether hedge funds or investment-banking “boutiques” - the former specializing in operations requiring large amounts of risk capital, and the latter specializing in operations requiring high-level financial creativity and connections.
If the authorities are wise, they will impose a size limitation on these operations, so that they are unable to become large enough to endanger the financial system or require taxpayer bailout. Naturally, pay for executives in these companies will be unlimited, in good years far higher than in the commoditized behemoths.
In general, the ordinary investor would be foolish to invest in the new hedge funds and investment banking boutiques. Insiders at those operations will always have an advantage over their outside investors, and will tend to treat their capital sources as “dumb money,” suitable only for extracting large management fees. The largest institutions, with an ongoing relationship with these houses, will be their primary sources of outside capital, but many of them will rely heavily on reinvestment of partner earnings, as Wall Street houses did before 1970.
For retail investors, the huge salary-capped behemoths will be ideal “widows-and-orphans” investments. They will not grow much, so will pay out most of their earnings as dividends. They will also not take large risks, so their earnings will fluctuate only moderately in any but the deepest recession. Because of their attractiveness as investments, they will have a very low cost of capital, another cost advantage enabling them to repel encroachments by more aggressive houses.
In general, as a believer in the free market, I strongly deprecate limitations on executive pay. But when the institution concerned is “too big to fail” the argument for such limitations is very strong indeed.
Sunday, February 1, 2009
Weekly Market Insight
NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS
Governments and central banks continue to fire from all directions. In the US, the fed funds rate is already at
zero. But the Fed continues to ease in different ways. Mr. Bernanke is now targeting not the fed funds rate but
rather private sector borrowing rates. By buying spread products, the Fed is trying to lower borrowing cost and
stimulate borrowing activity. Bank loans and leases outstanding increased by $8 billion in the latest week, the
first rise in four weeks, but are up just 1% from this time last year.
The Bank of Canada’s 50 basis points rate cut this week was not the last one for this cycle. Look for the Bank
to cut by another 50 basis points come March. This move is already fully discounted by the market and will not
have any significant impact on long-term rates.
But even if the Fed and the Bank of Canada are successful in lowering borrowing rates, you still need to create
conditions in which households will be willing to borrow. We know that there is some pent up demand for
borrowing following the recent decline in US long-term mortgage rates (after the Fed actively purchased MBA
securities), refinancing activity has tripled. But in order to insure a sustained rise in credit demand, we need a
stronger level of economic activity, and that’s where governments enter the picture.
In the US, the Obama Administration will soon introduce an estimated $875 billion in fiscal stimulus and in
Canada, we will see roughly $30 billion of new spending this year. A notable portion of this spending will go
towards infrastructure. And from an economic perspective, this is important as the economic multiplier of
infrastructure spending is significant. After all, when it comes to creating jobs and stimulating activity,
infrastructure spending is a much more effective tool than tax cuts. In the US, the impact of economic growth
of infrastructure spending worth 1% of GDP is more than double the impact of tax cuts, which have a greater
leakage to imported consumer goods, and which risk being saved by households. In Canada, $10 billion of
infrastructure spending can potentially create 110,000 jobs and lift economic growth by close to 1.5
percentage points—well above the stimulus effect of a tax cut of a similar size.
And that’s the main reason for the renewed optimism by the Bank of Canada, which now calls for a continual
recession in the coming six months but a healthy recovery in the second half. This is more or less in line with
our ongoing view—the combination of monetary and fiscal stimulus will be powerful enough to turn things
around in the second half of the year.
Benjamin Tal
Senior Economist
Economics & Strategy
Governments and central banks continue to fire from all directions. In the US, the fed funds rate is already at
zero. But the Fed continues to ease in different ways. Mr. Bernanke is now targeting not the fed funds rate but
rather private sector borrowing rates. By buying spread products, the Fed is trying to lower borrowing cost and
stimulate borrowing activity. Bank loans and leases outstanding increased by $8 billion in the latest week, the
first rise in four weeks, but are up just 1% from this time last year.
The Bank of Canada’s 50 basis points rate cut this week was not the last one for this cycle. Look for the Bank
to cut by another 50 basis points come March. This move is already fully discounted by the market and will not
have any significant impact on long-term rates.
But even if the Fed and the Bank of Canada are successful in lowering borrowing rates, you still need to create
conditions in which households will be willing to borrow. We know that there is some pent up demand for
borrowing following the recent decline in US long-term mortgage rates (after the Fed actively purchased MBA
securities), refinancing activity has tripled. But in order to insure a sustained rise in credit demand, we need a
stronger level of economic activity, and that’s where governments enter the picture.
In the US, the Obama Administration will soon introduce an estimated $875 billion in fiscal stimulus and in
Canada, we will see roughly $30 billion of new spending this year. A notable portion of this spending will go
towards infrastructure. And from an economic perspective, this is important as the economic multiplier of
infrastructure spending is significant. After all, when it comes to creating jobs and stimulating activity,
infrastructure spending is a much more effective tool than tax cuts. In the US, the impact of economic growth
of infrastructure spending worth 1% of GDP is more than double the impact of tax cuts, which have a greater
leakage to imported consumer goods, and which risk being saved by households. In Canada, $10 billion of
infrastructure spending can potentially create 110,000 jobs and lift economic growth by close to 1.5
percentage points—well above the stimulus effect of a tax cut of a similar size.
And that’s the main reason for the renewed optimism by the Bank of Canada, which now calls for a continual
recession in the coming six months but a healthy recovery in the second half. This is more or less in line with
our ongoing view—the combination of monetary and fiscal stimulus will be powerful enough to turn things
around in the second half of the year.
Benjamin Tal
Senior Economist
Economics & Strategy
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