Sunday, September 28, 2008

The Coming Shakeout

Saturday evening I had dinner with a young man I believe to be one of the most capable entrepreneurs that I have met in the Mid-Atlantic region of this United States. He has grown his company from three people to fourteen people over the last year and one half and has moved to bigger quarters. His revenues have increased rapidly and he has been profitable since the first month of his operations. He is in the Information Technology space and his specialty is in the area of search networks. He is very intelligent and a bundle of energy. He is also a great speaker and communicator.

We talked about the future and how he is positioned for the upcoming storm. If I were running a business right now I could not think of being in a better position than he is in. First of all, he knows who he is and what he stands for. This is a person that required his employees to give something back to the community right from day one they joined the firm…he himself is very active in community affairs. He believes so much in what he is doing and what his company has to offer that I have seen him turn down business when a potential customer has ask him to do something that he doesn’t believe equals up to the quality he demands in himself. He does not take on a customer just to build his customer base.

He stays focused and will not go into areas that he is not qualified to work in…he has a short list of other firms that are top performers in these other areas and easily shares them with potential customers.

He has done no marketing and does not need to do any for the near term because he is in such demand through follow up work or through word-of-mouth advertising that he needs little additional effort to grow his customer base. He has a full book but does not want to extend himself further at this time because he wants to maintain the quality of his work.

He has no debt! Furthermore, he has sufficient cash on hand and an adequate cash flow. He realizes that he may run into some months where cash flow might be negative over the next year or two, but with the liquid assets he has built up he seems to be prepared for some of these down months.

He has stayed focused. He has not branched out and diversified what he has to offer like many of his competitors. Thus he has not stretched his staff’s capabilities and has not created parts of his business that are now cash flow negative and drains resources from other, more crucial areas of the business.

As a case study, one could not pick a young firm and a young entrepreneur that is better positioned to weather out the coming shakeout.

To me, there are several important take-aways from this example. First of all, an entrepreneur, or for that matter, anyone who leads an organization, should know who he or she is and what their standards are. This is not something that comes after the fact, but is something that needs to be built into the leader before he or she commits to leading an organization. If you don’t know who you are, you will start to waver once you are faced with the decisions that will test you and your organization. And, once you begin to waver…

Second, an entrepreneur needs to maintain focus. When things are good and when pressure grows to take on more and diversify more it is very easy to lose focus and try and do all things for all people. The crucial thing in this age is to do something very well and continue to innovate in that field. Given the competition that is “out there” new products and services are constantly coming to the market and an entrepreneur cannot ‘blink’ or the competition will surpass him. Within this environment, diversification just enhances the competition’s changes to get in front of you.

Third, try and stay away from debt as much as you can. Taking on debt increases risk and the higher the risk is the greater the chance is that it will at some time divert one’s attention so that one loses focus. The business leader needs to create competitive advantage and sustainable competitive advantage comes developing some kind of market power relating to what his or her company produces.

If the business leader has to rely upon financial leverage to achieve exceptional returns, that business leader is just openly admitting that the firm does not have a market position of sustainable competitive advantage. The trouble with this is that when the business leader comes to rely on financial engineering to produce acceptable returns he or she has lost focus of the thing that has gotten the firm where it is and is betting on the financial markets to secure the future of the company. This is usually a bad bet.

My friend and I got to talking about my business activities. He knew that I had been in the process of starting up a private equity fund to work with young entrepreneurs in the urban environment. I believe very strongly that there are many exceptional opportunities to invest in young entrepreneurs within the inner city…investments in information technology and social networking. To me, this is important investment because the funds tend to stay in local communities, employment comes from local communities, and “give back” takes place in local communities. My plans also include the creation of a minority owned commercial bank and/or local credit unions.

Obviously this is not the time to build such a fund because the deployment of the monies would not take place in an efficient manner. This is a time to hold back, perfect plans, and get everything in place in order to be ready for when the time is right. One has to think of the future and be ready when opportunities rise to the surface.

So, I continue to write…my speaking engagements have increased (I have some open dates if anyone is interested…even some short courses are planned related to the subject of the financial crisis, Federal Reserve and government activity, and re-regulation for the future…and, of course, there is consulting on turn-arounds and restructurings and advising young entrepreneurs on how to prepare a start-up.

The coming shakeout is not going to be pleasant but we must continually work toward the future. My friend is an inspiration to me and a model for many other young individuals who would like to have their own company and who would also like to return something to their community. Everyone should be so lucky to have such a friend.

Friday, September 26, 2008

The Two Major Issues in this Crisis

There are two major issues that have to be confronted in this crisis. First, there is the pricing of assets. Second, there is the issue of capital. In my mind, the two need to be kept separate.

The first concern is that there are many securities that, at present, don’t have a market and hence their prices cannot be determined. This is primarily a short run issue. Typically in a situation like this the Federal Reserve provides sufficient support for the financial markets so that the markets stabilize and trading can once again take place. We are beyond that situation now and so we have to look further into what kind of problem might exist.

The situation we are in now is related to what economists call “the accelerator model”, a way of looking at things that Ben Bernanke is particularly fond of. On the up-side, the accelerator model helps explain what Charlie Kindleberger, an economist at MIT, popularized as the “mania” portion of a bubble. (See Kindleberger’s book, along with Robert Aliber, titled “Manias, Panics, and Crashes…a classic.) The problem with manias…and panics…is that they are cumulative. That is, they build on themselves.

The “accelerator model” in modern terms has a feedback mechanism in it that can create cumulative movements in asset prices. The particular channel this feedback mechanism works through is individual wealth. As the economy expands, asset prices rise. As asset prices rise, the wealth of individuals increase and they spend more out of this increased wealth. This additional spending raises asset prices further, credit grows to support this increase, and this leads to another round in which wealth grows further…an so on and so on.

Adherence to this model helps to explain Bernanke’s fear of inflation before last August.

But, the “accelerator model” works on the downside as well. The downside result has often been referred to as “deleveraging” or as a period of “debt deflation.” Here, as the economy slows or asset prices dip, the wealth of individuals declines. People reduce their spending and asset prices fall further. As asset prices decline, credit is tightened and this exacerbates the drop. This, obviously, is cumulative in behavior.

Just as Bernanke was concerned about the possibility of inflation in the spring and summer of 2007 he became extremely concerned about the possibility of debt deflation a week to ten days ago.

Did Chairman Bernanke panic? Did he over react? Only time will tell.

The issue before Congress now is whether or not they should enact a bailout plan that will help to stabilize the asset prices of a vast quantity of securities. Setting aside $700 billion in funds to help stabilize the market is the primary goal of the proposal.

ASIDE: whether or not the total is $700 billion or $1 trillion or $2 trillion is irrelevant. Supposedly when ask, a Treasury official said that there was no good reason for the choice of $700 billion, it was just that the number had to be quite large. This, of course, did not build confidence for the Paulson plan. However, in my judgment the answer is the correct one. No one knows how big the number needs to be. The crucial thing in a debt deflation is that those that are attempting to get out ahead of the situation need to have a lot of “chips” to play with. Whatever the number was it had to be a big one!

Return to message: is a proposal like this needed? Will such a proposal work? As I said in my Monday post…this is decision making under uncertainty…and this is beyond graduate school!

Another question that is being raised by House Republicans is whether or not this bill is philosophically (or ideologically) correct. The model these members of Congress work with initially cause them to reject such government interference with the market place. They have their arguments and we need to hear them before a final bill is passed. Any bill that is passed must have the general support of all members of Congress.

The second issue has to do with capital adequacy. It is argued that many financial organizations do not have sufficient capital to absorb the losses that exist on their balance sheets and will find it extremely difficult to continue business as usual if they are under-capitalized.

This issue is completely different from the first issue discussed above.

There are two choices here…either the market is allowed to work in the re-capitalization of these institutions or we allow the government to “invest” in these firms and become “owners”. The latter solution would mean that these institutions would be nationalized and we would, explicitly, socialize the financial system.

I guess we could call a combination of the two a possibility, but this would really be just bastard socialization…once you start this you have a socialized system regardless of how much of the system is in private hands.

To me there is no choice. I argue that the market should be allowed to determine who stays and who goes. What this will mean, however, is that more and more capital for American institutions will come from off shore. That is, the “wonderful” support for United States debt that has been accelerating in recent years, along with the decline in the value of the dollar, will lead to more and more foreign ownership of America’s assets.

Given this scenario, the major reason that might be given for a socialization of American finance is to keep it under American ownership, even if that ownership is coming from the government.

These two issues are the most important ones being faced in the current crisis. All the other things, to me, are secondary and should not muddy the waters of the debate going on.

ANOTHER ASIDE: I cannot agree with those that believe that this crisis was caused or exacerbated by “mark-to-market” accounting. I firmly believe in “mark-to-market” accounting because it increases the transparency of an institution’s decisions. Yes, it the market is moving around a lot there will be a lot of changes recorded on the balance sheet of a company, but, it was the management’s decision to have acquire such assets and the affect of these decisions should be obvious to shareholders and others. Riskier assets will require more marking to market. That is the choice of management. That choice should not be hidden.

Thursday, September 25, 2008

The Absence of Leadership

The New York Times has it right this morning. There is an absence of leadership in this country. See the lead editorial, “Absence of Leadership”:

Over the past six or seven months I have tried to emphasize two things. First, leadership must begin at the very top of an organization. The leader determines the culture and he or she must project this culture in everything that the leader says or does. My experience in business, government, and the not-for-profit sector is that if there is a leadership void at the top, even though others in the organization attempt to pick up the leadership reins, they cannot completely succeed. This is because there are others that will not go along because there is no one to “hold them in line” if they don’t follow those that are trying to pick up the leadership. Thus, things just don’t get done efficiently or effectively…and morale deteriorates.

Last night, the President referred several times to what “his” administration has been trying to do under “his” guidance. Yet, as the Times editorial points out, the whole rescue effort led by Hank Paulson has been highlighted by the fact that the President has been no where in sight. The President was pulled out of his bunker last week to speak to the press about the need for a bailout package, but his performance was like a puppet on strings and the voice that came out of his mouth was not his own. (See my post of September 22, 2008.)

Last night, with the whole Congressional effort lagging, the President was pulled out again to tell the American people that the thing we need to fear is fear itself and if the bailout bill was not passed quickly, Congress…not the administration…would be held responsible.

Again, the performance was less than believable, put on by someone that has no credibility.

In fact the show looked like a feeble re-run of past claims of impending disaster.

And, what does the absence of leadership get us? A bailout bill with little or no specifics; A Congress that is not cowered anymore by the idle threats of a lame duck; A nation that is not rallying to the call and is more against the bailout bill than for it; A brewing class war…the common man on main street and the greedy predator on Wall Street; and a market that has no idea where to go.

And, this is the second point I have tried to make…the increase in uncertainty faced by the financial markets. Yes, there are very wide swings in the stock market on a day-by-day basis. Yes, there has been a rush to quality and shorter term bonds. Yes, lending has dried up. This is what happens to markets that have little or no idea about what the future holds for them. Greater and greater volatility!!!

This, to me, is the bottom line of the current situation: there is little hope that we will get any leadership from the White House and the leadership of the Secretary of the Treasury does not substitute for the leadership of the President. There is a void in terms of “the leader of the people.” Hence, any bailout package that is forthcoming at this time will be less than satisfactory…and I believe that this is an understatement. And, this will mean continued uncertainty for the financial markets which can only lead to more volatility surrounding a weakening economy.

I fear that the pain is far from over.

And, I guess, what further disturbs me is that I don’t see the candidates for president “stepping up to the plate” to fill the void in leadership. They, of course, have to be careful in what they say with the pending bailout bill before Congress. However, people are claiming that the time is the worst since the Great Depression…that we are heading for a Second Great Depression…that those living have never faced anything like this…and so on and so on. The President says that times could get really, really bad. And, the responses we have gotten from our potential “Leader” leave us sadly with little confidence that the role will be adequately filled come January 20, 2009.

Financial markets…and the economy…thrive on confidence and trust. Confidence and trust allow market participants to make projections about the future and then confidently commit on an action plan. Without this confidence and trust, the future looks extremely hazy leading to only a tepid willingness to commit resources to any possible action plan.

The consequence of this…in general, stay as risk free as possible and as short as possible.

People may argue that this is not in the common interest. My answer is that, no, it is not in the common interest but our leaders have brought us to this point.

This is the same answer that I bring to the comment that “unbridled greed” brought us to the chaos that we are now experiencing. The leaders that set the economic policy of this country created the environment that rewarded people for acting in the way they did.

People respond to the incentives that are created by those individuals that determine the culture in which we live. It is always good to refresh ones’ mind on this point by reading and re-reading “Freakonomics”. It is also good to refresh ones’ mind to the fact that it is as normal for human beings to respond to ‘negative’ incentives as it is for them to respond to ‘positive’ incentives. See, for example, why Sumo wrestlers are like grade school teachers in Chicago!

Until we get some real leadership at the top in this country, my prediction is…hang on for the swings!

Sunday, September 21, 2008

Thoughts on "The Plan"

Well, “The Plan” is becoming a reality. What exactly it is and whether or not it will be successful is still a mystery. That is not the issue at this point in time.

To me the important thing is the philosophy behind “The Plan”. Up to now the policy makers have been shooting at a moving target…and the target that they have been going for is usually behind where the market and the institutions are. Thus, the policy makers have always been behind the curve…and things keep getting worse.

Now a new effort is being made. I think that we can clearly see the hand of Fed Chairman Ben Bernanke behind this move. I think that Bernanke finally won the day with the AIG effort. Bernanke, the student of the Great Depression, finally convinced everyone that the only way to really stop the down draft that was going on was to get out in front of it…not keep shooting behind it.

That is, the action had to be big enough to overwhelm the debt deflation going on.

This is the lesson from the Great Depression. One cannot let the debt deflation continue to cumulate. One must get out ahead of it.

This doesn’t mean that such actions may not cause problems in the future…inflation, moral hazard, or whatever. None of these are the problem now. If such problems are present in the future then the future will just have to deal with them. First…we have to reach the future without a major collapse.

The concern now is that debt deflation will get out-of-hand and the problem will only grow with time. That is why the policy makers believe that it is necessary to create a big enough plan to get ahead of the cumulating debt deflation and do more than is necessary to stop the downward cycle.

Will it be big enough? Will it succeed? Who knows? This is decision making under uncertainty and we are way beyond graduate school!

The policymakers believe that this package will be enough. But, they don’t know that either. My sense is that they just believe that the package needs to be big enough to really have a chance to work.

If “The Plan” works will this be the end of the effort?

No, the effort will still be in its early stages. The financial system and its regulatory framework will have to be revamped. What this administration is doing is attempting to buy time by stopping the downward spiral of financial markets and financial institutions. It is not proposing a solution about how the system will move forward. That will be up to the next administration.

Nothing the Paulson/Bernanke team has done suggests how the financial system and its regulation should be re-structured. The Fannie Mae/Freddie Mac bailout did not do it. Nothing that has taken place since that action has done it. This will be the job of the next administration.

And, Congress should remember this and not try and make all sorts of additions to “The Plan”.

In terms of the next administration, I believe that the two presidential candidates need to put their new programs and plans, like universal health care, on the back burner. I don’t believe that they will have much of a chance to put any of their promises or polices into place for three or four years. They are going to have to create the brave new world and get things back into order before anything else can be put into place. Thus, the candidates need to put their campaign promises into their back pocket for another time. I don’t think that it really helps the situation to talk much about them.

The presidential candidates need to see what the current administration puts into place and then needs to try and build on this to construct a plan to get financial institutions and markets back on their feet, to revamp the regulatory system, and to devise an economic policy that is both realistic and builds confidence, nationally and internationally. This is what the candidates are going to have to sell…first to the people of the United States and then to the Congress of the United States and then to the rest of the world.
The Paulson/Bernanke plan has to have a chance to work. It is not going to help right now to have the candidates confuse the issue with second guessing and petty attacks. This is going to be a fine line to walk, but the nation needs to pull together right now to stop the downward spiral.

Just one other point on the activities of this last week: it was necessary to get the President out in front of the cameras and speak about the financial chaos to the world. For too long in the current financial meltdown the President’s absence has been noticeable. Now, the whole world has seen the President speak out. Unfortunately for him, the puppet strings were quite obvious and one could see Hank Paulson’s lips move as the President attempted to mouth the words that were being spoken. One only has to wonder how much of his administration was conducted in this way only with someone named Dick Chaney controlling the strings and mouthing the words.

Thursday, September 18, 2008

It' One World Now!

The headlines this morning…The Federal Reserve, the European Central Bank, the Bank of Japan and other counterparts entered into a coordinated effort to provide liquidity to world markets so as to revive confidence in international financial markets and, hopefully avoid a melt-down. Now, almost $250 billion of dollars can be auctioned off around the world via swap lines within the world central banking network. Almost one quarter of a trillion dollars of liquidity is now available!

To my mind, the tipping point has been reached. The era of go-it-alone, unilateral, cowboy nation behavior has collapsed. It should be very, very difficult for a nation to act independently in its own interest in the future.

This has been coming for many years now, but, as usual, it takes a crisis to pull it off. Four major books in recent years have given us a picture of this world and the lessons of these books should be taken to heart. These books should be “must” reading:
Mohamed El-Erian—“When Markets Collide”;
Thomas Friedman—The World is Flat”;
David Smick—“The World is Curved”;
Fareed Zakaria—“The Post-American World”.
None of these books contends that America will lose its premier position in the world. What all of these authors imply, however, is that the United States must become a partner with other countries rather than the arbiter of world behavior. Not only has the world become more connected and interdependent, the world has also become more uncertain. The only way nations can function within such a world is to cooperate with one another and seek solutions together because the problems and difficulties they face are huge and affect everyone.

Historically, I would place George W. Bush alongside François Mitterrand in terms of country leaders that got caught up in an ideological dead end. In the 1980s, Mitterrand, who was the president of France and a Socialist ideologue, attempted to “go-it-alone” and introduce a very socialist program which included substantial budget deficits underwritten by the French central bank, capital controls and a possible government take-over of industries. Capital fight followed and private business investment dried up. Finally, in March 1983, Mitterrand, after many fierce battles, gave in to world financial markets, gave up his ideological stance and moved to tighten up the budget, make the French central bank independent, and fight inflation. This whole experience “was a brutal warning to all political leaders that the regime of global capital made it much harder for any government, whatever its democratic political mandate, to go its own way.” (This quote comes from Steven Solomon, “The Confidence Game: How Unelected Central Bankers Are Governing the Changed World Economy,” pgs. 286-287.)

George W. Bush, upon election to the U. S. presidency, established a “go-it-alone” effort, only in his case, the ideology was tilted to the Reaganomics of the 1980s…cutting taxes was the true test of his conservatism, everything else be damned. (It was a remarkable experience to listen in the primaries to ALL of the Republican candidates running to become their Party’s presidential nominee. They ALL bent over backwards attempting to convince people that they were the true heir of Ronald Reagan because they were going to provide the most tax cuts to Americans when they were elected President.)

Bush 43 got his tax cuts…and the Federal Reserve supported the tax cuts by keeping real interest rates negative just like a good member of the administration should…and now, like Mitterrand, Bush 43 is getting his market response. The only difference is that Bush 43 is not repenting and not changing his administration’s policies. He doesn’t have to…he’s a lame duck.

Another world leader facing his “Mitterrand moment” is Vladimir Putin, Prime Minister of Russia. Putin is finding out that even a Russian oligarch cannot “go-it-alone” and escape unscathed in terms of the opinion of world financial markets. Since the invasion of Georgia, the Russian stock market has fallen 55% and capital seems to be fleeing the country. The Russian stock market was closed on Wednesday and Thursday to stop the decline and the Russian government pledged the equivalent of almost $20 billion to shore up market confidence.

Bottom line—world leaders must decide on one of two choices going forward with respect to globalization. Either they can pull in the carpet through a national catering to populism, protectionism, and withdrawal from free-trade agreements or they can work with other nations to build a coordinated, cooperative world economic order that is composed of equal partners and not prima donnas.

To me, this is no choice at all. True leadership is going to come from those that realize the need of world partnerships and don’t pander to a national populist frenzy. True leadership is going to come from those that subscribe to the basic fundamentals of economics and finance (as discussed in my posts of September 15 and September 17). And true leadership is going to come from those that do not believe that their nation can just “go-it-alone”.

Wednesday, September 17, 2008

Fundamentals 101 (Part 2)

In my post about fundamentals on September 15, 2008, I started at the top…with the administration that has been in office in Washington, D. C. for almost eight years and the (supposedly) independent Federal Reserve System. My point is that the tone, the environment, the culture of the society starts at the top. And, if the leaders of our government are undisciplined and believe that they can do just about any thing they want to do without considering what others are doing, then this will set the pattern for other leaders within the society. It will pay…at least in the short run…to act in an undisciplined and irresponsible way.

Now, I would like to present what I believe to be some fundamentals for moving forward on the personal or business level. I believe that these fundamentals apply most of the time…the difficulty now is to re-establish them in an ambiguous and chaotic world. But, I am assuming that we will soon get some political leaders that will adhere to some of the fundamentals that were discussed in the previous post…we need an overall environment in which our leaders are disciplined and open.

The first of the personal or business fundamentals I would like to argue for today is for people to minimize the use of debt. The question is asked, “Where should I put my money today? In the stock market? In gold? Where?” My response is, pay off your debt as much as possible. I can think of very few instances today where a person or business can earn more on an investment of cash in something than they can reduce costs by paying down their debt. Plus, reducing debt reduces risk…not a bad thing to do in this environment.

A second fundamental of personal or business behavior is to re-focus and cut back on what one is doing. The tendency in times that are robust and heady is to diversify and stick your hand into a lot of different opportunities. Diversification looks good and enhances ones’ ability to grow and expand. Yet, we see over and over again that having a largely mixed portfolio can cause us to lose focus and, in particular, result in problems related to lack of oversight and a failure at risk management. People and businesses need to shed those things that are not within the scope of their primary interest and capability.

Another fundamental of operation that should be adhered to today is…reduce expenses…use resources more efficiently…especially resources that require a long term or fixed commitment. Not only does this protect cash flows…it also allows for greater flexibility of operations. Again, there is a benefit to performance over time, but there is also a reduction in risk because one can respond more rapidly to a changing environment or surprises.

Furthermore, don’t over produce. In such an environment it is better to have people want more of what you produce than to exceed demand and have to deal with unsold goods or services. As we have seen, an excess supply of anything can only be disposed of at ‘fire sale’ prices. This is not healthy for either the bottom line or for the market’s perception of what you do. If the market sees that customers aren’t buying all you produce, they will focus on the unsold inventory and not on the amount that is purchased. This also applies to financial institutions whose business it is to make loans.

Finally, I can’t stress enough the need for openness and transparency. There are two reasons for this. First, in terms of asymmetric information: in times like these where there is a substantial amount of uncertainty in the air, others will pull back from you if they do not know or understand what you are doing. As a consequence, values can drop and often they can drop precipitously. Being open and transparent about what you do and your problems and how you are attacking them is the best way to attempt to keep relationships alive. People will be more willing to do business with you if they believe you are being up front with them and open in your dealings.

There is a second aspect to openness and transparency that I believe is even more important than the first. This is the effect that a policy of openness and transparency has on your own behavior and the behavior of those that work with you. If you have a policy of keeping things out in the open you and your colleagues will respond more rapidly to problems as they arise and resolve these problems as quickly as you can. If you do this you will do your best to not allow problems to grow and become major issues that result in disruptive solutions.

I know that many of these ‘fundamentals’ seem to be conventional platitudes and are obvious. Sometimes, however, they just need to be restated and re-emphasized so as to bring us back to reality. There are reasons these things are called fundamentals. It is because they have long run survival value.

The problem with acting on these fundamental operational principles is that if a lot of people adhere to them there will be ‘macro’ difficulties for the economy as a whole. The general term given to such aggregate behavior is ‘debt deflation.’ If people reduce the amount of debt outstanding and cut back on producing and spending, the economy will spiral downward.

This was the situation John Maynard Keynes believed the world faced when he developed his theory of aggregate demand. His conclusion was that the only way to get out of a situation in which the private sector was withdrawing their expenditures was to substitute government expenditures for the private expenditures to expand aggregate demand. If people were attempting to retrench and get their economic and financial situation under control, government must step in and pick up the slack until confidence returned to the private sector so that its spending would rebound.

It should be noted that in his original work Keynes did not propose tax cuts as a way to stimulate aggregate demand…he proposed government projects that would directly put people back to work again. What is wrong with tax cuts in these circumstances? Well, if people are attempting to protect themselves financially and are becoming more risk averse, tax cuts will primarily be used to pay off debt or to hoard cash. This would not put people back to work again. Employment and confidence could only be regained by direct hiring which would raise incomes.

But, one can’t just keep buying ones self out of their problem.

Since Keynes wrote we have learned that much of what has been described above, when it is applied to business behavior, is a supply side response and not a demand side problem. That is,
businesses and financial institutions have over expanded in the past and now they are attempting to return to a more reasonable and controllable size of operation. Public expenditures that attempt to return them to their over expanded states only perpetrate the situation and postpone any correction for another time. Of course, if the government has continually underwritten business expansion in the past and perpetrated bloated operations and excessive risk taking, the adjustment that finally comes might just be immune to further efforts to keep the bubble from bursting until another time.

The basic problem is that humans, individually, as well as collectively, cannot continuously ignore fundamental principles. Again, to use a sports analogy, a player or a team that neglects the fundamentals of their sport will eventually come up against a competitor that does focus on the fundamentals and will be defeated, even if they are the better athlete. The United States may be in that situation now!

This is a tough time. There is going to be a lot of pain going forward. Eventually, however, the piper will be paid. The best thing that we can do is to get back to the basics and focus on those individuals and companies that also concentrate on the fundamentals and are disciplined enough to execute at a high level.

Monday, September 15, 2008

Fundamentals 101

Mase: Economics and Finance. September 15, 2008

Fundamentals 101

The United States (and the world) is in a crisis mode. It will continue to stay in a crisis mode for some time. In working through this transition period it is crucial to remember…that fundamentals are important.

Americans are always ones for sports analogies. Let’s start with the need to develop fundamentals. We emphasize the fundamentals of the golf swing in golf. We emphasize the fundamentals of hitting a baseball in baseball. We emphasize the fundamentals in football…and so on and so on.

But, in finance and economics we constantly reflect upon a new economics, a new era in finance, and a new…whatever. We keep finding reasons to believe that we have entered some new period that negates part or all that we have learned. And, when we follow this path, we always end up finding out that…well…that the fundamentals really do still apply.

We can certainly blame the leaders of the corporate world of finance and industry for their putting the fundamentals of finance aside in their quest to become the biggest and “the best”. (What “the best” means we will save for another time.) All I will say here and now is that they were followers…not leaders…and that led to the downfall of those that have failed or will fail.

The leaders I have most scorn for at the present time are those leaders that created the atmosphere…the culture…in which others had to operate. These leaders completely ignored the economic and financial fundamentals that have, over time, proven to be so important in performance. And, the leaders I am talking about here are the political leaders that “set the table” for the period of upheaval that we are now going through.

The number one fundamental that must be adhered to is the one that relates to the value of the currency of a country. The leaders of a country must not…let me repeat…must not…let the value of its currency decline precipitously. I am not talking about slavishly keeping the value of a currency at a particular price. History has shown that this kind of policy does not work either.

Focus upon the value of ones currency causes one to focus upon what your country is doing relative to what other countries are doing. Many people do not like this thought because it seems to make the economic and financial policy of our country dependent upon what everyone else is doing. These people do not want to give up their sovereignty.

The problem with acting independently of everyone else is…we are not independent of everyone else! We live in a world where everyone else is dependent upon everyone else…whether we like it or not!

First finger pointed in blame…the Bush 43 administration. It came into office believing that the United States was so special that it could act unilaterally on anything it chose…it acted that way.

Second finger pointed in blame…Alan Greenspan and the Federal Reserve System. Whether or not they claim that they were paying attention to the value of the United States Dollar they did not act as if the value of the dollar was of any interest to them. They allowed the dollar to decline in value for about seven years. The value of a country’s foreign currency is the NUMBER ONE price that a central bank needs to focus upon!

Why, does a central bank need to focus on the value of its currency in foreign exchange markets? It is because the value of the currency provides information about how market participants are perceiving the economic policy of a specific country vis-à-vis other countries. Sure, the markets can be wrong in the short term, but over seven years the markets must contain some pieces of information that are not totally off-the-charts in terms of what is going on.

This is an important attention to the value of your currency in foreign exchange markets.


But, that is why central banks are supposedly independent of the government of a nation.

Greenspan acted as if the Federal Reserve was nothing but a lackey of the Bush Administration!

If the Federal Reserve had acted as a real independent central bank…

Well, it didn’t…and see where it got us.

I am writing these things because we are currently in the midst of a presidential campaign. My concern is that not one of the candidates is addressing the real economic issues that the country faces. Furthermore, I don’t believe that they will before the election in November. This is due to the fact that neither of the major candidates wants to discuss the fundamentals that need to be re-addressed if the country is to get back on its feet. People want to hear what the candidates are going to do for them and not what fundamentals need to be re-established.

First, let me say that I believe that we are going to get through the current period of financial dislocations…there will still be failures, maybe even some large ones…but, we will get through this adjustment in the next eighteen months or so.

The concern seems to be growing that the economic problem will be one of stagflation. Let me just say here that the fundamentals of supply and demand analysis has not been surpassed. The problem with stagflation is that economic growth is slower than desired and that inflation is higher than desired.

NOTE: this is not a DEMAND-SIDE problem, IT IS A SUPPLY SIDE PROBLEM! ! !

Just goosing up aggregate demand with popular economic stimulus programs will not overcome the problem. Focusing just on demand-side solutions will only exacerbate, and not relieve the situation.

So, here is a fundamental teaching that we must not ignore.

Second, we live in an inter-dependent world. The United States cannot…repeat, cannot…just go off on its own and act unilaterally. We must talk with others. We must devise out programs, both economic and financial, within the context of what other nations are doing. Yes, this sacrifices some of our valued independence, but that is the way the world is. We must plan and live in such an inter-dependent world.

Here is another fundamental teaching that we must not ignore.

Third, the Federal Reserve must regain its independence once again. It must focus on what it should focus upon, the value of the United States dollar, and if other areas of the government cannot do what they want to do…then sorry, but this is the discipline that a real central bank bring to its nation.

This fundamental teaching cannot…let me repeat…cannot be ignored!

Sunday, September 7, 2008

Coming Home to Roost

Try as hard as it might, Bush 43 could not postpone the consequences of its actions until it January 20, 2009. Bush 41 largely escaped. Son’s administration was not so lucky.

Yes, things started unraveling early in 2007 with the subprime market leading the way. But, the economy did not ‘tank’ and many, including McCain’s friend, advisor, and one time choice for Secretary of the Treasury in a McCain administration, kept telling us that ‘things weren’t so bad’ and that some people just suffered from mental depression and were just whiners.

After the initial liquidity scare, the unwinding of financial positions has been relatively smooth. Sure, Bear Stearns was bailed out, but Citigroup and Merrill have gotten capital infusions and are still standing. The housing industry has suffered tremendously, but there have been no major wipe-outs. There now have been 11 takeovers in the banking industry, but they have been relatively small banks…in general. Retail trades have only experienced a few bankruptcies. Food chains have been suffering, but no real biggies here. Manufacturing has been on hold but most large companies seem to be holding on with a fair amount of cash on hand. (Hold your breath General Motors…)

Now, however, some of the bigger paychecks are coming due. Fannie Mae and Freddie Mac have been taken over, their top executives relieved of their positions, and the United States Treasury Department has committed the American Government to “an open-ended guarantee to provide as much capital as they (Fannie and Freddie) need to stave off insolvency.”

What might this commitment amount to?

Well, Fannie and Freddie have accumulated more than $5 trillion in assets. Five trillion dollars includes a lot of zeros. There have been estimates that this commitment could cost around $20 to $30 billion, but I quoted a figure of $200 billion in a recent post. These are big numbers so we need to be careful in trying to comprehend their size. If there were a 20% write off of asset value, this would amount to $1 trillion; a 10% write off would amount to $500 billion, a 5% write off would amount to $250 billion, and a 1% write off would amount to $50 billion.

You pick a number. What will be the amount of the write down of these assets?

The important thing is that action has finally been taken. The administration finally reached the point where a takeover could not be postponed any longer. In fact, that has been the case for the last twelve months or so. The people in authority kept postponing and postponing action until they have no further choice.

The Bernanke Fed has gotten a lot of attention and praise/blame for the dramatic reduction in the target Fed Funds rate it uses to anchor monetary policy. But, if you remember the situation in the spring of 2007, Bernanke and the Fed kept putting off and putting off any reduction in its target rate of interest because they did not comprehend the need for such action. Then, when they did move they felt the drop needed to be one of the most precipitous declines on record.

The same thing is true of many of the other responses of Bush 43 in 2007 or 2008.

This is an administration that was pro-business and hands off in terms of rules and regulations. This administration did not want any economic dislocation coming on its watch. Now, it is having to act and the question is, how much more is it going to have to do before it gives up office?

The irony of the situation reminds me of that faced by the Nixon administration back in August of 1971. I joined the Nixon administration as a Special Assistant to George Romney (HUD) on August 1. Sunday evening, August 15, President Nixon went on national television and announced the freezing of wages and prices. I was fortunate (or not, depending on your philosophical leanings) to attend meetings of the Cost of Living Council and the Committee on Interest and Dividends. It was remarkable to sit in these meetings, day-after-day, and see individuals that abhorred controls of any kind, attempt to administer wage and price controls. Many of these people were violently opposed to wage and price controls or, at least, were indifferent to their application.

I perceive that many in the current administration are going through this soul-searching at the present time. And, they are faced with the prospect of other intrusions into the economic and financial system as they wind down their terms in office. How many of them wish that they had left the administration a year or so ago?

Fred Mishkin, who resigned from the Board of Governors of the Federal Reserve System in August…how lucky you are!!!

I really believe that these people want out. And, what is one of our presidential candidates shouting? “I think that we’ve got to keep people in their homes. There’s got to be restructuring, there’s got to be reorganization, and there’s got to be some confidence that we’ve stopped this downward spiral.” Senator McCain concluded, “It’s hard, its tough, but it’s also the classic example of why we need change in Washington.”

My question here is, who is Senator McCain, if he is elected President, going to use to clean up the financial and economic mess? My take is that the current people want out…they are receiving enough of the blame for the current administration. And, who might be brought in…Phil Gramm and Jack Kemp? The Republican pool is relatively dry…it has been picked over for the last eight years. Shall McCain reach across the aisle? If he is going to bring in a bunch of Democrats to clean up the mess…isn’t this a little bizarre?

There is a lot a new administration is going to have to do when it gets in office to get the economy and the financial system working smoothly again. Yes, economic growth is going to have to be renewed, but there is also the underlying inflation that will still be worrisome. Yes, the regulatory system needs to be revisited. Yes, the dollar needs to be attended to? Yes, foreign money is buying up American assets at a record pace. Yes, we need a real energy policy. Yes, the auto industry is in the tank. Yes, home owners are losing their homes. Yes, these are just a part of the agenda that will be facing a new administration come January 20, 2009.

This agenda is why I don’t believe any new President is going to have much room to introduce new items that are on their social or economic agenda. I think the campaign message should be…I would like to do thus and so…but, because of the current mess that I will inherit, there will be very little I can do in the next two to three years. I know you would like to hear something different, but, in all honesty, that is all I can promise you at the present time.

The problems created by Bush 43 are coming home and we must face them head on. The absence of an energy policy has put the United States in an embarrassing hole that it is finding difficult to climb out of. But, we need to stop digging the hole deeper. Our policy with respect to the dollar has been abysmal and it has put many United States assets on the block for foreign interests. Our fiscal policy has been totally out-of-control and has placed a large amount of the United States government debt in foreign coffers. Our monetary and banking policies have ignored the innovation taking place in the financial sector and, as a consequence, our authorities have lost control of sub sector inflations…inflations that have resulted in credit expansions pertaining to specific asset stocks and not to their sector cash flows.

We have a long way to go before we are out of this economic and financial morass. To me, risk is still being underestimated in the markets. The Fannie and Freddie experience is only another step along the bumpy road ahead of us.

Thursday, September 4, 2008

The Summer of 2008 at the Fed

Time to take a quick look at what the Federal Reserve has been doing this summer…just as a check. Operationally, the Fed has done business, as usual. During the summer months, people take money out of the banking system for vacations and such and so Currency in Circulation goes up seasonally. Also, there usually is an increase in funding transfers which puts pressure on financial institutions to supply and clear funds through the banking system so that, generally, bank reserves held at the Federal Reserve increase seasonally. Responding to these movements just falls into the operational responsibilities of the Federal Reserve System.

Overall, looking at the Federal Reserve’s H.4.1 release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks”, we observe that Currency in Circulation increased by approximately $8.0 billion from the banking week ending June 25 to the banking week ending August 28. Also during this time period, the reserve balances of depository institutions at the Federal Reserve increased by about $8.5 billion. Thus, on a seasonal basis, there is an increase in the Monetary Base supplied to the public in the summer time.

These were the main changes on the operational side.

There were two changes in the actions of the Federal Reserve that related to the financial dislocations of earlier this year. One had to do with the lending of credit to primary dealers, which began operations on March 17, 2998. This category included credit extensions such as the arrangements involving JPMorgan Chase & Co. and The Bear Stearns Companies, Inc. In the first week this account existed, the balance shown was a $13.4 billion increase in Fed credit extended. The balance rose to a maximum amount of $38.1 billion in the banking week ended April 2, 2008 and then declined slowly after that. By June 26, 2008 this account dropped to zero as the resolution of the JPMorgan and Bear Stearns bailout reached its next stage.

The next stage of the JPMorgan and Bear Stearns arrangement with the Federal Reserve showed up in the formation of a limited liability company called “Maiden Lane LLC.” But let’s go to the actual statement of the Federal Reserve to define this company and how the funds advanced to it appear on the release showing the factors supplying and absorbing reserves to the banking system.

“The Board’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions
and Condition Statement of Federal Reserve Banks,” has been modified to include information
related to Maiden Lane LLC, a limited liability company formed to facilitate the arrangements
associated with JPMorgan Chase & Co.’s acquisition of Bear Stearns Companies, Inc.

On June 26, 2008, the Federal Reserve Bank of New York (FRBNY) extended credit to Maiden
Lane LLC under the authority of section 13(3) of the Federal Reserve Act. This limited liability
company was formed to acquire certain assets of Bear Stearns and to manage those assets through
time to maximize repayment of the credit extended and to minimize disruption to financial markets.
Payments by Maiden Lane LLC from the proceeds of the net portfolio holdings will be made in the
following order: operating expenses of the LLC, principal due to the FRBNY, interest due to the
FRBNY, principal due to JPMorgan Chase & Co., and interest due to JPMorgan Chase & Co. Any
remaining funds will be paid to the FRBNY.

Consistent with generally accepted accounting principles, the assets and liabilities of Maiden Lane
LLC have been consolidated with the assets and liabilities of the FRBNY in the preparation of the
statements of condition shown.”

Thus, the statement put out for the week ending July 2, 2008 had a new account called “Net portfolio holdings of Maiden Lane LLC” and showed a balance of $29.8 billion. This account declined to $29.2 billion by August 27, 2008.

What offset this increase in factors supplying reserves to the banking system? Net repurchase agreements declined by $11 billion in July and then declined by roughly another $10 billion in August. That is much of the increase in reserves supplied to the banking system during this time was offset by the decline in repurchase agreements. The initial support for the Bear Stearns bailout was a temporary phenomenon and so it seemingly was supported by a temporary supply of funds. As the accounting for the bailout was resolved, the temporary supply of funds was replaced by a more permanent source of funds consistent with the bailout agreement.

It should also be noted that NO additional funds were supplied to the banking system through the Term Auction Facility (TAF) during this time period. Auctions were held during this period, but the TAF line item began the period under review at $150.0 billion and ended the period at this same amount.

So what is the bottom line on the summer activity of the Federal Reserve?

To summarize…first, the Fed took care of business by supplying seasonal reserve needs to the banking system. Second, the Fed resolved the accounting treatment of the commitments made in the March bailout of Bear Stearns. Overall, nothing exciting was going on…which in the case of the central bank is a very good thing!

In terms of more aggregative data…things seem to be moving on relatively smoothly. As mentioned in my last post of September 1 ( which dealt with banking failures and the working out of banking failures: the situation may not be a good one and recovery may not take place as soon as we would like it to, but if the adjustment is going smoothly then that is the best that we can hope for in the near term. We don’t want surprises!

The Monetary Base (monthly on a non-seasonally adjusted basis) has grown, year-over-year, roughly between about 1.5% and 2.5% in the past six months. The year-over-year growth of total reserves at depository institutions, again monthly on a non-seasonally adjusted basis, has fluctuated a little bit more jumping roughly between 0.5% and 3.5% during the past six months. At present, however, there seems to be no trends established in either of the measures which seems to indicate that adjustments are taking place without any major disruptions. This is good!

Money stock growth (as measured by the broader M2 measure) seems to me to be too high for my comfort level but the year-over-year growth rate has remained relatively stable throughout 2008. This growth rate has fluctuated in the 6.0% to 6.5% range except in February and March when the Fed was resolving the liquidity crisis and the Bear Stearns bailout. In April, the rate of growth dropped back into the stated range. The interesting thing is that the year-over-year growth rate of the M1 money stock measure has popped up in the last two months after staying around a zero rate of growth for the first six months of the year. Seems like “Other Checkable Deposits” at both commercial banks and at thrift institutions have jumped up more than seasonally. (These are primarily NOW accounts and ATS accounts.) But, this appears to be just a re-arrangement of how people are managing their money because the increase in the growth rate of the M1 measure has not translated itself into an increase in the growth rate of the M2 measure.

So, things seem to be calm right now on the banking and monetary front. We can only hope that it stays so.

Monday, September 1, 2008

Commercial Banking and Bank Failures

Last Friday officials closed the tenth commercial bank this year. It was a small bank in Georgia with $1.1 billion in assets. The problem…rising loan defaults. The FDIC now has 117 banks on its list of institutions that are in danger of failing. The probability of a large number of these banks actually failing is quite large.

The failure of these banks does not get a lot of public attention. The reason for this is that most of these banks are relatively small and the losses they amass are not as eye-catching as the billions of dollars in charge offs of institutions like Merrill-Lynch and Citigroup. It is reported that the FDIC believes that the cost to the deposit insurance fund of this most recent failure to be in the neighborhood of $250 million to $350 million…a drop in the bucket.

But, the numbers add up as the number of defaults increases and the costs of a failure rises. Legitimate concern grows over the ability of the deposit insurance fund to handle future bank failures as well as the ability of the FDIC to administer a large number of failures. And, this doesn’t even consider some large bank failures that a few analysts assure us will take place. In terms of the losses in all financial institutions, the numbers, at present, are dominated by the overhang of the $200 billion that is the estimated cost of the Fannie Mae and Freddie Mac bailout.

The closing of commercial banks will only work itself out slowly over an extended period of time and, in general, the working out of these closures will be smooth and orderly. We are not in a liquidity crisis at this time, we are in a credit crisis. A liquidity crisis is a short term phenomenon where one side of the market, the ‘buy’ side, disappears. A credit crisis is a longer term situation in which borrowers default on their loans over time, a situation in which both sides of the lending transaction attempt to “work things out”.

A liquidity crisis occurs in a financial market where financial assets are traded on a regular basis. The essence of the market is the ability to buy or sell financial assets in a short period of time without having to make much price concession in order to complete a transaction. The liquidity crisis takes place when buyers are reluctant to acquire the asset and sellers have to substantially discount the assets they want to sell in order to have any hope of finding a buyer in the market.

The credit crisis that we are now going through in the commercial banking industry is one basically related to ‘non-market traded assets’. These are primarily assets that are on the books of the originator so that there is no market price which can be used to value the assets. These are loans made by the bank to a customer in which the bank keeps the loan that it has made. The customer then gets into a financial bind and either is unable to fully meet the terms of repayment or cannot repay at all.

In terms of banking practice, the commercial bank initially does nothing to adjust the value of the loan for the failure of the customer to meet the terms of the loan. The loan will first migrate through the bank’s delinquency report going from 30 days past due to 60 days past due to 90 days past due and so on. Loan collection efforts lag this movement through the delinquency list, going from computer generated delinquency notices to calls to direct collection efforts to ultimately selling the loan to a collection agency.

In my experience within the banking industry, the psychology of the management of a commercial bank goes from a belief that the customer is just have some timing problems, to “things will work themselves out”, to “we may have a problem here so let’s see how we can work with the customers and get things back on track”, to “we have a real problem here and we need to get tough”, to… Bankers have a real tendency to postpone action on the loans that they have put on their books because they have trouble believing that they have made a mistake. The loans are “personal”, something that shouldn’t happen in business. Right?

The consequence of this behavior is that substantial time usually elapses before commercial banks act on their loan portfolio problems. Examination and regulation can only partially speed up this process because the bank exams only take place periodically. Furthermore, it is the banks records and documentation that the examiners review and so time for observation and follow up must be allowed for. This is the reason for “watch” lists, not action.

The bottom line…the identification of bad loans and the process for correctly valuing these assets takes a long time. Consequently, a situation like the one we are in cannot be expected to work itself out quickly…the affects of the credit crisis will last of awhile.

One other issue in the banking arena I would like to discuss…start up banks. The bank that was taken over on Friday was located in the Atlanta suburbs. A Wall Street Journal article, ( reports that sixty (60) banks were formed in the Atlanta area between 2003 and 2007! Sixty banks!!!

I live in the Philadelphia area. Just last night I passed a new bank that I had no idea where it had come from and who was running it. This just reminded me that new, small banks had been popping up all over the place in the last few years. The number of new start up banks in the United States must be astronomical over the last five years!

Why this is so astounding to me is that it indicates, to me, a real let down on the part of the regulators…on the part of the Federal Government. Putting many, many new institutions into markets that are well banked is extremely dangerous. Yes, big banks don’t serve local neighborhoods as well as do smaller banks with a local focus. Still, the smaller bank must establish a niche market and is usually desperate for quality loans. Emphasis is on growth so loan generation is a must. And, these loans are not made to sell because the new bank wants the balance sheet growth, so the loans are booked. “High quality” borrowers are generally taken up by existing banks so any effort to get these loans must include concessions on rate or term of some other element of the loan agreement that squeezes the new bank. More often the new bank must go after loans of lesser credit or into local speculative deals. The Wall Street Journal article says that the Atlanta area, during this expansion in banks, was “marked by overbuilding and loose lending practices during the real-estate boom.” The staff of the regulators had to keep up with all of these new banks at a time when the staffs were being contained for cost reasons and the bigger banks were going into more and more complex transactions.

This last comment raises another point. My experience is that many of these “professionals” that started up these new banks had a pretty high opinion of themselves. They think that they are pretty sophisticated. In one of the commercial banks I turned around, I was astounded by the Investment Policy the bank had concocted, the board of the bank had approved, and the regulators had never made mention of. This was a small startup bank that had been in existence maybe five years and had assets of about $100 million. Their investment policy allowed them to engage in some of the most sophisticated investment vehicles that existed at the time. In my review of the management that had been in place, there was no one…repeat, no one…in the institution that had any qualifications to transact in any of the investment vehicles they had the authority to invest in. And, this authority, written down and approved by the bank’s board of directors, had not seemed to bother the examiners and regulators at all! Why do I think that this picture could have been duplicated many times over in the last eight years?

One final point about the current situation: a credit crisis like the one that we are going through usually has an impact on the extension of credit going forward. Commercial banks that have just been burnt with charge offs and faced the possibility of extinction become risk averse and do not extend credit. Bank funds will not be readily available to support much economic expansion.