Thursday, July 28, 2011

Can Anyone Manage the "Too Big To Fail" Banks


An interesting article: “Once Unthinkable, Breakup of Big Banks Now Seems Feasible,” (http://dealbook.nytimes.com/2011/07/27/once-unthinkable-breakup-of-big-banks-now-seems-feasible/?pagemode=print) appeared in the New York Times on Thursday.

The basic question posed in the article: “Lawmakers and regulators have failed to remake our system with smaller, safer institutions.  What about investors?”

Our largest banks are not performing that well.  Shouldn’t stockholders demand better performances?

In terms of Return on Shareholder’s Equity (ROE), Wells Fargo has been at the top of the list of the Big Four.  With the exception of 2008, Wells has earned an ROE of around 10 percent, give or take a little. 

JPMorganChase has not done as well since it was attempting to play “catch up” with the others in the Big Four in the middle 2000s.  Other than in 2008, it has consistently improved its performance with some analysts arguing that it will earn around an 11 percent ROE in 2011.

Citigroup and Bank of America are lagging substantially behind these two.  Citi seems to be recovering from the disasters of 2007, 2008, and 2009, but its performance is still far from stellar.  Bank of America is…terrible.  Both companies will probably not see a 10 percent ROE for many years. 

The point the author of the above article, Jesse Eisinger, is trying to make is that such terrible performances should be met with shareholder demands to restructure in order to improve performance.  Of the four, Citigroup has made the greatest effort to do this but it is an indication of how badly the bank was managed that even this effort has left a lot of work still to be done. 
Bank of America seems to be in a daze.  I don’t think anyone there knows what they are doing.

JPMorganChase, having survived the financial collapse as well as anyone, is trying to expand into areas round the world in which it has not previously been competitive. 

The question proposed by Eisinger is a good one.  Given the performances of these organizations, shouldn’t the shareholders demand some leadership that would rationalize these organizations and get them back on the track to earning competitive returns, which in my mind is an ROE, after taxes, that exceeds 15 percent?

How has the market reacted?  Well, the only bank whose stock price trades above book value has been Wells Fargo trading at about 1 ¼ times book.  JPMorganChase trades at book; Citigroup trades at about ¾ book; and Bank of America trades at around ½ book.

The banking industry, led by these four banks, spent the latter part of the twentieth century building up financial conglomerates through mergers and acquisitions.  The push was to build, build, build.  Financial performance came from financial engineering and financial innovation.  Increased risk taking and greater and greater financial leverage were the games to be played.  Off-balance sheet accounting became a way to hide risk and to “jack up” returns.

As former Citigroup chairman and CEO “Chuck” Prince is famous for saying, “If the music is still playing, you must keep on dancing.”

The problems that accumulated due to the merger and acquisition binge that took place before the financial crisis hit was exacerbated from actions taken after the financial crisis hit by the acquisitions these organizations made in cooperation with the federal government.  Need one mention the acquisitions of Merrill Lynch, Washington Mutual, and Bear Stearns, among others?

Conglomerates, generally, have never had a history of being great financial performance.  Just putting together different kinds of businesses without any reason, without the possibility of achieving any synergies, has not produced exceptional results.  In most cases the resulting performance of such combination is abysmal.

Given this belief, one really needs to ask a question about the “quality” of the performances recorded before 2007.  The amount of accounting tricks, off-balance sheet “slight of hand”, failure to mark-to-market underwater or bad assets and so on sure made some of these banks look like they were really something.

Yet, when things got tough all this “magic” went away.  Banks even stated that some of the calls for accounting “sanity” caused them all the troubles they ran into.

Again, “If you say the problem is out there, that is the problem.”

In my view, the regulators are never really going to get these organizations under control, make them economically sound.  The pressure to do this must come from the owners, the shareholders.

Eisinger presents three reasons why this is unlikely.  First, a large number of bank owners (institutions) tend to be “passive and conflicted.”  Second, top managers get paid for running larger institutions.  If the banks became smaller, top executive salaries would decline.  Third, the growth in world trade requires large banks to support the large, multinational corporations. 

To me, the only true test is performance.  Can large, multinational banks earn a return that justifies people and institutions investing in them?  Can they earn a 15 percent ROE after taxes through achieving sustainable competitive advantage?  Or, do they need to take on excessive business and financial risk accompanied by accounting “gimmicks” to earn such a return?

I have three immediate responses to this.  First, financial regulators and legislators can never do the job we would like to think they might do.  For one, they are always fighting the last war.  They are still trying to prevent a 2008-2009 crisis from happening again.  In addition, given the changes taking place in information technology, it will be extremely difficult to keep up with everything that is going on in the banking system thereby making these institutions even harder to regulate.

Second, the number of “banks” in the banking system is going to continue to decline.  Small- and medium-sized banks are going to find it harder and harder to find niches that are not being eroded by the Internet, mobile devices, and non-banking organizations.  My prediction has been that America will have less than 4,000 banks in five years and this trend will continue. 

Finally, the best thing that Congress and the regulators can do is to require more openness and transparency in the banking system.  We have seen what accounting tricks, lack of disclosure, and failure to record realistic asset values can do to “pumping” up the banking system.  Required greater disclosure can go a long way toward investor understanding what a bank and its management are doing. 

Also, other tools can be used to bring market instruments into the picture as an early-warning system like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs, and “To Regulate Finance, Try the Market” in Foreign Policy.

The regulators are not going to correct the “Too Big To Fail” problem.  Maybe the owners of the “Big” Banks should correct the problem.

Wednesday, July 27, 2011

Washington Going Nowhere: Dollar Hits New Lows


For fifty years, the United States government has followed a policy of credit inflation.  And, I am blaming both parties…the (Keynesian) Democrats and the (“we’re all Keynesians now”—Richard Nixon) Republicans. 

The current discussions going on in Washington, D. C. don’t really give me much hope for the future.  Congress and the White House may talk about reducing deficits now, but both sides of the talks don’t seem to have any idea about creating a sustainable government policy with respect to the creation of federal debt.

As I have reported before, since January 1961, the public debt of the United States has increased at a compound rate of growth in excess of 8 percent per year.  This has resulted in the public debt now being in the neighborhood of $14 trillion. 

Over the past two years, I have argued that in the next ten years, the federal debt will at least double from its current level.  If we cut the deficit by $4 trillion…or $3 trillion…or $2 trillion…figures that have been tossed around in the current debates…we will still add massive amounts to the existing debt levels. 

This amount of debt, I don’t believe, is sustainable even after these cuts. 

Why has the United States government amassed so much debt during this time period?

The reason is that the number one goal of the government’s economic policy has been to achieve high levels of employment…low levels of unemployment.  

As I have written elsewhere, the achievement of this goal is impossible.  And, all the government’s efforts to attain this objective have just resulted in making the employment situation worse.  Not only has the official unemployment rate been greater than the target unemployment rate for this period, the level of under-employment in the United States has risen to the point where about one in five people of working age are underemployed…either unemployed, employed part time but want to be employed full time, or have dropped out of the labor market. 

So, the federal government has followed a policy of credit inflation for fifty years and has not only not achieved its goal but has made the employment situation much worse.

In addition, the policies of the federal government have resulted in a tremendous skewing of the income/wealth distribution in the United States away from those earning the least and in favor of those earning the most.  This was certainly not something desired by the perpetrators of these policies.

Wasn’t there any indication that something was wrong? 

In my view there was some very clear evidence that something was wrong.  The value of the United States dollar against other currencies in the world has been an indicator that investors throughout the world thought that the economic policies of the United States government were not sound and that there was little or no hope that the United States government would re-establish any discipline over its budgeting process.  The feeling was that as long as the United States continued to pursue the effort to achieve full employment, fiscal discipline would be ignored.

My argument is that the United States has followed an explicit policy of credit inflation since the early 1960s.  The period began with the value of the United States dollar pegged against gold.  However, the credit inflation of the 1960s brought this to an end as President Nixon took the dollar off the gold standard on August 15, 1971 and floated the dollar in the foreign exchange market. 

Since then, the trend has been downward.  This is shown in the following chart. 

There are two exceptions to the downward movement in the value of the dollar.  The first is the Volcker monetary tightening coming in the early 1980s which resulting in the short term peak in the value of the dollar in February 1985.  The second is the Rubin fiscal tightening that took place in the late 1990s with the near term peak in the dollar’s value occurring in July of 2002. 

Otherwise we have the following results:
Measured from January 2, 1973, the value of the dollar has declined by around 37 percent to the present;
Measured from the its peak value in February 1985, the value of the dollar has declined by about 54 percent;
Measured from its peak value in July 2002, the value of the dollar has declined by almost 40 percent;
Measured from the “flight to quality” peak value during the recent financial crisis in March 2009, the value of the dollar has declined by over 20 percent.

Although the value of the dollar rose during the first European sovereign debt crisis in 2010, it has declined almost constantly during the most recent problems.

International financial markets don’t think much of the economic policies of the United States government.  And, the basic reason the United States has been able to get away with this total lack of discipline has been that the United States currency is the reserve currency of the world.

Now, I am not one that believes that the budget of the United States government has to be balanced at all times or even over time.  I do believe that fiscal discipline must be established so that credit inflation is kept under control.  Over the past fifty years, the real compound growth rate of the United States has been slightly more than 3 percent.  If the government could constrain its budget so that the public debt and the economy grew at no roughly in line with one another, I think the country could live with that and credit inflation would not be a major problem.

However, I don’t see our current crop of politicians capable of exhibiting such discipline.

Tuesday, July 26, 2011

U. S. Corporate Profits are being earned "off shore"


Recently I have written about how the Fed’s injection of funds into the banking system has gone over seas because that is where the profits are.  See “Federal Reserve Money Continues to Go Offshore,” http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore. 

Now we are getting more and more information that non-financial resources are also going offshore because that is where manufacturing profits are as well.  See the Wall Street Journal article “Business Abroad Drives U. S. Profits,” http://professional.wsj.com/article/SB10001424053111904772304576466003840674770.html?mod=ITP_marketplace_0&mg=reno-wsj.

“A third of the way through the second-quarter reporting season, earnings at companies in the Standard & Poor’s 500–stock index are the highest in four years…”

“Corporate profits—one of the few areas of strength in the limp U. S recovery—appear to be weathering the economy’s soft patch.  But the gains in many cases have come from international operations, particularly in emerging markets.”

Companies conforming to this pattern include Air Products & Chemicals, United Technologies Corp., Hasbro Inc., McDonald’s Corp. and General Electric Co. among others.

While American consumers and small- to medium-sized businesses fight through a period of debt deflation trying desperately to get their balance sheets under control (http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) larger American corporations seem to be doing just fine, thank you, in international markets. 

It seems as if about half of the monies these corporations are spending on capital investment is going into other countries.  That is where the sales are so that is where the funds are going.

Also, the investment that is being done in the United States is going more to increase productivity and lower costs than it is to expand employment and generate further economic activity. 

In terms of aggregate figures, the article reports that “U. S. multinational corporations cut their work forces at home by 2.9 million during the 2000s while increasing them overseas by 2.4 million, according to data from the U. S. Commerce Department.” 

In contrast to the slow-growing United States economy, companies found substantial purchasing strength elsewhere.  General Electric, for example, said it experienced double-digit revenue growth in each of its international divisions in the second quarter.  The largest growth came in India, registering a 91 percent gain; in China, revenues rose by 35 percent and orders increased by 80 percent. 

This is what happens when capital can flow freely around the globe. 

Money will follow opportunity.

The United States prospered through the last fifty years of credit inflation because it had the reserve currency of the world.  Others were willing to take on United States debt because the world still traded in U. S. dollars. 

But, this credit inflation did two things.  First, it eroded the productive ability of the United States. See my post “Why This Economic Expansion is Going Nowhere,” http://seekingalpha.com/article/279928-why-this-economic-expansion-is-going-nowhere.

Second, it resulted in a build up of consumer debt and business debt that was unsustainable and had to be reduced.  The reduction of this is the debt deflation the United States is now experiencing. 

The government’s attempts to push further credit inflation on the economy is just pushing money out into the rest-of-the- world, as reported in some of my posts mentioned above, and has created economic growth…and profits…elsewhere.

In a world of freely flowing capital, a nation cannot just conduct its economic policy independently of the rest of the world.  As stated above, the United States got away with it for a long period of time because it had the reserve currency of the world.  But, this lack of discipline has caught up with us and more and more the statistics are supporting this conclusion.

The other thing the credit inflation policies of the United States government has done is to skew the income/wealth distribution in America toward the wealthy.  Small- and medium-sized business are not profiting from the current efforts to stimulate the economy.  However, as reported, the larger, wealthier companies are doing very, very well. 

Friday, July 22, 2011

It Depends Upon Your Definition of "Is"--Greek Bailout 2 or GB2!


Is Greece declaring default on it sovereign bonds?

To some, it depends upon your definition of “is”. 

Is a “selected default” or a “restricted default” a default?

There is only one answer in my book.  Greece is declaring default.

The reason Greece is defaulting is because Greece is insolvent.   (See my post from Wednesday, http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

At least some of Greece’s sovereign debt will be written down by around 20 percent in the new deal reached yesterday among European officials.  (I will not use the title “leaders” for this group of individuals.)  On Monday of this week, Greek bonds were selling at about a 50 percent discount.  As word that a possible agreement might be reached by European officials, the discount declined and the bonds were selling at 60 percent of par or 65 percent.

The question is, is this enough of a haircut?

There are other provisions: new longer-term bonds to replace shorter-term bonds, lower interest rates, and additional help for Portugal and Ireland.

However, it seems as if the most general comment on the new package is that the eurozone has bought itself some time.   

The first response of the financial markets has been positive reflecting that the Europeans have done something good.  However, as the news continued to sink in, markets backed off once again. (“Jitters over eurozone fringe snuff out rally”, http://www.ft.com/intl/cms/s/0/3de1daa0-b451-11e0-9eb8-00144feabdc0.html#axzz1SlzuB7bE.)

GB2 may not be enough.  And, then there is the fear of contagion: Is GB2 large enough to protect against the “Lehman Brothers” effect?  At first the failure of Lehman Brothers on September 15, 2008 seemed to be self-contained…but then problems occurred as financial concern spread to other areas and other firms. 

What about Portugal?  What about Ireland?  What about Spain…and Italy?

And, what about the United States?

There still are a lot of unanswered questions.

My response to this is two-fold.  First when you are in trouble, like Greece…and others within the eurozone…you need to act decisively and in a way that creates a belief that you mean to back up what you do. 

We work in a world of incomplete information.  We don’t know precisely what the correct amount of action is needed to solve a problem.  My view is that a leader needs to act decisively enough so that there is a good chance that the problem will actually be solved.  Also, the leader needs to act in a way that conveys to others that she or he is in charge of the effort and that whatever needs to be done will be done.

Second, the leader needs to create the belief that she or he will follow up on what has been done to close any gaps that might still be found to exist.  Financial markets must come to believe in that the leader will "stick at it" until the problem is corrected.

The officials in Europe have failed on both accounts.  First of all, they have denied and denied and denied that there was any problem they were accountable for.  It was always someone else’s fault. 

Second, the officials in Europe have never wanted to do more than the bare minimum in trying to correct the situation.  “How little can I get away with?” seems to be the question they ask. 

Third, no one seems to want to be in charge. 

Which leads me to my final point, the financial markets do not have much regard for anyone in the European hierarchy.  In this they seem to reflect the sentiment of the citizens of Europe. 

“Restricted default” or “Selected default”?  This seems to be like being partly pregnant: in my understanding you are either pregnant or you are not pregnant!

When will the European debt crisis be resolved?

It looks to me like the can has just been kicked a little further down the road.   

Thursday, July 21, 2011

The Future of Banking: Dodd-Frank at One Year


Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.    

Wednesday, July 20, 2011

Where Are The Leaders In Europe?


The story unfolding in Europe in a nutshell:

“Undercapitalized banks are supporting over-indebted governments by holding their IOUs; over-indebted governments are supporting troubled banks; and there is insufficient equity in the European banking system to absorb the losses implicit in the solvency gap.  The outcome is that the European Central Bank ends up providing liquidity on an open-ended basis to the peripheral countries to keep their banking systems afloat at the cost of an ever weaker balance sheet.  The one surprise in all this is that more of the retail deposit base of southern Europe has not disappeared in capital flight.”

From John Plender, “Time for Eurozone Policymakers to Grasp the Nettle”: http://www.ft.com/intl/cms/s/0/207fb2a4-ac9d-11e0-a2f3-00144feabdc0.html#axzz1SZnxOYcr.

Almost everyone in Europe seems to have his or her head in a hole in the ground ignoring reality.

Anytime we hear anything from them it is always about who is to blame for the current crisis…the international banking community…greedy speculators…rating agencies…or the cheating being done in world class men’s soccer. 

Real leadership seems to be totally absent from the scene.

Few make such a blatant claim as the New York Times did this morning: “Greece is effectively insolvent.” (http://www.nytimes.com/2011/07/20/world/europe/20europe.html?_r=1&ref=todayspaper)

There, I wrote it!

Greece is effectively insolvent!

It is not the international banking community that is causing the problem.  It is not “greedy speculators” or the rating agencies causing the problem.

The problem exists because of what the Greek government has done.  (For another take on this see Thomas Freidman’s column in the New York Times this morning:  http://www.nytimes.com/2011/07/20/opinion/20friedman.html?ref=opinion.)

Countries…people and businesses…cannot live way beyond their means forever. 

Greece did this to itself, and now the debt is coming due.

Does the Greek debt need to be written done?  You betcha’!

Will the write down be around 50 percent of face value?  That is what the market seems to think.

Can the banks holding Greek sovereign debt weather such a hair cut?  Certainly the “cowardly” stress tests just administered by the eurozone officials give us no such information about this possibility. 

However, sufficient information has been made public about the balance sheets of eurozone banks to indicate that many banks (many more than the nine identified by the stress tests) might have a “hard go” if this amount of a write down did take place.

But, we are in “hard go” country…thanks to the leadership in this area of the world.

Leadership that postpones dealing with problems is not leadership at all. 

“If one says that the problem is ‘out there’…that is the problem!” One of my favorite quotes from Stephen Covey.

I have worked with many failed institutions and in every case when one reviews the records, previous management never assumed that the fault was their own…it was always someone else’s fault. (Are you listening Mr. Murdoch?) 

As a consequence, steps were never taken to correct the problems faced by the organization and, therefore, the problems just got bigger and bigger and bigger.

The same has been true with Greece.

But, the contagion issue arises.  Is this the “Lehman Brothers” moment for Europe?  Will Portugal, Italy, and Spain follow in the footsteps of Greece?

These countries are not immune from the criticism leveled at Greece…and the statement of Plender above.  They have exposed themselves to the fate of the debtor and the debt collector is at the door.  Interest rates now paid by these nations on their debt are exorbitant and unsustainable. 

The losses must be absorbed…they cannot continue to be postponed in the hope that further credit inflation can buy them out of their dilemma.

Read my lips: the debt levels are unsustainable and must be dealt with now!

I like the quote at the end of the New York Times article quoted above: “The market is far more intelligent and resilient than a lot of politicians realize,” said Lee C. Bucheit, a lawyer who has handled sovereign defaults. “Investors realize that sometimes you make money and sometimes you don’t.  But they can’t abide prolonged uncertainty.”

I would close with a slightly modified statement: “Investors can’t abide a prolonged absence of leadership.”

Are you listening America? 

Tuesday, July 19, 2011

Asset Values: A Look At The Stock Markets


Over the past year, I have spent a lot of time discussing the problems created by falling house prices and the effect this has on debt levels and personal solvency. Falling house prices have placed many owners in the uncomfortable position of having no equity or negative equity in their homes.

Recently, I wrote a post considering the economic value of small businesses and the impact this is having on the sales of these organizations.  The falling valuations of small businesses have put many owners in a similar position where the equity they have in their businesses has become rather small or has even become negative. (http://seekingalpha.com/article/279506-debt-deflation-and-the-selling-of-small-businesses)

Today in the Financial Times, financial manager and author Andrew Smithers provides us with a look at the valuations attached to larger businesses as represented by their values on stock exchanges.  (See “The Conditions For The Next Crisis Are Firmly In Place”, http://www.ft.com/intl/cms/s/0/f1ff9be8-a3e5-11e0-9f5c-00144feabdc0.html#axzz1SZnxOYcr.)

His fundamental conclusion, the US stock market is “overvalued” and this connected with high levels of private sector debt point to a very precarious situation for the economy.  In the US, “private sector debt is 2.6 times gross domestic product, and nearly twice the level reached after the 1929 crash.”

His estimates of the US stock market: it is “about 60 percent overpriced.” 

Smithers comes to this conclusion using two well known measures of stock market valuation: the “q” ratio, “the ratio of market value of non-financial companies to their net worth, adjusted for inflation”; and CAPE, “which is the cyclically adjusted price to earnings ratio.”  (The “q” ratio was developed by Nobel-prize winning Yale economist James Tobin and CAPE was developed by current Yale economist Robert Shiller.)

He cautions about the use of the ratio in trying to determine market moves: “Value provides little guide to short-term market movements.” 

“If we are lucky, stock markets will not fall sharply for some time.”

The reason is that when corporations are strong buyers of their own stock, the stock markets stay buoyant.  In fact, “the US stock market has risen and fallen exactly in line with corporate buying.”

Thus, Smithers continues, it is important to “predict whether companies will continue to be strong net buyers of shares in the months ahead.”

A key predictive variable…whether or not companies have “relatively high levels of cash compared with their total debt levels”…which US companies currently possess. 

“Over the past decade, at least, cash ratios have been a leading indicator of equity purchases by firms.” 

But, Smithers warns about the near-record level of debt that corporations hold “whether measured gross or net of cash, and whether compared with net worth or output.”

He says that this fact is “startlingly at variance with the claims frequently made that US company balance sheets are in great shape.”  Smithers argues that the aggregate data are most important here and not the individual balance sheets.

It is here I differ with Smithers.  I have argued over the past year that the economy has split into two components...those companies that are in “good” to “great” shape and have a lot of cash on hand and have even borrowed at the excessively low interest rates to improve their cash positions…and those that are in “bad” to “terrible” shape.  The division is, in essence, between the “haves” and the “have not’s.”

Some big companies are in really good shape financially while many other large- to medium-sized companies are not in very good shape at all.  These well off big companies are “keeping their powder dry”, buying companies here and there, and also purchasing some of their stock.  The others…well…they are really struggling. 

This is one reason merger and acquisition activity has been so strong this year.

But, this situation is also one underwritten by the Fed with very, very low interest rates and quantitative easing.  The “haves” have it all!  The “have not’s” have next to nothing.

So far the Fed’s quantitative easing has kept the stock market going and part of this, as described by Smithers, has been the underwriting of the cash accounts of many of the biggest corporations which has led to a portion of the stock buybacks that have taken place.  (Further gains have been achieved by using the Fed’s money to go “off shore” and get into world commodity and equity markets. See http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.)

Of course, the businesses that are not in “good” financial health cannot engage in these activities.

Thus, the big and better off are fed…and the others must scratch for their survival.

Other than this slight disagreement with Smithers, we can get back to the crux of the story.

The US stock market, according to the two measures discussed here, is overvalued by about 60 percent. 

We cannot predict the exact timing of market movements, but, historically, whenever these measures get so “out-of-line” there has eventually been a correction. 

Smithers places this correction out somewhere in 2013.  Why?  “It’s the first year of the new Chinese government, of the new European stability mechanism, and—most important of all—the first year of the new US government.” 

Wherever the “blow” comes from, corporate cash flows “will almost certainly fall sharply”

Consequently,Smithers asks, “If corporate cash flow drops, who will buy the stock market?”

My question is, “When will the large- and medium-sized firms that are not in good financial shape and that are overvalued have to sell?”  We have seen this phenomenon take place in real estate.  We have seen it take place with the smaller businesses. Given the analysis presented above, this phenomenon is going to spread over the next year or two to even the larger businesses.  And, with market values too high, acquisition prices will be below stock market values, hence the markets will fall.

This is something that fiscal stimulus and quantitative easing cannot offset.  It is a part of the debt deflation process that follows years of credit inflation. 

Sunday, July 17, 2011

Why This Economic Expansion is Going Nowhere


This economic expansion is now in its twenty-fourth month.  It is one of the weakest expansions on record.  And, it seems to be going nowhere.

One reason for this is that there is just too much debt still outstanding in the economy.  The economy is experiencing a debt deflation where more and more people and businesses feel over-burdened with the debt loads they are carrying on their balance sheets.

The government, especially the Federal Reserve, is trying to counter this by pushing hard on the credit inflation button to extend the fifty years or so of credit inflation we have already experienced.  The problem with this is that each new round of credit inflation puts more and more people and businesses into unsustainable positions so that expansions rely on a smaller and smaller proportion of the economy to drive further economic growth. (http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation)

 Debt takes time to work off or work out.  The bigger the debt-load the longer and harder it is for the people and businesses to climb out of their holes.  Repeated cycles of credit inflation not only end up with more people digging holes, it also contributes to some existing holes becoming deeper. 

Hence with every cycle recoveries become harder to achieve and the subsequent economic growth becomes less and less robust.

Another reason why economic growth is having trouble picking up momentum is because of the dislocations that exist within the economy.  Credit inflation causes many distortions beyond what it does to the balance sheets of people and businesses.

Most analysts concentrate on the unemployment rate.  Right now this figure rests just over 9.0 percent.  Analysts focus on this variable as the crucial one for the upcoming 2012 election. 

To me, a more important measure of the dislocation of human resources in the economy is the amount of under-employment we are experiencing.  This number includes those individuals that have left the workforce or are employed but are not fully employed.

The under-employment rate in the United States right now runs about 20.0 percent.  About one out of every five Americans is under-employed. 

This number was under 10.0 percent in the 1960s and has trended up ever since. 

The reason:  the number one goal of the economic policy of the United States government was to achieve high rates of employment…low rates of unemployment.  The best way to do this when unemployment arose was to stimulate the economy through the monetary and fiscal policies of the United States government to put people back to work in the jobs they have previously been laid off from.  This, of course, resulted in more and more of the human capital in the country being underutilized…a capacity utilization problem.

Adding to this was the shift in employment in the country with relatively more and more of the new jobs opening up being in finance and financial services and less and less in manufacturing.  Many “potential” workers find themselves limited in terms of opportunity either through geographic location or educational training.  Both of these results came from the governments attempt to achieve high levels of employment through credit inflation.

Finally, there is the problem of capacity utilization of physical capital.  As one can see in the accompanying chart, capacity utilization in American industry was in the 87.0 to 90.0 percent range in the 1960s.  As the proportion of human capital being used in this country trended downward from the1960s to the present, capacity utilization in manufacturing has also trended downward.  

One can observe very clearly in this chart the cycles of capacity utilization associated with each recession during this time period.  Also, one can not that with every cycle in capacity utilization that the “new” peak achieved is lower than the peak reached during the previous cycle…with the exception of the 1995-1997 experience.

Right now, United States manufacturing seems to be “peaking” out just below 77.0% of capacity, down from a previous peak of about 82.0 percent of capacity.  It has been stuck at this level for at least seven months now, through June.

My argument is that just as credit inflation is responsible for the growing under-employment in the United States work force, credit inflation is also responsible for the growing under-employment of the physical capital of the United States.  Credit inflation distorts business decisions and leads to a capital stock that is less and less productive over time.

So, here are three reasons why I place a low probability on the United States economy achieving a more robust economic recovery: the debt load on people and businesses; the dislocation existing in the labor market leading to high rates of under-employment; and the dislocation existing in the use of physical capital in the United States leading to low rates of capacity utilization. 

Note that credit inflation can only be a short run panacea for these problems.  Credit inflation leads to greater debt buildup adding to the unsustainability of the debt load being carried by people and businesses.  Credit inflation works to put people back into the jobs they recently lost but as the society changes, the old jobs go away.  And, credit inflation affects the productivity of the country’s physical capital making the existing capital stock less and less usable.  There are no good answers here.