"All government policies adopted to meet a crisis presume that the government knows how to effect the rescue it seeks. If the crisis arises from an attack by foreigners, the government purports to know how to mount military countermeasures that will defeat or disable the enemy. If the crisis consists of economic malfunctions, the government purports to know how to alter its spending, taxing, or regulation so that the economy will be restored to sound operation. These presumptions are in general counterfactual." Delusions of Power by Robert Higgs
"Public policies are determined and laws are made by small minorities playing upon the fears and imbecilities of the mob – sometimes minorities of intelligent and honest men, but usually minorities of rogues." H.L.Mencken
A little finance never hurts and two articles on equities caught my attention. The first article comes from Bloomberg, where they cite some research by Wharton Professor Jeremy Siegel. The professor's research shows that for the first time since 1861, the thirty year return on bonds exceeds that of equity. You will remember from introductory finance class that equity returns should exceed bond returns given the higher risk in being an equityholder. A few possible explanations for this rare phenomena:
Equities are undervalued
We are in some sort of "war" market akin to the U.S. Civil War
Demand for bonds is disproportionately high, driving up prices and returns, in response to various global uncertainties (the other side of point 1.)
The other article cites some high level mathematical analysis from Cornell Professor Robert Jarrow and Columbia Professor Phillip Protter to identify bubbles, or overvaluation, in different asset classes including equities. For example, the methodology correctly identified the dot.com era and the price runup after the LinkedIn IPO as bubbles. Also interesting, the methodology shows that current gold prices are not a bubble. Of course trading on such math should correct for the bubble in a given stock. Question I have is whether the professors have applied their methodology to whole asset classes such as bonds or equities to see if they give us any insight into the current existence of bubbles. If bonds showed "bubble" behavior, that might explain Siegel's findings.
Harvard Business School produces a lot of high quality research, frequently distributed through their own publications such as Harvard Business Review. Some of it is thought provoking and some of it is seminal work in the field. Examples of seminal work would include the early work of Michael Porter and Clayton Christensen.
The article states that market capitalism may breakdown within the next 25 years and become disfunctional for the following reasons:
Increasing inequality in wealth distribution
Increasing immigration to rich countries
Fragile financial systems
Climate change and environmental degradation
Continuing degradation in education and healthcare
Increasing government corruption that disrupts free markets
The traditional protectors--business, government and international institutions--can no longer manage the problems
While this analysis may appear to just be the liberal thinking of a few academics, the near collapse of world financial markets in 2008 suggests to me that the professors should not be ignored.
The proposed solution is "the creation of entities that can organize large-scale collective action" that disrupt markets through innovative solutions. Implicit in this proposal is rejection of the idea that only governments are responsible for collective action. The historical black and white distinction between government and businesses in determining the "public interest" must be loosened. According to the article, many business leaders are afraid to wade into the area of the public interest, perhaps more comfortable operating only on the basis of self-interest. The authors conclude that capitalism may be lost if business leaders cannot change to take a more active role in the "public interest".
The seminal idea is to develop a framework that facilitates this change in business thinking to embrace the public good without abandoning responsibilities to shareholders. Some may think of Porter's "shared value" as a solution, but I think his approach is merely incrementalism. Rather than starting from Porter's perspective of competitive advantage, the framework needs to start by defining the public good. Economists have argued about the definition of public good for centuries, but businesses rarely discuss the theme. We do not need to reconcile the views of Hayek, Friedman and Keynes. Perhaps all we need is a definition that businesses can accept and an HBS framework that helps CEOs to understand the issues and act to solve the wide ranging problems before it is too late. A thoughtful discussion of the public good would also probably lead to a re-definition of the role of government and a more effective and smaller style of government. That would be a daunting task but maybe business could frame the issue in terms of the public good. My thoughts on public good are here.
Note: Porter's "shared value", the article discussed above and the work of Christensen and others at HBS in education indicate a new trend at HBS which has not been much in evidence in HBS publications for the 30 years I have been a reader. Simply put, I think the professors at HBS are encouraging capitalists to take over many of the traditional roles of government or at least to pursue profitable opportunities that previously were government responsibilities. I very much like that idea if my interpretation is correct.
I was writing a post on Mexico, which will come out next week. This writing prompted me to recall a situation during the Clinton Administration where Mexico was about to default its debt and the U.S. Congress was deadlocked and unwilling to help Mexico. Robert Rubin, then Secretary of the Treasury and former CEO of Goldman Sachs, devised an elegant solution by finding an Executive Branch authority to lend money to Mexico. In this congressional deadlock Ruben found a way to avoid congressional approval.
Now I do not think we can find an Executive Branch authority to raise the debt ceiling, although I hope someone examined this possibility (perhaps declaring war on Iraq?). However, there may be some possibilities to postpone the default and thereby give Washington more time to find a compromise. I recognize that time is short but this is my idea:
The Executive Branch could ask for U.S. Government loans to be prepaid, such as foreign aid loans which total about $20 billion, and any other type of loans. I am not expecting full repayment but we might raise $50 billion quickly. Alternatively, perhaps the Executive Branch could repo such loans to the big banks it bailed out in 2008. An outright sale might require congressional approval, but repos might slip by the existing law.
Now the current Secretary of the Treasury, Tim Geithner, was an Under Secretary under Rubin, so hopefully he remembers Rubin's elegant solution. However, he might be distracted by the politics, as everyone in Washington appears to be. I do not actually think there will be a default, but hopefully the Executive Branch has a back up plan.
This has been a comparatively even handed post on a controversial subject, but I cannot fully control my feelings on the subject. There is an old saying that goes something like this "if there is a problem, shoot all the lawyers". If you substitute "Washington politicians" for lawyers my sentiments on the U.S. Government defaulting would be captured very accurately.
Note: The story below from ABC News suggests some other people are thinking about a solution involing Executive Branch authority.
Much has been made recently about the income inequality in the U.S. and the trend for this inequality to worsen. This new story from the Economist documents the trend. What surprised me in the story is that income inequality in China is also increasing.
The Gini Coefficient measures the inequality in a distribution, with 1 being a completely concentrated distribution and 0 representing total equality. The U.S. Gini Coefficient increased from .34 to .38 in the twenty years 1985-2005. China's coefficient has increased from .28 to .40 in the same period. Brazil's Coefficient declined in the same period from a comparatively high .59 to .55.
In looking at China one could speculate that an elite is capturing a bigger share of income. Private business owners are definitely becoming an increasingly important part of the economy, which would also explain the trend for greater income concentration. I think this trend toward income concentration in China bears watching as a possible leading indicator of social unrest in China.
I travel alot for One Laptop per Child and frequently meet foreign government officials and university administrators. After discussing the benefits of primary school education through OLPC, the discussion invariably turns to whether OLPC can help to foster entrepreneurship in their country. The discussion turns to entrepreneurship for two reasons:
Everyone wants to tap into the worldwide open source communities for Linux and Sugar that make OLPC possible and duplicate such programming communities in their countries, universities or organizations
Everyone wants OLPC to facilitate access to MIT and in particular the MIT Media Lab (from which OLPC started) and the MIT Entrepreneurship Center, perhaps the leading academic entrepreneurship program in the world (Disclosure: I taught a course in social entrepreneurship at the MIT Sloan School of Management in January 2011.)
As I read Daniel J. Isenberg's article in Harvard Business Review "How to Start an Entrepreneurial Revolution" I find that I agree with some of his findings but generally I disagree with his conclusions. Isenberg's conclusions about an environment that fosters entrepreneurship in foreign economies are:
Stop emulating Silicon Valley
Shape the Ecosystem Around Local Conditions ("foster homegrown solutions—ones based on the realities of their own circumstances, be they natural resources, geographic location, or culture")
Engage the Private Sector from the Start
Favor the High Potentials (support and foster companies with world class potential)
Get a Big Win on the Board (entrepreneurship is viral and a successful example will spawn further successes )
Tackle Cultural Change Head-On (entrepreneurship needs to lose its stigma and become something supported by society)
Stress the Roots (encourage resourcefulness by rationing capital)
Don’t Overengineer Clusters; Help Them Grow Organically (“pave the footpath by gently encouraging supportive economic activity to form around already successful ventures")
Reform Legal, Bureaucratic, and Regulatory Frameworks
My conclusions to foster entrepreneurship are based on ten years working in Indonesia (a hot bed of entrepreneurship despite a then authoritarian government), eleven years of working with entrepreneurial clients in the Caribbean and Central America, five years of teaching entrepreneurship to many foreign university students and eighteen months representing OLPC. My conclusions are:
1. Capital is King. Many entreprenurs around the world can build $3-10 million companies through Isenberg's "stress the roots" approach, but they cannot achieve "world class" status for lack of access to capital. I was lucky to build a billion dollar publicly traded company in Indonesia, but the reason, in large part was that I was better able to access capital than my competitors. I recently lectured a group of Haitian entrepreneurs through a program spons0red by Digicel Group, Dennis O'brien's telecommunications company. This very optimistic group of Haitian business owners cited access to capital as their biggest problem despite the total devastation of their country by an earthquake. Financing techniques for entrepreneurs was the subject of the lecture.
Isenberg cites the successful Israeli example of combining government funds with management of the monies through professional venture capital and private equity funds. I like this example, which has been used in Florida where some government pension monies are under the management of Hamilton Lane to invest in early stage companies. (Florida, a state with a population of almost 19 million, at last count had less than ten "real" venture capital firms.) I would encourage a portion of the monies in such approaches to be specifically earmarked for "seed" investments and for the VCs not to be disguised private equity investors.
In Indonesia one of the largest untapped pools of capital was the reserves of the local insurance companies. Within reasonable and appropriate asset allocation and risk profiles perhaps insurance reserves in some developing countries could be directed to local investments in secured loans to provide medium term growth capital.
2. Integrate Foreign Investment into the Entrepreneurship Initiative. Foreign multi-nationals provide many benefits to foreign countries, not the least of which is hands on training in professional management to local staff. Due to weaker education systems in many countries, most entrepreneurs have only limited access to the thinking and processes of modern management. This lack of experience is a major factor in limiting the emergence of world class companies.
Perhaps foreign investors must have social responsibility programs that support local entrepreneurship. Programs in education, local suppliers and services and sabbaticals for employees to work for a year in a local company all would qualify. Preferential tax rates might encourage this activity. The Digicel workshops for Haitian entrepreneurs is an example of such a program (albeit with no particular tax incentives).
3. Education is Critical. Several academic studies have shown that a part of the success of Silicon Valley and Boston as entrepreneurship centers is their proximity to great universities. Mayor Bloomberg's recent initiative to attract a world class engineering school to New York City as a means to foster greater entrepreneurship there points out the need for education in certain subjects that tend to produce more entrepreneurs. Of course, if we provide good engineering universities, access to capital and professional venture capital investors, a country would be well on its way to duplicating the critical success factors that explain Silicon Valley or Boston.
Based on conversations with many government officials around the world, the development of intellectual property is going to be the engine of economic growth in the 21st century. This concept is a basic tenet underlying the philosophy of OLPC, which in part explains the success of the program and the approximately 2 million computers distributed to children. Improved education, and in particular science, math and engineering, is a necessary part of any sustainable entrepreneurship program at the country level. Procter & Gamble's social responsibility program in Latin America focuses on education, which suggests that they share my view on the importance of education in emerging markets.
4. Focus on Entrepreneurship. Isenberg cites the example of Malaysia's program to foster entreprenurship in the idigenous population as a failure and support for his concept of "stress the roots" by encouraging resourcefulness. I agree but I think Isenberg fails to draw the more important conclusion. The indigenous population in Malaysia is not some small tribe of nomadic Indians but rather the majority of the population. Malaysia has a history of failed programs to support the indigenous majority while the Chinese minority thrives. Malaysia's entrepreneurship program failed because it did not focus on entrepreneurship but rather addressed a wider range of social and political issues. I see many governments starting good projects only to fail because they have too many social or political objectives. If governments would refrain from discrimination on the basis of culture, race or religion and not try to solve all the problems with one solution, their programs would be much more effective.
An example that supports this view of focus is the Uruguay program to implement OLPC. Uruguay is the first country in the world where every child in primary school (450,000) has a laptop computer (from OLPC) and the program has garnered worldwide acclaim for the country. The reason that this program succeeded, in large part, was that the government had one simple goal--include every child in Urugauy with no exceptions--rather than adopting discriminatory programs or complex, multiple social goals.
5. Liberalize the Legal System. The structure and philosophy of the U.S. legal system has been a major factor to explain the scale of entrepreneurship. The U.S. system is built on the concept that if something is not prohibited by law, it is permitted. Many countries adopt the contrary approach--if it is not permitted by law, it is prohibited. This later controlling view of legal systems greatly inhibits entrepreneurship. I have thirty years of stories where entrepreneurs were stopped by government bureaucrats from expanding their businesses because a law did not permit something. What countries need to do to foster entrepreneurship is to change the philosophy of their legal systems to make them permitting rather than inhibiting.
Professor Isenberg should be applauded for this important article on the importance of entrepreneurship in developing economies. Perhaps our differences of opinion will foster further debate and research on this important topic.
Chinese President Hu Jintao will be visiting Washington this week for high level talks on a wide range of issues. In anticipation of the visit the Wall Street Journal and other leading newspapers prepared questions for the President and received written answers. In the WSJ article two quotes attributed to President Hu caught my attention:
"U.S. monetary policy "has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level.""
"The current international currency system is the product of the past,"
Much as President Obama explains the undervalued Yuan as apart of the cause of U.S. economic problems, President Hu accuses the U.S. of contributing to the escalating inflation in China by the Federal Reserve's excessive growth of the money supply. Both Presidents are correct in their criticism but nothing will change as each President gives first priority to their domestic economy.
President Hu's comments on the currency system strike me as wishful thinking for several reasons:
An estimated 65 percent of China's currency reserves of $2.8 trillion are in U.S. Dollars, giving President Hu the largest "long" position in any currency (or commodity) in history; unwinding that position by swapping into other currencies would create enormous loses and might very well destroy the entire world economy.
If China were to move its reserves into alternative currencies to an even greater percentage, the economies of those countries would significantly lose their export markets and their economies would grind to a halt
For President Hu to remake the currency system, the Yuan would have to become a freely traded market currency; there is not a single centrally-controlled government that allows its currency to float subject to market forces (ignore any small countries in Africa) and China is not likely to do it soon.
One possible alternative for President Hu might be to encourage more foreign investment by Chinese companies in the U.S. Such a strategy might be high risk politically but it might be less disruptive economically. Maybe start with Exxon or Wal-Mart. You need to make big investments to have any real effect.
We all live our personal and professional lives based on forecasts. Forecasts are used for many routine things such as buying a home. investing in a college education and planning for retirement. Some rely on other people's advice and some of us like to make our own forecasts. Everyone has heard stories about the forecaster that called the stock market crash of 1929 or the economic crisis of 2008. An article in Boston.com describes a new academic study on the accuracy of forecasters by Jerker Denrell of Oxford and Christina Fang of NYU. The conclusions from the paper are:
"Economists who had a better record at calling extreme events had a worse record in general."
"The analyst with the largest number as well as the highest proportion of accurate and extreme forecasts had, by far, the worst forecasting record."
"Those who correctly predict extreme events tend to have a greater tendency to make extreme predictions; those who make extreme predictions tend to spend most of the time being wrong."
The conclusions I draw:
A forecaster who correctly calls an extreme event is probably not reliable to call the next extreme event
Good forecasters tend to forecast well in normal times and are not likely to forsee extreme events
One of my former students wrote and asked me what I thought of this article from the New York Times. The article draws out the parallels between the government in Greece (and their current debt crisis) and the U.S. (and the current economic problems).
The trend in the U.S. is concerning. We are in a deep struggle over values (Obama's wealth distribution tendencies vs the extremist Christian right views of the Republicans). In many ways this leads to a dysfunctional government, out of touch with the U.S. people. The situation is further exacerbated by the two wars we are currently fighting, using an expensive outsource model which appears to lead to unprecedented levels of greed and corruption.
Could the debt of the U.S., forecasted by some to reach 140 percent of GDP, overpower the most robust economy in history and lead to U.S. debt defaults? Not likely. As recently as the Clinton administration, the U.S. ran budget surpluses. We know how to reduce government spending and the related debt. We just need the will and to elect the appropriate representatives in Washington. Such a realignment will be delayed by the current economic situation and the inevitable higher interest rates in the U.S. (probably starting after the 2010 elections). If Obama is a one term President, that will be a sign that we are moving toward more rational government spending. If we withdraw from either Iraq or Afghanistan (or both) that will be further evidence that good decisions are being made. Reduced unemployment and the discontinuation of economic stimulus packages from Washington will also be a very positive sign. I think if the U.S. economy returns to a more normal state and people become more optimistic, then I think you will see the will to change Washington and bring in rational thinkers to manage the economy. It's probably 5-10 years away.
Going short U.S. treasuries may be a good bet (higher interest rates), but I would not count on the bonds trading at default prices.
Last night CNN had a story about the recent Goldman Sachs lawsuit. The SEC is alleging that Goldman mislead investors in a complex real estate backed securities transaction. From the facts released to date, it is not yet clear to me that Goldman did anything wrong. That's not the story.
The Obama campaign's prowess in using social media and the Internet is well documented. CNN showed that if you Google "Goldman Sachs SEC" the results show a paid link to www.BarackObama.com for "Help Change Wall Street". (Search results below.) Clicking through on the link brings one to an Obama donation request page.
For the President to fund raise off of a federal government initiated lawsuit by an agency under his control is at a minimum poor judgment, potentially an abuse of power and perhaps cause for a congressional investigation. If the constitutional scholars in the Obama campaign were to argue that legally the SEC is not under the control of the President, I would point out that the "appearance of impropriety" is an issue to also consider.
These events could herald in a new field of law wherein the government abuses it power through the use of the Internet. Beware.
Oligarchy is a form of government that does not get much discussion or support here in the U.S. After watching this video of Representative Pete Stark from California the viability of democracy may be called into question.
This video was sent by a loyal reader who found it on Zero Hedge. Profanity from the Representative may offend certain readers and you may wish to close the office door before viewing.
A loyal reader of this blog sent me today's press release from the Treasury Department, the introduction of which is below.
"WASHINGTON – The U.S. Department of the Treasury announced today that 10 of the largest U.S. financial institutions participating in the Capital Purchase Program (CPP) have met the requirements for repayment established by the primary federal banking supervisors. Following consultation with the primary banking supervisor of each institution, Treasury has notified the institutions that they are now eligible to complete the repayment process. If these firms choose to do so, Treasury will receive $68 billion in repayment proceeds."
The reader posed two good questions to me:
Too much repayment, too fast?
Was this money really ever needed?
Answer 1
Given the scarcity of capital in current markets, the general nervousness that surrounds the economy, the fact that we are seeing only a very few positive economic indicators, and the economic "upturn" could be a false signal, I would not have given the government back their money yet. Having to go back and ask the Treasury for a second capital injection in the future should definitely be a CEO career ending event.
Answer 2
The money was never really needed, except by Bear Stearns, Lehman Brothers and AIG. Only the later group had real cash flow problems. Almost everybody else had to take the money in order to increase confidence in the financial system.
As I have said before, a financial crisis is in large part a crisis of confidence. A crisis is of such consequence that most people immediately overreact, especially when it is the first financial crisis of their lifetime, government tenure or banking career. When the government gets involved significantly in the "turnaround" and all its aspects, we can be confident that the government will overspend, over regulate and generally focus on issues of no economic consequence. This is true regardless of political party.
The best thing the Obama administration could do would be to stop spending stimulus money and recognize that more normal market forces are now at work and will gradually right the U.S. economy. Maybe even in time for the 2012 presidential elections.
If the government continues stimulus spending and running huge deficits, government borrowing will crowd the private sector out of the capital markets and we will see interest rates not seen since 1980, when the Fed Funds rate was above 10 percent for almost the entire year and peaked at 19.44 percent. In the early 1980s government borrowing was to finally pay for the Vietnam War. (As an aside, someday the U.S. has to pay for the wars in Iraq and Afghanistan.)
The current Fed Funds rate is at an extremely low historical rate of approximately 19 basis points, .0019, in large part to provide economic stimulus. However, the U.S. Government can not borrow forever before bondholders demand higher returns to match the enormous supply of new bonds coming on the market each month. Then interest rates will move upward dramatically. Will they reach 1980 levels--hopefully not, but interest rates have to move much higher.
Today I am speaking at FIU in a workshop for non-profit organizations. My theme is how to sustain growth in these challenging economic times. I have spent my entire career in the for profit sector, in part because many of the non-profits I have encountered lack clear goals and objectives and the discipline to achieve them.
Every time that I speak on non-profit issues I become more strongly convinced that sound business practices are the best way to run a non-profit and that innovation in "business model" is a key to the success of a non-profit. Innovate in business model to sustain growth is today's speech. A great example of innovation in non-profit business model is Vittana. Visit the site to see what some very smart people (ex-Amazon--the booksellers, not the jungle) are doing to provide loans for education to children in the third world.
For further thoughts on non-profit business model innovation, read this post. Send me an email and I will send you today's Powerpoint deck.
Daniel Buenza, a Professor at Columbia University Business School (my alma mater), focuses his research on the social studies of finance. In a recent article he describes his research over the last three years on the derivatives trading desk of a major bank. The period examined included the recent financial crisis and the bank came through unscathed, i.e. no huge losses or need for a capital call. Before we get to Dr. Buenza's conclusions on why the bank avoided the errors of their peers, lets first examine this new concept of social studies of finance. At least it is new to me and hopefully of interest to you--my respected readers.
Basically the social studies of finance examines the role of technological artifacts and mental models in capital markets. Technological artifacts are artificial human constructs that provide knowledge. (More on this subject here.) Wikipedia defines a mental model as "an explanation of someone's thought process for how something works in the real world". In summary, the social studies of finance involves the study of the role of technology-based and "pure thinking" models in capital markets. Obviously the two types of models can interact on the same problem. In a simple Excel model, you change the assumptions and the company cash flow changes. This would be an example of the two models interacting. Program trading would be an example of technology-based modeling where the model basically trades the position. Playing Texas Hold'em would be an example of the pure thinking model.
The unscathed, unnamed bank that Buenza studied managed to avoid catastrophe by a principle called reflexivity. Reflexivity is nothing more than the ability to reconsider your position on an issue. In finance terms, it would be to reconsider your assumptions. In other words the mental model is reexamined, thereby leading to a change in the technology (computer model) which governed the trading strategy.
The particular bank in question had a very collegial atmosphere, free exchange of information between colleagues and no superstars to upset the flow. This culture allowed traders to gather much more data and to change their mental models more easily, thereby avoiding the current financial disaster. When trading model driven positions, there is a tendency to over rely on the model and be slow to realize the model is no longer trading profitably. Excessive positions and a slowness to realize that the trading models were no longer working properly is a large part of the cause of the current financial crisis.
Most of us do not trade derivatives, but Buenza's study of the bank points out the importance of maintaining a culture that is conducive to changing assumptions. Most air crashes are due to pilot error and in most of those cases the co-pilot remained silent while knowing the pilot was making a terrible mistake. It is not easy to maintain a culture where reflexivity is the practice, but it may help you avoid disaster in your business.
Venture capitalist confidence in the economy may be improving for the first time since 1st quarter 2007. As reported by Mark Cannice at the University of San Francisco:
"The quarterly Silicon Valley Venture Capitalist Confidence Index™ (Bloomberg ticker symbol: USFSVVCI) is based on an on-going survey of San Francisco Bay Area/Silicon Valley venture capitalists. The Index measures and reports the opinions of professional venture capitalists in their estimation of the high-growth venture entrepreneurial environment in the San Francisco Bay Area over the next 6 - 18 months.The Silicon Valley Venture Capitalist Confidence Index for the first quarter of 2009, based on a March 2009 survey of 30 San Francisco Bay Area venture capitalists, registered 3.03 on a 5 point scale (with 5 indicating high confidence and 1 indicating low confidence). This quarter’s reading rose from the previous quarter’s reading of 2.77 (a 5 year low).."
The historic chart is below.
Perhaps another small piece of evidence to suggest an upturn in the economy.
Note:I found this information through a tweet by @briannorgard.
Atlantic, a monthly magazine, has a fascinating article this month in which they compare U.S. economic behavior over the last few years to the behavior of emerging markets. The basic premise is that the Wall Street elite have taken control of the government in much the same way that economic oligarchies in emerging markets control their governments. In the article the key question for the future of the U.S. economy is whether the government has the resolve to break the control of Wall Street over the economy.
The author of the story is Simon Johnson, the former chief economist at the IMF, which makes the analysis and the proposed solution more meaningful. I am not prepared to agree that Wall Street controls the U.S. economy, but the article is well worth reading.
Note: I found the story through a post by Umair Haique at HarvardBusiness.org.
I have always believed that an early indicator of the economy starting to improve would be a large acquisition by a Fortune 500 company or one of the large private equity firms.
Today the NYT and WSJ announced that IBM is in discussions to buy Sun Microsystems for a 100% premium to the current Sun stock price. The obvious strategic benefit to IBM is that it would strengthen their market position in servers.
Now, if CISCO, who announced last week that they are entering the server market, was to enter the bidding for Sun, that would be very encouraging. CISCO has a long history of acquisitions, which I discussed in this post.
Let's hope I am right and that this is an early indicator that the economy is turning up.
The New York Times reported Sunday that AIG will be paying bonuses of $165 million to executives in their derivatives unit and another $121 million to other executives in the insurance part of the company. Why is this happening after a government bailout of $170 billion? Supposedly, the answer is that AIG is contractually obligated to make the payments.
Now let's review a few facts:
AIG can not sell its traditional insurance units because of massive unresolved tax issues. If these tax issues flowed through the 2008 income statement would the insurance executives still be entitled to bonuses. Also, is anybody looking at whether these executives are guilty of tax fraud?
The government could have invalidated the bonus agreements for the derivatives unit as a condition for the bailout. Why was this small item overlooked?
The Board of AIG has a fiduciary responsibility to shareholders. Obviously in developing the bonus systems there was some horrendously poor judgement exercised. For example, the $170 billion dollars in unhedged derivative contracts that AIG kept on its books. When will someone bring suit against the directors of AIG for failure to exercise fiduciary responsibility?
Rather than pay a dime in bonuses, I would bring every criminal charge I could against management at AIG. The bonus agreement payouts would be staid until the "fruits of the criminal act" issues were resolved. With the DOJ proceeding deliberately, some of the executives would be bankrupted by legal fees and others might not see their bonuses for 5-10 years.
I have nothing against executive bonuses, but without the availability of the death penalty I would be bringing criminal charges as a way to stop bonus payments at AIG, Citi, BofA, etc. Such poor management does not deserve bonuses.
After reading 50 blog posts this morning about the end of the economic world being near, I have had enough. Time to propose a solution.
First we should restate the problem, which I have done as recently as last week. The current problems have been brought on by issues of liquidity, leverage, transparency....and confidence. The status of each factor is shown below.
Liquidity--the situation has improved significantly in the last few months
Leverage--improving, particularly as the government invests in the troubled companies and lenders become more conservative in their lending practices
Transparency--not likely to improve until the SEC stops thinking like lawyers (who have to win court cases) and starts to proactively investigate bums, con men and avaricious corporate types. However, at this point, transparency is the least of the problems except as it affects government bailouts, e.g. AIG. More on this below.
Confidence--there is none and therein lies the real problem. When Warren Buffett is confused, suffice it to say there is no confidence left in markets and particularly stock markets.
To understand the lack of confidence look at the 30 day volatility index, VIX, which is shown below. As you may recall from Finance 101, volatility is the measure of the standard deviation in the compounded returns of a financial instrument. As volatility increases, the risk increases and the price of the underlying financial instrument declines. The VIX is based on the S&P 500, so it is a measure of the volatility in equities for the next 30 days. The VIX 52 week trading range is 15.82--89.53 with a current price at about 50. Anything above 30 is considered unusually volatile. The last time it traded below 30 was September 2008. The last time it touched 40 was in January 2009 when the market rallied. Therein lies the first clue to how to get the economy back on track. Reduce perceived risk in the stock market.
The second factor that needs to be addressed is the short sellers, particularly in equities and equity indexes. Every pundit, expert and honest man has been on television or the Internet calling the bottom of the stock market ("buy") or saying the world is ending ('sell"). Nearly everybody advocating for a bottom, cheap stocks or some positive economic indicator is long equities, such as Mr. Buffett. Nearly everybody saying that the DJIA is going to 5000 is short equities (probably Soros). Logic would indicate that short positions are at an all time high (although it might be hard to prove given the low per share prices). So, the second clue we have is that we need to squeeze the shorts in order for the market to rebound and for some confidence to return. (When the shorts are squeezed they have to buy stocks to cover their position and prices go up.)
To summarize my argument so far, I think we need to see a rally in the stock market to restore confidence in the economy and we need to squeeze the short sellers in order to have a sustained rally. Yes--I am saying rally the equity markets and that will restore confidence--and not restore confidence and the markets will rally. Therein lies the magic in my plan, which has two parts:
First, we need to get all the bad news out. Whatever the total amount of the bailout is for AIG needs to come out. No more piece meal information or partial investments. Whatever the capital requirement for Citibank and/or B of A or any other institution we can not let fail, figure out the numbers, disclose them and fund the problem--now. Every time there is an announcement on AIG or Citibank the VIX spikes. The government's poor management of the information/problem is exacerbating the market risk and leading to a decline in investor confidence. Do not tell me you can not price the securities. If that were the case then maybe the mark to market or fair market value is zero. Deal with it.
Now for the outrageous original part!! Drum roll. The U.S. government should announce a plan to purchase up to $1 trillion in exchange traded U.S. equities, beginning in 90 days, over the next year (or two). Exchange traded equities would exclude bulletin board stocks, indexes (which the shorts like) and options (also liked by shorts). For clarity, the government could also trade the positions or in other words be a seller. To pay for this, we could cut back on the economic stimulus package (which will not work), forget about health care reform for another four years or economize on military spending, just to name three obvious alternatives.
The benefits to the plan are as follows:
By announcing it in advance, everybody will start buying before the U.S. government. In fact, everybody jumping into the market might actually not require the government to buy much equity in order to sustain a rally. A few token purchases to make the program look real may be all that is required.
Such an announcement/rally will draw many foreign investors, strengthening the U.S. Dollar and making imports here much cheaper. Cheaper imports could kick start some other economies like China or Mexico, who would then start buying U.S. exports.
Consumer demand would return with a better stock market and consumers have lead the U.S. economy out of the last several recessions.
Capital gains tax revenue would increase as long equity holders took some hopefully taxable gains in the rally, in a small way helping to pay for the program.
The short sellers of equity would have to cover their positions by buying stocks quickly, which would greatly contribute to the rally. They would also be somewhat timid about going short again for fear the government might re-enter the market as a buyer.
The equity markets might have enough life in them to support some IPOs or secondary issues by listed companies that need equity capital. Some people might even buy bank stocks.
In pondering my outrageous idea I realize that everybody will hate it. The Republicans because it is another government stimulus but.... a lot of Republicans are still long equities. The Democrats will hate it because it does nothing for the foreclosure problem but....I think it would create jobs more quickly than infrastructure investment.
Unless Obama calls me this week while I am in Washington, I do not expect my idea to get much traction. However, I am reasonably certain that confidence in the markets is a key stumbling block to economic recovery and we need some new ideas for how to restore confidence. I am going to continue to think about the current problems but the next proposal will probably be equally outrageous. Maybe Mr. Buffett will come up with something in the mean time.
EconomicPic is a blog devoted to pictorial presentation of economic data. It is a very informative blog particularly in these days of severe economic malaise.
The picture below comes from a post today and shows the loss in market capitalization of the major U.S. banks over the last 16 months or so. While the loss of nearly 1 trillion in capital is staggering, banks typically leverage their balance sheets at 20:1 or higher. So a loss of bank capital multiplied by 20 represents the potential contraction in liquidity in the U.S. financial system. The U.S. has lost as much as 20 trillion in capital due to the financial losses of the banks.
As Dean Light at HBS said about the current economic crisis, it's a matter of "liquidity, leverage and transparency". Yes-- and it may be a $20 trillion problem. Forget jobs, mortgages, healthcare and all the other issues Washington mentions. To turn around the economy we need to focus on re-building and re-capitalizing the banking system.
