Fifteen Notes on Our Troubled Global Economy

1) It’s nice to see someone else recommend my proposal for partially solving housing woes.  Immigration made America great.  Kudos to my Great-great-grandparents.

2) Is there Any Such Thing as Systemic Risk? Surely you jest.  Systemic risk exists apart from klutzy governmental intervention, as noted in my article, Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost.

3) The Economist has another good post on the effect of past buybacks affecting companies today.  As for me, I criticized dividends in the past:

David Merkel
Buybacks Depend on the Management Team
1/5/2006 12:11 PM EST

I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.

A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.

My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.

One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.

Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.

Position: None

4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.  Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.  Management discretion should play a small role.

5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”  It’s too broad, as others have pointed out.  I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.  Separate the living from the wounded from the dead.

The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.  The wounded file plans for recovery, and the domiciliary states monitor them.  The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.  No money from the public is used.

We have made so many errors in our “nationalization” (bailout) that it isn’t funny.  We give money to them, rather than taking them through insolvency.  Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.  We don’t require plans for recovery to be filed.  Further, we let non-experts interfere in the process (the politicians).  Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.

The concept of the “stress test” is crucial here.  It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).  Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.

I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.  Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.  We have wasted enough money already with too little in results.

One final comment — for years, many claimed that the banks were better regulated than the insurers.  Who will claim that now?

6) Equity Private rides again at Finem Respice (“look to the end”).  A good first post on how this all will not end well.

7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.

8 ) What has happened to Saab is what should happen to insolvent automakers here in the US.  The companies will survive in a smaller form, with the old owners wiped out, and new owners recapitalizing them.

9)  Will the new housing plan work?  I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.  There are also the issues of favoritism, and rewarding those less prudent.  We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).  (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)  As it is, many people will not be eligible for the help.

10) How do you eat an elephant?  One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?  Reasonably well, though it took a while.  Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.  One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.

So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.  In America, we want to get this over with quickly, but not do a “big bang” either.  That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.  All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.  Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.

11) If you want to search for prices and other data on bonds, look here.

12) Marc Faber makes many of the point that I have made about the crisis in this editorial.

13) Swiss bankruptcy?  I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.  Add Switzerland to the list with Austria on Eastern European lending troubles.

14) What is Buffett thinking in his recent sale of stocks?  Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.  He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.  Could he be wrong?  Yes, but over the year, he has been pretty good at estimating the relative values of assets.  He’s made his share of mistakes recently, but 95% of investors have been in that same boat.  At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.  Berky is interesting here.

15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.  Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.