Quick commercial…Lew Spellman, a Finance department faculty member at McCombs and founder of TheSpellmanReport.com is sponsoring the 2012 Texas Financial Market Roundtable on Thursday evening, June 7th from 7:30 to 9 pm at the AT&T Center.  The discussants are leading Wall Street financial economists, Dave Rosenberg, John Mauldin and Rich Yamarone. This is an RSVP event with seating very limited at this time so if you have an interest click on the Roundtable link above and reserve a seat.

 

Recent quote.  I was quoted in The Houston Chronicle this week in an article about low interest rates and the stealth bank bailout.  Here’s the link.

 

Now, on to today’s entry…

I was trying to decide what to write about, but there was only one issue in the news last week – Facebook (“FB”).  I wanted to share all the numbers that I read over the past week.  They’ll make you the smartest kid on the block.

 

FACEBOOK FACTS

Whippersnapper.  CEO Mark Zuckerberg is 28 years old and is now worth $19.25 billion.  (We could argue that this number is misleading because he just got married on Saturday…)

 

The fortunate few.  FB has a total workforce of 3,500.

 

They need the money!  In Palo Alto, not far from FB’s headquarters, the median home price in the 94306 zip code was $1.6MM in Q1.

 

Everyone but me.  FB has 901 million active monthly users.  There are approximately seven billion people in the world – so that means that approximately 13% of the world’s population are FB users.  (I don’t have a FB account because it would have hurt too much when everyone de-friended me after I supported the Affordable Care Act.)

 

Get a life.  In Q1, daily active users increased by 41% to 526 million.

 

Get a girlfriend / boyfriend or hobby.  More than half of those under 35 use FB every day.

 

No wonder we’re falling behind.  There are approximately 200 million monthly users in the US – approximately 2/3 of our population.

 

This number is probably overstated b/c you don’t admit what you’re really doing online.  Americans, on average, now spend 20 percent of their online time on FB.

 

I don’t trust you, but here’s my personal information.  An AP-CNBC poll this past week showed that nearly 60% of those surveyed say they have little or no trust of FB, despite spending an estimated 20% of their online time on the site.

 

Here’s a picture of me wiping my baby’s butt.  Approximately 300MM photos are uploaded to the site daily.

 

BACKGROUND FACTS ON THE IPO

8X bigger offering than Google.  The $16 billion IPO was the third largest IPO behind Visa and GM.  Google raised $1.9 billion in its IPO (and had a market cap of $23 billion).

 

Investors seemed excited.  The IPO was originally targeted to be priced in the $28 – $35 range.  That was raised to the $34 – $38 range.  The IPO was finally priced at $38.

 

A real double!  FB increased both its share price and number of shares.  Since 1995, only 3.4% of companies did this when going public.

 

The real winners of an IPO.  The lead underwriters were Morgan Stanley (38% of the offering), JPM (20%) and GS (15%).

 

Some lucky retail investors made 23 cents per share on Friday.  Retail allotment of the IPO was approximately 10% – 20%.

 

I don’t want to own this, but I’m sure that my shares would look great in your portfolio.  Insiders sold tremendous amounts of their shares.  In contrast, early investors in LinkedIn sold almost no shares in their IPO.  When GOOG went public, existing shareholders represented 28% of shares.  Private holders sold no shares of Yahoo and Amazon when they went public.

 

This was more about cashing out than raising capital.  FB’s biggest investors cashed out as much as one half of their stakes in FB.  Approximately 57% of the offering will be coming from current holders (rather than the company).

 

Smart move…I never keep $20 billion in just one company.  Mark Zuckerberg (CEO) sold 30 million shares and will continue to own 32% of the company (503.6MM shares).  He will control 56% of the voting shares.

 

Revenge of the nerds.  It is estimated that the IPO turned approximately 1,000 FB employees into paper millionaires.

 

 

FACEBOOK FUNDAMENTALS

2011 revenue was $3.7 billion, up 88%.

 

Sales are projected to rise 65% this year to $6.1 billion.

 

The company earned $1 billion last year, a 65% increase.

 

In Q1, profit fell 32% to $205MM.  Sales growth slowed and marketing costs doubled.

 

FB’s operating margin was 47% last year; in 2005 (after GOOG went public), Google’s was 34%.

 

FB has bought almost two dozen companies over the past two years.

 

VALUATION

A wee bit pricey.  FB is trading at 26X sales for the 12 months ended March 31st and 107X earnings.  The sales multiple is higher than every company in the S&P 500.

 

Google’s IPO was cheap on a relative basis.  When Google went public, it was trading at 10X sales.  Currently, GOOG has $38 billion of revenue and is trading at 5.5X revenue ($207 billion).

 

Hopefully they’ll keep growing earnings.  FB is trading at approximately 60X this year’s projected earnings and 40X next year’s.

 

5.5X more expensive than the tech market.  The average Nasdaq P/E is 19.7.

 

Pretty impressive company.  FB ended the day with a market capitalization of almost $105 billion.  That’s 2.5X bigger than Hewlett-Packard ($42B).  It’s also bigger than Amazon ($96B), McDonald’s ($91B) and Disney ($78B).

 

Back to whacky tech-type valuation metrics.  At a market value of $105 billion, investors are estimating that each person with a FB page is worth roughly $117.  Last year, each FV user generated $4 worth of sales.

 

ADVERTISING

Ad driven business.  Advertising represented 85% of FB’s revenue.

 

Wrong direction.  Ad revenue for Q1 was down 6% from the prior quarter.

 

Low level of sales per user.  There are estimates that FB made $9.50 in ad revenue per US user (last year).  GOOG made $63.

 

Are you blaming the Volt on Facebook?  GM pulled $10MM in ads from FB this past week, saying that they were ineffective.  Nearly half of all advertisers see the ad dollars spent on FB as experimental.

 

 

TRADING

The IPO price.  Facebook (“FB”) went public at $38.

 

The highlight.  It traded as high as $45.

 

I hope you didn’t buy at $45.  FB closed at $38.23 (near its low).  This means that the vast majority of people who bought in the aftermarket (in other words, they didn’t get any of the initial offering at $38) ended the day at a loss.

 

The last ones in the door.  People who bought recently (in the private market) also lost.  Prior to the IPO, FB shares were trading on SharesPost for $44.10.

 

Huge volume.  Trading started at 11:30 AM EST.  More than 200 million shares changed hands in the first hour of trading.  By the end of the day, 571 million shares had traded.

 

Regardless of the weak price action, don’t forget…it’s impressive that FB could do this offering in a relatively weak market.

 

I ALWAYS LIKE TO LEAVE YOU ANGRY

Co-founder Eduardo Saverin (one of Mark Zuckerberg’s Harvard roommates) has renounced his U.S. citizenship.  His spokesman said, “U.S. citizens are severely restricted as to what they can invest in and where they can maintain accounts.”  Even if you take him at his word (that this isn’t about taxes), could you imagine renouncing your citizenship so you could get higher investment returns?  More evidence that you can have all the money in the world and still be a total loser.

 

Losers unite.  I would love to see Saverin buy the Lakers so we could have all the losers congregate in one spot.  I love reading Kobe Bryant’s comments after the Lakers lose – and listening to him blame everyone else.

 

Have a great week.

 

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Quick commercial…if you’re in south Florida, I’ll be speaking on Wednesday night in Ft. Lauderdale.  Here’s a link to more information.  (The cost for nonmembers is $55.)

Today’s blog has two short pieces:

1. some thoughts on the EU

2. a few interesting stats

 

The Eurozone crisis continues.

Here are my thoughts:

1. Imagine that the US, Canada and Mexico had a common currency.  The three individual countries would lose the ability to use monetary policy to respond to their particular economic needs.  They’d also lose the ability to devalue their currency if exports were weak.  That’s what you have in Europe.  It doesn’t work.

 

2. In order for the common currency to work, countries need to have similar characteristics.  Unit labor costs should be similar, economic cycles should be similar, fiscal policies should be similar.  Greece and Germany…not that similar.

 

3. Many people argue that the US is very much like the EU – a group of states with a common currency.   Of course, the US is nothing like the EU.  We have a federal government, the states must balance their budgets, we all speak the same language and we have the ability to freely move among states – chasing opportunity.  (We have our own problems, but they’re not caused by a common currency.)

 

4. Governments like the Greek government (do they have a government now?) are problematic.  They responded to difficult economic times by expanding the government payrolls rather than becoming competitive.  But again, the real problem is that they’re not competitive.

 

5. You can’t really believe that time will heal these problems, can you?  Gimmicks designed to keep interest rates low in problem countries…will these help?  They delay the inevitable.  Do you really think that a country like Spain, with 25% unemployment, is going to fix their problems by cutting their budget?

 

6. Germany gets a lot of credit in the press for being much more efficient than other EU countries.  But, an alternative way of looking at the situation is simply to say that they are benefiting from a currency that won’t appreciate.  In other words, the way that they became the world’s largest exporter is by having an undervalued currency.  If the euro breaks apart and they have their own currency, it will appreciate greatly.

 

7. There is value to the EU situation dragging on.  It allows markets to get ready for the inevitable nature of what has to happen.  It will seem much less significant when Greece stops using the euro than if this had happened two years ago.

 

8.  With that said, leaving the euro will cause even more pain in Greece.  One of the biggest problems is that when they return to their own currency, it will be worth much less.  For businesses and individuals that have borrowed (in euros) from non-Greek institutions, they’re going to be unable to pay these loans back.  That will lead to a lot of bankruptcies.

 

A Few Interesting Stats

1. According to a recent MetLife study, nearly half of Americans say they gave money to a family member in the prior year to help pay bills.

 

2. The Employee Benefit Research Institute predicts that nearly half of Americans ages 36 to 62 may not be able to afford even basic living expenses in retirement.

 

3. In 2010, nearly one-fifth of 45- to 54-year-olds didn’t have health insurance.

 

4. The European Commission (the EU’s executive arm) sees unemployment in the euro zone averaging 11% this year, up from 10.2% in 2011. Only six months ago, the commission predicted unemployment would fall slightly this year to 10.1%.

 

5. Even with Medicare benefits, a 65-year-old couple retiring in 2012 will spend at least $240,000 in health-care costs during their retirement, according to a report from Fidelity Investments released Wednesday. That figure represents a 4% increase from last year, when the study estimated such costs would average at least $230,000.

 

Have a great week.

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The Fiscal Cliff – Investors are worried about the economic impact of tax increases that could take effect in January 2012.  Most notably, people are worried about the expiration of the Bush tax cuts, the expiration of the payroll tax cuts and automatic spending cuts (from the sequester).  Chairman Bernanke referred to this while testifying before the House Financial Services Committee when he said, “Under current law, on January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases.  I hope that Congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date.”

 

This tells me one thing…the Great Recession has been followed by a Horrible Recovery.  If raising the top tax rate back to the levels before President Bush took office (which were still below 40%) and withdrawing 6.2% of employee salaries for payroll taxes (rather than 4.2%) would push us off of a cliff, that should give you an idea of where we are.  In other words, things are so bad that we couldn’t go back to the tax structure of the beginning of this century and survive.  I’m not going to argue with that.  It just tells you the dismal state of our economy.

 

The Socialist vs. The Conservative – no, I’m not talking about President Obama against Governor Romeny.  (President Obama isn’t a socialist and Governor Romney isn’t a conservative.)  It will be interesting to see what happens in the EU now that France has signaled their discontent with Germany by electing a left-leaning President.  The war against austerity is building.

 

Tell Me What I Already Believe – with respect to cable news, Fox News is the most watched source.  Now, it seems like MSNBC might be passing CNN.  Maybe people don’t like CNN (and what it’s become).  But, CNN has tried to maintain its position as the nonpartisan news source.  Fox is the source for the right and MSNBC is the source for the left.

 

So You Want to Know How Divided Our Country Is – I read an article that said that the issue of the so-called “Buffett tax” was raised at Berkshire Hathaway’s annual meeting.  I read that one shareholder said that his 84-year old father didn’t want to hold Berkshire’s stock because of Buffett’s support for this rule.  Apparently, half the audience cheered.  Buffett suggested that the 84-year old should consider owning Murdoch’s company instead.  That led to applause from another portion of the audience.  Buffett also said that running a company didn’t mean that he had to put his citizenship in a blind trust.

 

Debt Inequality – CNN had an interesting chart showing the 25-year change in “debt-to-income” ratios for the top 5% and the bottom 95%.  Back in 1983, the levels were approximately equal.  But, the bottom 95% have doubled their ratios!  Of course, this doesn’t answer the question of why the debt ratio has increased.  See chart below.

Another Lousy Report Card – the employment report showed that we only created 115K jobs in April.  That’s not going to solve our labor problems any time soon.  Yet, our unemployment rate dropped to 8.1%.  The reason for this seemingly incongruous result is that the participation rate dropped to 63.6%, the lowest rate since 1981.  There are many reasons that the participation rate is so low (and the reality is that we don’t know all the reasons).  Possibilities include discouraged workers (many of whom will return if they believe jobs are returning), retiring baby boomers (people leaving the work force at an increasing rate) and the large number of people joining the ranks of the disabled (see my blog from two weeks ago).

 

Some Unemployment Rates are More Important Than Others – The Financial Times reports that job growth in the 14 states pivotal to the presidential election has advanced at a slower rate than the rest of the country.

 

Lower Demand for Employees.  Atlanta Fed President Lockhart said that on the demand side (for employees), many businesses that existed five years ago are gone.  While this is normal, we have fewer start-ups because of the weak economy and difficulty getting financing.  Also, many businesses that weathered the recession made deep and apparently permanent cuts in the workforce.  Many businesses have also made investments in technology that have eliminated the need for certain types of jobs (and the skills that these firms now demand may be quite different than in the past).

 

Congratulations Jay!  My oldest son Jay had some great success this weekend in the fifth-grade level of a state academic competition in Ft. Worth.  He placed first in two competitions (Math and Maps/Charts/Graphs) and placed third in Number Sense.  Congratulations Jay!

 

Have a great week.

 

If you enjoy this blog, please forward it to others who may be interested.

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I guess I haven’t been receiving enough hate mail recently.  There’s no other logical reason why I’d write about the ACA.  So, let me start by disclosing my bias.  I recently spent some time studying the ACA (primarily reading some papers on both sides of the issues).  Ultimately, I’m in favor of the ACA.

I’m not writing in an attempt to convince you to support the ACA.  I believe that most of us have political or personal beliefs that result in us supporting or opposing this law.  (If you don’t believe this, ask why the Supreme Court justices could have different opinions on these issues.)  I think that my support for the ACA comes down to my twelve years of Catholic school that led me to judge issues by how they affect the weak and the poor.   These are my personal beliefs that affect my political beliefs.  I understand that many of you have personal and political beliefs that may lead you to oppose this law.

So then…what is the purpose of today’s blog?  In addition to generating hate mail, I want to give you some basic thoughts and I want to tell you some of the good and bad about the law.  Realize that this is a short piece – it is not intended to be a treatise that covers all of the issues.

 

The Basics of the ACA

The ACA is premised on three key ideas:

1. Insurers cannot turn anyone down or exclude people with pre-existing conditions.

2. Everyone must have health insurance (“the individual mandate”).

3. The government will subsidize health insurance for people who will struggle to afford it.  People who have income up to 400% of the poverty level will receive partial subsidies.

 

The Economic Reason for the Individual Mandate

Without the individual mandate, the ACA would likely fail.  Since insurers are not allowed to turn anyone down, healthy people could stay uninsured until they become sick (if there is no individual mandate).  Once they become sick, they would buy insurance (because they can’t be turned down).

If this is what happens, the pool of people who are being insured will be the “sick pool” and will not include the healthy people (who choose to stay uninsured until they actually need insurance).  If an insurer is only selling insurance to the “sick”, the cost will be high.  At that point, many people won’t be able to afford insurance and the system will fail.

 

The Individual Mandate Is a Republican Idea!

In the early-to-mid 1990s, the Republicans were opposed to the Clinton health plan.  One alternative was proposed by a Republican Senator and a Democratic Senator.  It included an individual mandate.  It was supported by 19 Republican senators (including Bob Dole).  If you don’t believe me about this, read this piece by PolitiFact.  Obviously, the Massachusetts plan (signed by then-Governor Romney) also has an individual mandate.

 

 

The Single Best Thing About Universal Health Insurance

Regardless of whether you support or are opposed to the ACA, there’s one thing that we should all be able to agree on.  The ability to obtain health insurance (without working for a large employer) will allow a larger number of people to take the risk of an entrepreneurial venture.  In other words, if I can obtain health insurance on my own, I’m more likely to take the risk of starting a business.   Hopefully, we can all agree that we want to support entrepreneurial activity.  We can argue about the cost of this law, but this benefit is great.

 

Other Reasons That I Like the ACA

1. We will insure approximately 32 million people who don’t currently have insurance.

2. Many of the people who are currently uninsured are still receiving treatment.  Unfortunately, much of this treatment is through emergency rooms – a very expensive way to get treatment.  We’re all paying for this already.  The hospitals and service providers ultimately pass these costs on to us.  We need to find a way to treat these people in a cheaper way.

3. The majority of people who will gain insurance are the working poor.  In other words, these are people who are working in jobs that don’t offer insurance or they are people who have previously made the decision to not participate in insurance.

4. A very similar plan has been successful in Massachusetts.  The “uninsured” rate is 2.6% (lowest in the nation) and they have kept costs low.  (This plan was developed under Governor Romney.)

5. The exchange (think of this as a simple, online market) will make it much easier to compare health plans.  It will also mean that people who are not obtaining insurance through their employer will be able to get affordable insurance that is more than just “catastrophic” insurance.

 

Reasons to Be Concerned About the ACA

1. Many of the cost assumptions are likely to be wrong.  We assume that we’re going to reduce payments to Medicare providers, that a review board will allow us to reduce costs, that tax laws will remain in place forever, etc.

2. In addition, we have already started collecting some of the ACA tax revenue even though most of the costs start in 2014.  That leads to distrust about the ten-year estimates (to reduce the deficit).  (In other words, as an exaggeration, if we collect revenue for ten years, but offer services for one year, it’s hard to say that this is reducing our deficit.  In the future, we’ll have ten years of revenue and ten years of costs.)  The flip side of this complaint is that estimates are that the second ten years will be more beneficial (to our budget) than the first ten years.

3. Massachusetts is different than the US.  They started with a much lower rate of uninsured people than the U.S. (8% vs. 15%), they have higher income than the U.S. (so more of the bill could be put on the citizens rather than the government), they had resources (from a federal government plan) that were used to fund their insurance law and (most importantly) their law had bipartisan support.

4. This law does a little to “bend the cost curve”, but not a lot.

 

Conclusion

Again, my goal is not to convince anyone of anything…and this is not intended to be a treatise.  This is a difficult issue and we have no idea of how the numbers will turn out.  But, regardless of how you feel about it, the politics should bother you.  The partisanship is absurd.  We have a problem – we pay more for health care than all other developed countries, we have higher mortality rates than most developed countries and we have less access to healthcare for a larger percentage of our citizens.  The Democrats took a Republican solution and now the Republicans are being forced to argue against it.  This is really “Romneycare” not “Obamacare.”  Maybe we can all get along and call it “Rombamacare.”

 

 

Have a great week.

If you enjoy this blog, please forward it to others who may be interested.

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There continues to be more discussion about student debt.  There was a great article a week ago in in Barron’s, titled “What a Drag!”  Below, I’ve listed some of the key numbers and ideas (taken straight from the article).  The big takeaway seems to be that the amount of debt is large, it’s impacting the lives of graduates, but it’s unlikely to blow up like mortgages did.  It will be a hindrance on our economy and the lives of the debtors – it’s like having a second car loan (and for some people…it’s a really big, fancy car loan).  Here’s what the article said:

 

SIZE OF DEBT

1. The Fed stated that there is $870 billion of student loans carried by 37 million people.  This is greater than total auto loans.  It’s also greater than credit card debt.
2. The Consumer Financial Protection Bureau asserts that the debt is over $1 trillion when you include interest that has been capitalized (added to the outstanding balance).
3. Two-thirds of the college seniors who graduated in 2010 had student loans averaging $25,250.
4. Student debt borrowing by the 34-to-49 age range has soared by more than 40% over the past three years (the fastest of any age group).  This may be due to bad economic times that prompted many to seek more training.
5. The 30-to-39 age group owes more than any other age decile, with a per-borrower debt load of $28,500.  The 40-to-49 age decile is next with a balance of $26,000.
6. Loans to parents have increased 75% since the 2005-06 school year, to an estimated $100 billion in federally backed loans.
7. Pell grants allow students to borrow up to $5,550 per year.  Federal undergraduate loans are capped at an aggregate of $57,500.

 

RISING TUITION

1. There is research that argues that tuition has increased as a result of the availability of these loans.
2. Private four-year college tuition and fees have increased 181% over the past 30 years.  Public four-year college tuitions have risen by 268%.
3. In-state tuition at public universities averages $8,244.  Private tuition averages $28,500.
4. Ivy League schools led the increase in prices during the 1980s.  They knew that there was demand for a limited number of seats.  There was also a signaling effect.
5. State governments know that there is a large gap between private and public tuition.  This may mean that state governments will continue to cut appropriations to schools.
6. For-profit schools derive 90% of there revenues from government loans (and the GI bill).
7. For-profit schools account for 40% – 50% of all student-loan defaults.
8. Schools often lack cost controls and have to pay for high-salaried professors, expensive presidents and provosts, huge administrative bureaucracies and lavish physical plants.

 

OTHER PROBLEMS

1. Delinquencies are reported at 10% but may be double that when you properly account for things like loan-payment deferrals.
2. Tuition is rising and income is stagnant.  That means that people need to borrow more (and that it’s harder to pay back).  Tuition and fees at four-year schools increased 300% from 1990 – 2011.  Over the same period, overall inflation was 75% and health care costs increase 150%.
3. High debt levels (and weak job prospects) make graduates reluctant to buy cars, homes or spouses.  Weak family formation is not a promising sign for the housing market.

 

THIS IS NOT THE MORTGAGE MARKET

1. Student loans are just one-tenth of the size of the home-mortgage market.  Subprime mortgages (including alt-A and option ARMs) were bundled into $2.5 trillion worth of securitizations at their peak.  In addition, all of this was amplified by credit default swaps.
2. The bulk of the student debt is guaranteed by the federal government.
3. The government has particularly strong collection powers.  They can garnish wages, take income-tax refunds or Social Security payments.
4.  Student debt is generally not dischargeable in bankruptcy.
5. The government claims to recover 85 cents on the dollar from defaulters.  Contrast this with credit card recoveries that tend to be closer to ten cents on the dollar.

 

Have a great week.

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There has long been a disconnect between gold and institutional investors. The instincts of these managers of large sums are typically tied to the generation of cash flows to feed the monster — that is, the institution’s cash flow needs. Alternative emphasis is given to growth, especially if obligations are long duration and not fixed. This is usually true for pension funds, endowments, some insurance companies or individuals investing for retirement.

For these investors, the preferred investment habitat tends to be a blend of income-generating fixed income and equity type investments that are thought to contain the potential for growth. Because gold, as an investment class, provides neither steady income nor systematic growth, it succeeds in only providing emotional discomfort for these investors.

Warren Buffet’s recent article in Fortune is a reflection of this sentiment. First on the list of asset categories to consider are bonds or, more generally, fixed income. His analysis is instructive.

From his point of view, over the relevant time frame of the 47 years he has been at the helm of Berkshire Hathaway, continuous rolling short term Treasuries bills would have averaged 5.7% annually. But if an investor paid income taxes at a rate averaging 25%, the return is reduced by 1.4 points. Buffet then goes on to point out that the return is then further reduced in real terms by the invisible inflation “tax” which would have devoured the remaining 4.3%. Hence rolling short-term Treasuries would have yielded nothing in real terms.

If one held long maturity Treasuries over this period — which included 30 years of general Treasury bond price appreciation — the investment outcome is questionable if you take into account the declining purchasing power of goods in U.S. dollar terms.  It is even worse when compared to a market basket of goods from around the world.

In Buffett’s terms, fixed-dollar investments have fallen a staggering 86% in real dollar value since 1965 during his tenure at Berkshire Hathaway. He points out that today it takes no less than $7 to buy what $1 did when he arrived in Omaha.

He concludes with the recommendation that fixed dollar income investments should come with warning labels advising you that they’re bad for your financial health.

What if contractual steady income doesn’t perform well? Asset categories outside the normal preferred habitat need to be examined. That’s where gold comes in, especially considering that for the first time in our monetary history the central bank has adopted positive inflation as a policy goal. Nonetheless, the institutional sale is a hard one, not just because it’s not been a member of the preferred habitat, but according to Buffet it has other fatal defects.

After conceding in a backhanded way that gold has performed well, with reference to its near $10 trillion in market capitalization, he argues that it doesn’t qualify to be in his preferred investment habitat because it doesn’t produce a growing revenue stream — and if it doesn’t grow, it doesn’t compound.

Rather, he states that his preference would be to employ his capital with growth commodities such as farmland or businesses that will continue to grow its bread-and-butter capacity that can be sold in real terms. That is to say, he rejects gold because it doesn’t produce gold sprouts. Gold is just inert, lying in neatly stacked bars in a subterranean vault. It has but limited use in electronics, jewelry, dentistry and few other applications.

Buffett then goes on to compare the rising price of the sprout-less gold to a Ponzi scheme, which depends upon finding a bigger fool to pay yet a higher price for the same subterranean inert matter. This is apparently proving easier to do by the day as the developed world continues to run outsized fiscal deficits and then compels its central banks to purchase its paper.

Instead, Buffett prefers investments such as Coca-Cola or See’s Candy, which have the ability to sell more candy in the future at the prevailing price level as a means to produce real growth.

That’s where I depart from the Sage of Omaha. While not arguing with the ability of See’s Candy to deliver and the American sweet tooth to be unaffected by the growing concerns for obesity, I believe he fails to see the new product that gold represents and its growing sales potential.

This is “the new calculus of gold.”

In a wealth-accumulating economy there is always demand for an ultimate store of value for wealth preservation. In finance terms, there is always a demand for some asset for which an investor takes no default risk, nor inflation risk, and can be obtained and sold on liquid markets.

For decades, U.S. Treasury debt took over from gold as the market’s preferred store of value. Treasury bonds mythically had no default risk and little inflation risk when central banks were not under pressure to be concerned about unemployment, lending to insolvent banks, or propping up the value of government debt. Moreover, U.S. dollar-denominated Treasuries served not only as the store of value but also sprouted interest payments.

But all that has changed, perhaps not forever but likely for the next four decades, as developed world democratic governments will be under pressure from their constituents to make good on the social contracts of social security and comprehensive health care to the bulging baby boomer population. And, if need be, they will recapture the central banks (by legislative changes if necessary) if they fail to support U.S. Treasury prices.

Given the debt and monetary growth ramifications of these pressures, investors will seek an alternative embodiment of a store of value other than fixed dollar denominated assets, especially sovereigns. With all other developed countries in similar straits and emerging market countries exposed to inflation generation from developed country central banks, their currencies and sovereigns also fail to qualify. Hence, gold has reemerged to play the role of the store of value, despite its sprout-less property. Sprouts are the icing on the cake but not the cake itself — and many gold admirers remember Mark Twain’s old saw: ‘I am more concerned with the return of my money than the return on my money.’

The New Calculus of Gold has much more to its story than merely the market-designated good for inflation and default protection, with or without sprouts.

We are at a historic point in time when both consumer and government debt have grown dramatically relative to income, which is our underlying economic problem (See Roadblocks to Recovery: An Interview with Dr. Lacy Hunt). In the great debt run-up of the last few decades, lenders or bond investors underwrote debt or loans based on either the borrower’s cash flow to service the debt or based on the borrower’s collateral, or both.

But debt has a maturity, and when the maturity is reached, borrowers seek to go back to the well and roll the debt over. From the easy lending days of the turn of the 21st century, the value of what has traditionally been accepted by the lender as good collateral has declined in market value as well as market esteem. That includes residential houses and commercial real estate for mortgages, mortgages for mortgage-backed securities, and mortgage-backed securities for CDOs.  Even government securities and guarantees have been questioned especially from abroad when collateral value is set by the credit rating of the collateral. By that measure even U.S. Treasuries and government guarantees fail the test of good collateral given rating downgrades.

Hence, the great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.

As described in the accompanying news story (J.P. Morgan to Accept Gold as Collateral), gold is now being accepted (or more likely demanded) as collateral for bank loans, which increases the demand for gold. Furthermore the scarcity of collateral has spread to Europe, where debt is now being priced according to the value of its collateral, and clearing houses are accepting gold as collateral and for exchange settlement. Furthermore in this environment of collateral scarcity, clearing houses that service the shadow banking repo loan closures are closing loans despite the arrival of the collateral (prosaically called settlement fails) but it doesn’t stop the loan from being closed without any collateral, either good or bad and is now causing a regulatory backlash to tighten up actual collateral.

In addition to the demand for gold as collateral to back private debt, there are growing instances of commercial banks and central banks stocking up on gold as assets to meet the perception of depositors that banks or currencies are financially healthy. In this regard there is a shifting of foreign exchange reserves of world central banks away from foreign currency (dollars) into gold as shown in the Figure.

Most importantly, China, in its not so secret desire for the Yuan to be a world reserve currency, is accumulating domestically produced gold as it bans exportation, and at the same time it is shifting its foreign exchange reserves from currency into gold. If the Yuan has a chance to have reserve currency status it likely would require gold backing. A gold-backed Yuan would make a big dent in the U.S. market for the dollar and Treasuries as the world’s store of value asset. A gold-backed Yuan would be the equivalent of gold certificates in a warehouse and denominated in a currency that would be on the upswing and very desirable as compared to developed country sovereigns or currency. It might even be more appealing than gold certificates stored in a Swiss warehouse, denominated in a currency that is not allowed by its central bank to appreciate.

We have entered an environment with elevated debt to collateral and elevated currency to goods, and gold is again demanded by market forces to enhance the value of debt paper and otherwise fiat currency.

What we are witnessing is a sea change in which market forces are driving a de facto return to the gold standard. All that is missing for this to be a de jure gold standard is some regulatory and legal recognition and one has been proposed. The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.

This implies banks would be regulatory blessed to operate with less equity capital than is normally required of banks if they held more gold as an asset. Basically,  regulators would allow banks to be more leveraged, meaning the banks would not suffer as much equity dilution to recapitalize after sovereign and mortgage write downs. Not only would gold then be backstopping debt and currency but also be backstopping bank equity capital.  So the realm of gold is expanding to fill the void of other “money good” assets and elevating its demand.

The world has gravitated from one gold-backed paper currency to another before, and it likely is happening again. It would depend on whether investors in liquid, default-free, inflation-free paper prefer gold-backed Chinese Yuan to Swiss warehouse receipts or deposits from large international banks with large gold positions that operate with lots of leverage. This is a market choice that will determine the gold linked paper store of value, but the point is that all the paper contenders derive value from the gold backing, and thereby expands the demand for the shiny metal. This is the new calculus of gold. This state of affairs is likely to remain until developed world governments no longer reach for the unreachable and pressure their central banks to finance it.

If you enjoy this blog, please forward it to others who may be interested.

I frequently talk about Social Security and we always think about the Social Security retirement payments.  But Social Security is actually OASDI – “Old Age, Survivors and Disability Insurance.”  Today, it’s time to talk about disability.

Here are some quick background facts about disability insurance:

1. You are eligible for disability insurance if you have paid payroll tax for five of the ten most recent years.  The payroll tax is 1.8% (the employee pays .9% and the employer pays .9%).
2. You are entitled to disability if you have a medical condition that has lasted or is expected to last at least one year or will result in death.  You must be unable to engage in previous work or adjust to a different type of work.
3. The benefits are equivalent to the Social Security payments that you would receive if you retired at full retirement age.  (FRA used to be 65 but is in the process of gradually being changed to 67.)
4. After you’ve been disabled for two years, you are entitled to Medicare.  This is a very attractive feature for recipients.

 

Ten Things You Should Know About Disability

There are so many outrageous things to tell you about the disability program.  Here are ten.

1. Almost 5% of working age people (25 – 64) are receiving disability payments.  Do you believe one-in-twenty people are disabled?
2. Disability has become a safety net.  Two percent of working age people applied for disability in 2010.  Do you believe that 2% of all working people became disabled in 2010 or do you believe a weak job market had something to do with this?
3. Disability has become the program of choice after 99 weeks of unemployment insurance lapse.  Look at the chart below (from Krueger and Mueller, cited at bottom of today’s blog).  You can see that people who do not have access to $5,000 claim disability at a much higher rate when their unemployment insurance lapses.  Think about this – there’s no reason that this group should have a higher disability rate than people who have access to $5,000.
4. Once someone goes on disability, there is little chance that they will ever return to work.  There are three ways to leave disability: you can die, you can reach full retirement age and shift to the Social Security payroll or you can return to work.  Less than 1% leave the disability roll by returning to work.  See chart below from Autor’s paper (cited at bottom of today’s blog).
5. If your initial claim for disability insurance is denied, your appeal is heard by an Administrative Law Judge.  The ALJ will reverse 75% of the initial decisions.  Think about this: the appellant is represented by an attorney.  The government, on the other hand, does not have an advocate at the hearing.  As a former prosecutor, I’ll let you in on a little secret…it’s easier to win a trial or a hearing when there’s no one arguing against you.
6. The disability “trust fund” is expected to be exhausted in the next few years.   They are currently taking in 20% – 30% less than they are spending.  Go figure.
7. Some rocket scientists want to start to allocate more of our payroll taxes to disability (and away from Social Security) in order to save the disability fund.  Talk about robbing Peter to pay Paul.  Of course, this was our solution in the 1990s.  We’re a nation of morons.  Or better said, we’re a nation that has elected a bunch of morons.
8. In 2010, there were approximately $124 billion of cash payments under the disability system and the Medicare payments (to people receiving disability) cost approximately $70 billion.  The total spending is approximately $1,500 for every U.S. household.  It’s 7.3% of federal non-defense spending.
9. Spending has grown at a real rate (i.e., greater than inflation) of 5.6% for the past 20 years.  All other Social Security spending increased at a 2.2% real rate.  In 1988, disability spending was one in ten dollars spent by the Social Security system.  Now, it’s almost one in five dollars.

10. The average new awardee is 48.8 years old.  The present value of the cash and medical benefits that they will receive (until Social Security takes over) is $270,000.

 

Some Final Thoughts

I don’t dispute that plenty of people are disabled and need these benefits.  In fact, I want these people to receive payments.  I want the money to be there so that we can pay these people.  But there is far too much fraud going on.  I’m sorry, but 5% of the population is not disabled.  Work is becoming less physical.  Medical care is better.  There’s little reason to believe that real disabilities increase in a recession or that unemployment insurance exhaustees without money should have a higher incidence of disability than those with money. Finally, you can’t convince me that only 1% of disabled people recover in a year.

Two last random things to consider:

1. This is one factor (among many) that accounts for a drop in the labor participation rate (so the unemployment rate is misleadingly low).
2. While counterintuitive, you could also argue that this is a justification for extending unemployment benefits (like we did).  We need to give people time to find work.  Otherwise, some of them claim disability.  Once we lose them to disability, they’re gone.  You have to accept the fact that some people are gaming the system.  If we let them get on disability, the game is over and we just lost $270K in present value terms.

 

SOURCES:

David H. Autor, “The Unsustainable Rise of the Disability Rolls in the United States: Causes, Consequences and Policy Options,” National Bureau of Economic Research (December 2011).

Krueger, Alan, and Andreas Mueller. In progress. “Applications for Disability Insurance and the Exhaustion of Unemployment Insurance Benefits: New Evidence from a Survey of Unemployed Workers.”  (Cited in “Unemployment Insurance Extensions and Reforms in the American Jobs Act” by the Executive Office of the President)

 

 

Have a great week.

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In Monday’s blog, I mentioned a presentation in Austin that was scheduled for tonight (Wednesday night).  Unfortunately, we decided to cancel it.  It looked like attendance was going to be low.

 

On a happier note, thanks to those of you who participated in the webinar on Monday.  It was the biggest one that we’ve ever done at McCombs.

 

I’ll be back to writing by Monday (if not sooner).

Have a great “rest of the week.”

Sandy

A NEW commercial…on Wednesday night, April 11th (this Wednesday), I’ll be presenting “Numbers All Americans Need to Know” in Austin.  Here’s the link if you want to sign up.

 

Also, don’t forget today’s (Monday) webinar (mentioned in my prior blog).  Here’s the link to that.

 

Now, on to today’s blog…

 

Robert Wilmers, M&T’s Chairman and CEO wrote a letter to his investors (as part of the company’s annual report) that has received a lot of attention.  After reviewing his company’s performance, his letter explained how the public no longer trusts banks or their leaders.  As a result, regulation is being enacted that will hurt the industry and the overall economy.

 

Below, I have pulled out some of his comments about bankers.  In addition, here is a pdf of the relevant part of his letter (the part about the banks and not the part about M&T).  Here are some of his key comments and numbers about bankers:

1. A 2011 Gallup survey found that only a quarter of the American public expressed confidence in the integrity of bankers.
2. The Wall Street banks were central to the financial crisis and continue to distort our economy.  Main Street banks were often victims of the crisis.
3. The financial crisis has resulted in the decimation of public trust in once-respected institutions and their leaders.
4. The result of this has been rulemaking that will burden the efficiency of the American financial system for years to come and will potentially have broader implications for the overall economy.
5. Bank leaders used to be seen as community leaders and even national leaders.
6. The average compensation in the financial services industry used to be exactly the same as the average income of a non-farm U.S. worker.
7. Investment banks used to be kept separate from traditional banks.  Everyone specialized in markets and thoroughly understood those markets.
8. As banks started investing in areas where they possessed little knowledge, the reputation of banks and their leaders dwindled.
9. The subprime crisis was characterized by Wall Street banks betting on and borrowing against increasingly opaque financial instruments, built on algorithms rather than underwriting.  The banks created instruments that they did not understand.

10. Bankers contorted the overall economy.  Insurance, finance and real estate was 11.5% of GDP in 1950.  By 2000, it had reached 20.6%.

11. Today, the largest six banks own or service roughly 56% of all mortgages and nearly two-thirds of those in foreclosure proceedings.

12. One bank services almost $2 trillion and close to 30% of all mortgages in foreclosure.

13. Since 2002, the six largest banks have been hit by at least 207 separate fines, sanctions or legal awards totaling $47.8 billion.  None of these banks had fewer than 22 infractions.  One had 39 across seven countries, on three different continents.

14. According to a study done by M&T, over the past two years, the top six banks have been cited 1,150 times by The Wall Street Journal and The New York Times in articles about their improper activities.

15. At a time when the American economy is stuck in the doldrums and so many are unemployed or under-employed, the average compensation for the chief executives of four of the six largest banks in 2010 was $17.3 million – more than 262 times that of the average American worker.

16. One bank with 33,000 employees earned a 3.7% return on common equity in 2011, yet its employees received an average compensation of $367,000 – more than five times of the average U.S. worker.  (NOTE: I’m not sure where Wilmers is getting his data…the average US worker is not making $73,400…try cutting that in half.)

17. The Wall Street banks continue to fight against regulation that would limit their capacity to trade for their own accounts – while enjoying the backing of deposit insurance – and thus seek to keep in place a system which puts taxpayers at high risk.

18. In 2011, the six largest banks spent $31.5 million on lobbying activities.  All told, the six firms employed 234 registered lobbyists.

19. It is difficult, if not impossible for bankers – who once were viewed as thoughtful stewards of the overall economy – to plausibly play a leadership role today.

 

Wilmers continues on by saying that others were also at fault.  Here are a few of the best statistics he cited:

1. As of September 2011, of the 2.2 million mortgages undergoing foreclosure, about 730,000 (33%) were owned or guaranteed by the GSEs.  Of the estimated 850,000 repossessed homes, 182,212 (21%) were held by Fannie and Freddie.
2. M&T looked at a sample of 2,769 residential mortgage-backed issues originated between 2004 and 2007 with a total face value of $564 billion.  Of that sample, 2,679 (99%) were rated triple-A at origination by S&P.  Today, 90% of these bonds are rated non-investment grade.
3. M&T’s cost of complying with regulation has increased from $50 million in 2003 to $95 million in 2011.  In addition, their insurance premium to the FDIC (to maintain and replenish the Fund) increased from $4.5 million in 2006 to an annualized rate of $197.7 million at the end of 2011.
4. M&T’s “likely tally of annual compliance costs and revenue lost from these regulations is $342.6 million and would have represented 28% of pre-tax income in 2011.”
5. The Dodd-Frank Act contains, by one estimate, 400 new rulemaking requirements, only 86 of which were finalized by the start of 2012.

 

Wilmers concludes that the total distrust for bankers has led to rulemaking that will hurt our nation’s competitiveness.  My intuition is that he’s right.  We regulate in the rear-view mirror (creating rules that fix yesterday’s problems).  But, more importantly, he’s right because this is human nature.  The bankers were a huge part of the problem and they’re to blame for much of the rule-making that is going on.

 

Have a great week.

If you enjoy this blog, please forward it to others who may be interested.

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IMPORTANT: if you don’t receive the email in step 3 or you don’t click on the link, you won’t be on the list.  Sometimes, people who use corporate emails get blocked (it’s probably 50% of the time).  So if you don’t get the email, you know you need to use a personal email.

 

 

 

Quick commercial…for all UT alumni, I’m doing a free webinar on Monday at noon CST.  Here’s the link, where you can sign up.  It’s called “Numbers All Americans Should Know.”  I will discuss some of the key numbers concerning our unfunded liabilities, disability and healthcare.  Hopefully, it will be a good primer for understanding some of the basic numbers that people are talking about.  The webinar is a slightly shorter version of presentations that I’ve done recently in Ft. Worth, Dallas, D.C., NY and our Alumni Business Conference (so if you attended any of these, you probably don’t want to attend the webinar).

 

Now, on to today’s blog.  I read four articles that you might find interesting:

 

1. Student Debt for Retirees

The Washington post published an article (“Senior Citizens Continue to Bear Burden of Student Loans”) that said:

1. Americans 60 and older still owe approximately $36 billion in student loans.

2. More than 10% of those loans are delinquent.  As a result, it’s not uncommon for Social Security checks to be garnished.

3. Borrowers age 60 and above account for a little less than 5% of the outstanding student loans.  Americans aged 50 and older account for 17% of this debt.

4. Democratic Senator Richard Durbin has introduced legislation that would allow private student loan debt to be discharged in bankruptcy.

 

 

2. How China Steals Our Secrets

Richard Clarke, the special adviser for cybersecurity to President George W. Bush wrote a great op-ed piece in The New York Times.  It’s titled, “How China Steals Our Secrets.”  He argued that President Obama needs to promote legislation that will help the government stop stolen data from leaving the country.

 

In his piece, he said that FBI Director Robert Mueller “said cyberattacks would soon replace terrorism as the agency’s No. 1 concern as foreign hackers, particularly from China, penetrate American firms’ computers and steal huge amounts of valuable data and intellectual property.”  He quoted Gen. Keith B. Alexander, head of the military’s Cyber Command as calling the cybertheft “the greatest transfer of wealth in history.”

 

Clarke argued that by failing to act, Washington is effectively fulfilling China’s research requirements while helping to put Americans out of work.

 

3. GSA Chief Resigns Amid Reports of Excessive Spending

The chief of the General Services Administration (a federal agency) resigned and two of her top deputies were fired after they held a “training conference” for 300 employees in Las Vegas.  (Here’s a link to the story.)  The total cost (including the “planning” trips) was $823,000.  Some of the money was spent on a clown and a mind reader.  The truly offensive part of this whole thing is that they hired a clown when they probably could have had a Congressman appear for free.

 

Here’s the pdf of the actual report about the festivities.  It’s truly amazing that a group of people could work together and make such a bad decision.  While I know that many people read stories like this and generalize to “the government is always wasteful,” that’s not my goal.  Similarly, when I read about an incompetent doctor or a scandalous school teacher, I don’t assume that they are all that way.  (With that said, I have no problem thinking the worst about all politicians.)

 

4. Five Years After Crisis, No Normal Recovery

Carmen Reinhart and Kenneth Rogoff wrote a piece on Bloomberg arguing that they continue to be right and this isn’t a conventional economic recovery.  They take issue with a recent Fed research paper.  Reinhart and Rogoff have consistently argued that recessions that result from a financial crisis are deeper and last longer.

 

They also state that in ten of fifteen severe post-WWII financial crises, unemployment didn’t return to pre-crisis levels even after a decade.  That doesn’t sound promising.

 

 

Have a great weekend.

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Last Monday morning, Fed chairman Bernanke gave a speech titled, “Recent Developments in the Labor Market.”  It was an early morning speech (before the market opened).  Here’s the link.  Market commentators attributed the market’s 160 point Monday rally to Bernanke’s comments.  There was one main takeaway…monetary policy would stay accommodative.

 

Personally, I think it would be more exciting to see the market rally because of earnings or strong fundamental news.  It’s less exciting to think that the market is rallying because money is cheap and will stay cheap.

 

Regardless, I think that Bernanke’s comments were much more interesting than simply “viva la low rates.”  In today’s blog, I want to describe the most interesting things he said.  If you want more details (and who wouldn’t?), here’s a pdf of an outline that I wrote about the speech.  It will take just a few minutes to read and the back of the pdf file includes all of Chairman Bernanke’s slides.

 

Now, the short version of Bernanke’s key points…

1. There’s no question that there’s some good news in the labor market.  Payrolls have increased almost 250K / month for the past three months, there’s been a significant increase in aggregate hours worked, the unemployment rate has dropped, household expectations have improved, business hiring plans have improved, new claims for unemployment insurance have decreased and measures of breadth of hiring across industry have improved.

 

2. There are still many negative signs in the labor market.  Private payrolls are still five million jobs below peak (plus the population has grown).  The unemployment rate is well above a sustainable level (and 3% above the 20 year average).  Total hours worked are below pre-crisis level.  Long-term unemployment is very high.  We’ve seen more of a decline in layoffs than an increase in hiring.

 

3. Okun’s law suggests that we need to have GDP growth 2% higher than our potential growth (for one year) in order to lower unemployment by 1%.  As a result, it seems like the positive employment numbers are not in sync with the pace of expansion.

 

4. While the decrease in the participation rate has had an impact, we have seen a drop in the unemployment rate of marginally attached workers to the same extent as the overall unemployment rate.  This indicates that the “weak” are getting jobs at the same rate as the overall population.  This story contradicts the idea of the weak simply dropping out.

 

5. The increase in employment reflects a catch-up from outsized job losses during recession.  Employers feared that the economy was going to be even worse than it turned out to be.  In addition, they may have feared a credit crunch, so they tried to conserve cash.  Employers are simply getting back to normal staffing.

 

6. To the extent that we’re just recovering from “over-firing”, we need high growth to lower the unemployment rate further.

 

7. The high percentage of people who have been unemployed for longer than six months reduces our productive capacity over the long-term.  We have a loss of skills.  It could also slow our rate of recovery in the short-term because it takes longer to match these people to jobs.

 

8. It takes older workers longer to find new jobs.  This is a structural unemployment problem that has been raising our unemployment rate because a larger percentage of our labor force is older (the aging baby boomers).

 

9. Since we need higher growth to regain jobs, this can be supported by continued accommodative policy.  In addition, if our unemployment is generally cyclical (rather than structural), this also speaks to continued accommodative policy.

 

10. Even if the unemployment problem is mostly cyclical, if it continues on for too long, it can become structural.  Skills can atrophy.

 

Have a great week.

 

If you enjoy this blog, please forward it to others who may be interested.

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IMPORTANT: if you don’t receive the email in step 3 or you don’t click on the link, you won’t be on the list.  Sometimes, people who use corporate emails get blocked (it’s probably 50% of the time).  So if you don’t get the email, you know you need to use a personal email.

 

 

 

 

Since the housing and mortgage expansion reached its unsustainable zenith nearly five years ago, economic headwinds and financial contraction have been at the forefront of financial market discussions. Two years ago, the sovereign debt problems of the developed world further added demand-side challenges (See Lacy Hunt Interview: Roadblocks to Recovery).  Over that time economic policy has concentrated on resurrecting demand via government debt-financed spending or monetary expansion.  It is safe to say that we have now learned that the Keynesian tools that served well in a less debt-challenged environment no longer solves the macroeconomic problem.  If it did, we would not be facing the question of yet another QE.

Moreover, we do not have an answer to the larger question of the sustainability of the Western social model of a government-funded retirement with medical care.

In the following guest blog, Dr. Wilfried Prewo points out that a decade ago, Germany was faced with a similar problem of sustaining the economy and delivering on the government’s social commitments.  As a result, she devised supply-side policies that have been very effective in meeting both goals. Today, Germany has the lowest unit labor cost despite also having the highest wages in Europe. As a result, she runs a trade surplus, has relatively low unemployment and a near balanced fiscal budget.  The U.S. has a lot to learn from these innovative supply-side policies.

Germany: Export Powerhouse Despite High Wages
by Dr. Wildfried Prewo

Just ten years ago, Germany was labelled the “sick man of Europe”. Following its remarkable post-WW II recovery, Germany became complacent in the three decades from 1970 to 2000. Its labor cost rose to the highest in the world, benefits became more and more generous, and the work-week was shortened to as low as 35 hours. Productivity growth slowed down, wage increases did not. Germany’s competitiveness as measured by unit labour cost (labour cost adjusted by productivity) slumped and threatened Germany’s export success despite otherwise superior engineering and product quality.

Over these three decades, Germany’s social model became less and less sustainable. With every recession during that period, unemployment ratcheted up and, in the following upswing, did not recede to the pre-recession level. With higher unemployment, payroll taxes had to be raised, thus exacerbating the labor cost situation and spinning a vicious cycle of higher unemployment and yet higher payroll taxes. In 2003, when Germany shrank by 0.2 percent, unemployment was 10.5 percent. But in 2005, with positive growth of 0.8, unemployment still stood at 11.7 percent. Then things changed.

By the time of the Lehman Brothers collapse, in September 2008, German unemployment had been brought down to 7.3 percent. Even more remarkable is the fact that, a year later, in 2009, when Germany’s GDP shrank by 4.7 percent in recession following the financial crisis, unemployment had hardly increased (7.9 percent in September 2009). Another September later, in 2010, when German GDP grew by 3.6 percent, unemployment was at 7.2 percent. Now, in February 2012, unemployment is at a seasonal 7.4 percent. If we were not overwhelmed by the debt crisis in Europe’s olive belt, prospects would be bright.

The improvement – or better, structural change – in Germany’s labor market was not achieved by axing wages and benefits. In 1997, German hourly compensation costs (wages plus benefits) in manufacturing were 29 percent higher than in the U.S., making Germany the world’s labor cost leader at that time. In 2009, Germany’s wages still were among the highest in the world, with only four small countries (Norway, Denmark, Belgium, Austria) having higher wages. But from 1997 to 2010, German labor cost had an annual average increase of 1.9 percent only, as compared with 3.2 percent in the U.S. Over the last decade, wages in Germany did not fully compensate for inflation. On top of that, German labor productivity did increase and restrained German unit labor cost to an increase of just 6% from 2000 to 2011. Contrast that with percentage increases of 19.9 in the U.S., 24.1 in the 27 EU countries overall, 32.5 in Italy, a major German competitor in machines and autos, or even 31.2 in Greece. (As an aside: This shows that the profligacy of countries like Greece and Italy was the cause of their debt crisis, and it shows what has to be corrected.)

The German labor cost mitigation was primarily not the work of government, but a joint and self-organized effort of companies and their employees. It was a sea change in labor relations as it replaced rigid work conditions and one-size-fits-all union wages by a myriad of flexible plans.

The change in labor relations began around 2003 and in small and medium sized companies with a lower degree of union influence. At that time, many of these companies, still reeling from the previous 2001/02 recession with its onerous cost of severance packages, were not profitable and strapped for money to invest in new equipment and material in a feeble recovery. The employees realized the dire situation and, in trying to preserve their own jobs, made significant concessions: Work rules were made more flexible, weekly hours were increased to 40 and beyond without extra pay; annual, in some cases even life-time work time budgets replaced rigid weekly hours; this allowed companies the flexibility to adjust weekly work hours to demand, say, anywhere from 25 to 45 hours as long as they stayed within the longer-term, annual time budget. Overtime compensation was scrapped. Even the regular wage for extra hours was not paid out in cash, but deposited in individual deferred compensation accounts which were to serve as rainy day funds.

By the beginning of the 2008 recession, these accounts were bloated and could then be depleted as companies sharply reduced their work hours during the recession. This preserved income levels, and German private consumption remained a robust pillar throughout the downturn. (As an automatic stabilizer, the German law compensating for “Kurzarbeit” had the same effect; under this government program, the wage reduction due to a recession-induced shorter work week is compensated by unemployment insurance at the unemployment benefit level, allowing a worker an effective take-home pay of around 90 percent of his previous wage, even if he is idled for a third of the week.)

In return, German companies guaranteed not to reduce their labor force except under exceptional circumstances, and they kept that promise. Companies also promised investment in German production facilities in order to allay labor fears that offshoring and outsourcing, a must-do in any globalized industry, would come at the cost of German employment.

German labor unions at first fought this bottom-up development as it reduced their influence and, of course, poked holes into their rigid and top-down, one-size-fits-all union contracts. But eventually, reason prevailed and the unions condoned these agreements by their rank and file members in the companies. Flexible union contracts that offer cafeteria-style provisions for individual companies’ circumstances are now standard.

With nominal unit labor cost remaining nearly flat over the last decade, German companies benefited from the strong decline in real unit labor cost. As a result, the profits of German companies, as a share of GDP, jumped from 14.8 percent in 2000 to 20.9 percent in 2008. German companies could invest and deleverage at the same time. When the 2008 recession hit them, they were in a financially robust state. By September 2011, they had more than erased the damage their balance sheets suffered during the recession.

On the cost side, these changes in labor relations were the major reason for Germany’s V-shaped recovery from the recession. On the demand side, the recovery was fuelled, as early as in the spring of 2009, by strong export orders from China and other Asian countries that were not inflicted by the financial crisis. The German export mix of cars, machinery, chemicals, and other investment goods with a high engineering content and requiring a skilled labor force is exactly what is demanded by strongly growing emerging markets. While in 2000 only 1.6 percent of German exports went to China, that share had risen to 5.6 percent by 2010. For the major emerging markets, the BRIC countries together (Brazil, Russia, India, China), the increase was from a share of 3.9 to 10.4 percent. Germany is now exporting more to the BRICs than to the U.S., whose share of German exports declined from 10.3 to 6.8 percent in the decade. (In absolute numbers, German exports to the U.S. are not lower now than in 2000.) Another symbol for the rising importance of emerging markets is that, since 2010, Mercedes has been selling considerably more of its top-of-the-line cars, the S class, in China than in the United States.

Manufactured goods with cutting-edge technologies require good engineers and a highly skilled labor force. Many Western countries, including the U.S., have the first, a pool of good engineers, but what the U.S., France, the U.K., or Italy as major German competitors lack is a broad highly skilled labor force. Too often, the manufacturing workforces in American or British companies consist of workers who have been trained for brief periods and only for the specific skills at their work stations. In Germany, the typical worker has undergone a three-year vocational training program after leaving school. As a consequence, Germany has few unskilled workers, and the systematic training at the beginning of the career is a base for further training later on as will inevitably be required by technical change. Germany is not the only country offering such a system; Austria, Switzerland, or Denmark have similar systems. All of these are countries which are successful in exporting and which also pay high wages. Comparing wages among industrial countries is a comparison between apples and oranges if skill differences are not taken into account.

In foreign production facilities where nationwide training systems do not exist, German companies often engage in considerable in-house training efforts in order to be able to achieve the same product quality as in Germany. Although these isolated, single-company training efforts are less efficient than a nationwide system, they are a second-best solution and work. One example: Who would guess the name of the largest exporter of American made cars to outside the NAFTA region? It is a German company – BMW. I am convinced that American machinery or chemicals manufacturers could emulate the German export success if there were a similar training system.

Society also benefits from systematic youth training: In January 2012, unemployment among young people (age 15-24) stood at 16.0 percent in the U.S., 22.4 in the EU as a whole, 23.3 in France, 31.1 in Italy, and a staggering 49.9 in Spain. In Germany, the rate is only 7.8, and the situation is comparable for Austria or Switzerland. In the other countries, youth unemployment is roughly double the overall unemployment rate and a cause for social problems.

When contemplating economic policies for the United States, it might be worthwhile to consider systematic youth training. It will take more time than an election cycle to show its effect and it is not a quick fix, but quick fixes rarely lead to a sustainable resolution.

prewo@hannover.ihk.de

March 22, 2012

Wilfried Prewo is chief executive of the Hannover Chamber of Industry and Commerce in Hannover, Germany. He holds a Ph.D. in economics from Johns Hopkins University and has taught economics, early in his career, at the University of Texas at Austin.

The extent and implication of the U. S. debt overload. Neither monetary nor fiscal policy can solve the debt problem nor the profound side effects of excess debt.

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Welling at Weeden Interview

Today, I want to share three articles that I found interesting.  They involve:

1. profit margins (is the stock market expensive)

2. the FHA – the next housing disaster

3. an unbelievable article about student debt

 

Profit Margins

James Montier of GMO wrote an interesting piece titled, “What Goes Up Must Come Down!”  Here’s the link to their site.  Here are some of his key ideas:

1. U.S. profit margins are at record highs according to NIPA data.  See Exhibit 1.

 

2. It’s strange to see these record high margins during such a weak economic recovery.

 

3. GMO believes in reversion to the mean.  (Wall Street analysts, on the other hand, expect profit margins to continue to rise.)

 

4. I always think about total return as a combination of:

A. change in price/earnings multiple (it can contract or expand); plus

B. change in earnings; plus

C. dividend yield.

 

But, Montier broke it down a little bit more.  Instead of just using change in earnings (the second variable), he used change in sales plus change in margin.  (Change in sales and change in margins is the same as change in earnings.)  He argues that S&P 500 profit margins are currently 7.8% and should revert to 6% over the next seven years.

 

5. These are the assumptions that result in GMO’s estimate that real returns from stocks will average .4% for the next seven years.

 

6. He argues that the government deficit is the reason for the high margins.  Once the government slows its deficit, profits will drop.

 

The FHA

Business Week published an interesting article this week, called “FHA Bailout Risk Looming Larger After Guarantee Binge”.  Here’s the link.  A few ideas from the article:

 

The FHA guarantees $1.1 trillion in home loans.  This has tripled (to $1.1 trillion) since 2007.   They have been counting on growth in home prices to rebuild their insurance fund.

 

Moody’s predicts that home prices will fall 3% in 2012 before growing 1.4% in 2013 and 6.5% in 2014.  The FHA used projections that called for increases of 1.2% in 2012 and 3.8% in 2013.

 

NYU Professor Andrew Caplin says that losses will be deeper than the FHA predicts because the agency uses a home-price index that excludes distressed sales.

 

By law, the fund is supposed to hold 2% of its portfolio in reserve.  As of September 30th, it held only .24%.  It has paid out $37 billion to cover defaults over the past three years.

 

Joe Gyourko of the Wharton School predicts that taxpayers will be on the hook for between $50 billion and $100 billion.

 

Student Debt

There have been loads of articles recently about the cost of college and the amount of outstanding student debt.  But, you need to read this article.  Student debt is starting long before college.  Here’s the link.

 

Have a great weekend.

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Today, I want to start with a quick commercial and I hope you’ll forward this to anyone who you think may be interested.  We’re starting a new program at McCombs – The Master of Science in Finance.  The degree consists of 36 credit hours and takes ten months.  This is going to be a great program for recent college graduates who want to gain deep finance knowledge.  There is no prior finance training or work experience required.  If you’re interested, here’s a link to learn more.  I’m looking forward to teaching Investments in the program.  Now, on to this week’s blog…

 

Many times, I blog about papers or articles.  Every so often, I suggest that you should really read an article for yourself.  This is one such time.  The Dallas Federal Reserve Bank released their annual report this week.  The lead article in the report was written by Harvey Rosenblum (the Dallas Fed’s Director of Research and Executive Vice-President).  It’s titled, “Choosing the Road to Prosperity: Why We Must End Too Big to Fail – Now”.  Here’s the link.

Here are some of the most important points from the article (many lifted verbatim):

1. The road to prosperity requires a roadmap that finds ways around the potential hazards posed by the financial institutions that have been deemed “too big to fail” (TBTF).

 

2. The top five banks controlled 52% of bank assets in 2010.  In 1970, this was only 17%.

 

3. The term TBTF disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.

 

4. Monetary policy operates by impacting the decisions made by businesses, lenders, borrowers and consumers.

 

5. The Fed has kept interest rates low since December of 2008.  This has had a punishing impact on savers.

 

6. Usually, easy monetary policy helps the economy rebound much faster.  One problem is that banks still have toxic assets.  As a result, banks are still less willing to lend.  Individuals and businesses are concerned about the future and are less willing to borrow.  Low interest rates don’t provide the stimulus necessary.

 

7. Banks need more capital.  Monetary policy can not be effective when a major portion of the banking system is undercapitalized.

 

8. Most Americans came away from the financial crisis believing that economy policy favors the big and well-connected.  They saw a topsy-turvy world that rewarded many of the largest financial institutions that lost risky bets and drove the economy into a ditch.  These events left a residue of distrust for the government, the banking system, the Fed and capitalism itself.

 

9. TBTF has violated the basic tenets of a capitalist system.  Capitalism requires the freedom to succeed and the freedom to fail.  (Quoting Allan Meltzer, “Capitalism without failure is like religion without sin.”)  Capitalism requires government to enforce the rule of law.  (The privatization of profits and socialization of losses is completely unacceptable.)  Capitalism requires businesses and individuals be held accountable for the consequences of their actions.  (Virtually nobody has been held accountable for their role in the financial crisis.)

 

10. People disillusioned with capitalism aren’t as eager to engage in productive activities.  They’re likely to approach economic decisions with suspicion and cynicism, shying away from the risk that drives entrepreneurial capitalism.

 

11. There are two challenges facing the US economy in 2012 and beyond.  In the short-term, we need to repair the financial system’s machinery so that monetary policy can have a greater impact.  To secure the long-term, the country must find a way to ensure that taxpayers won’t be on the hook for another massive bailout.

 

12. Dodd-Frank has inadvertently undermined growth by adding to uncertainty.  The law’s sheer length, breadth and complexity create an obstacle to transparency, which may deepen Main Street’s distrust of Washington and Wall Street, especially as big institutions use their lawyers and lobbyists to protect their turf.

 

13. Policymakers can make their most immediate impact by requiring banks to hold additional capital, providing added protection against bad loans and investments.

 

14. The big banks that pose systemic risk should be forced to hold additional capital.  This will result in more “skin in the game” and add market discipline.

 

15. Small banks did not cause the crisis and should not have additional capital requirements.

 

16. The assumed future bailout of TBTF banks gives them a significant advantage in the cost of raising funds.  Requiring TBTF banks to hold more capital will level the playing field.

 

17. Banks aren’t being required to raise more capital until 2016 or 2017.  But, there will be advantages to banks that move quicker.  Banks that quickly clean up their balance sheet will be able to raise capital quicker.

 

18. The Fed’s zero-interest-rate policy assisted the banking industry’s capital rebuilding process.  It reduced banks’ cost of funds and enhanced profitability.  We are taxing savers to pay for the recapitalization of the TBTF banks.

 

19. We need to codify and clarify Dodd-Frank quickly.  We don’t need hundreds of pages of regulation.  We need more capital.

 

20. Under Dodd-Frank, future bailouts must be approved by the Treasury secretary.  This means that the President ultimately decides.  The result is that this will be a political decision.  If the new law lacks credibility, we’re more likely to have another financial crisis.

 

21. Ultimately, Dodd-Frank leaves TBTF entrenched.

 

22. The TBTF survivors (of the financial crisis) look very similar to 2008.  They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power.  They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation.  Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.

 

23. We must break the nation’s biggest banks into smaller units.  (Of course, this will be difficult to do.)

 

24. A financial system composed of more banks, numerous enough to ensure competition in funding businesses and households but none of them big enough to put the overall economy in jeopardy, will give the United States a better chance of navigating through future financial potholes and precipices.  As this more level playing field emerges, it will begin to restore our nation’s faith in the system of market capitalism.

 

Have a great week.

 

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Why the participation rate matters.  Everyone following the markets is aware that the unemployment rate has dropped from approximately 10% to 8.3%.  Part of this improvement is the result of job creation (which is a great thing).  But, part of the decrease in unemployment is simply the result of fewer people “participating in the labor force.”  In other words, to calculate the unemployment rate, we divide the number of unemployed people by the number of people participating in the labor force.  To be part of the labor force, you need to either have a job or be actively looking for a job.  So, if you quit looking for a job, you no longer count as unemployed.

 

The participation rate has dropped.  The labor force participation rate has dropped from 67% to 64%.  If the participation rate were 66%, the unemployment rate would be 11%+.  It’s important to understand whether the participation rate will return to the 66% – 67% range.  If it will return to that range, it means that we have to create many more jobs as people return to the work force.

 

A recent paper argues that the drop in the participation rate is a demographic trend.  I want to share a recent Chicago Fed Letter written by Daniel Aaronson, Jonathan Davis and Luojia Hu.  It’s titled, “Explaining the Decline in the U.S. Labor Force Participation Rate.”  Here’s the link.  In this paper, they argue that approximately half of the decline in the participation rate can be explained by demographic patterns.  (The remainder of the drop is caused by the recession.  Realize that people always drop out of the work force when there is a recession.)  Much of this blog entry is lifted directly from their paper.

 

Explaining the prior increase in the participation rate.  From the early 1960s through the end of the last century, the labor force participation rate increased.  See chart 1 below.  This was the result of several factors:

 

1. more women entered the labor force (one-in-three women were in the work force in 1948, but this reached 60% by the mid-1990s)

 

2. the large baby boom cohort entered their prime working years during the 1970s and 1980s

 

3. improvements in health technology increased the health and longevity of the work force; it also forced people to work longer in order to accumulate enough wealth to support lengthier retirements

 

4. there was a shift away from manual labor occupations (which tend to have shorter average career lengths)

The participation rate has dropped during this decade.  Since peaking at 67.3% in early 2000, the labor force participation rate has dropped approximately 3.3% to 64%.  This decline is twice as large as any since World War II.  The authors conclude that just under half of the drop can be traced to long-running demographic patterns.  These demographic patterns include:

 

1. the ongoing retirement of baby boomers – in 1996, the first baby boomers turned 50, an age when labor force participation traditionally peaks

 

2. there has been a long-running downward shift in teen work activity (and this picked up speed during the later half of the 2000s)

 

We’re below trend, but the trend in participation is down.  While the participation rate is below the trend (by approximately 1%), the trend is expected to continue down.  See Chart 3 below.  Note: this chart may look odd to you because the numbers are higher than you expect (since the participation rate should be near 64%).  The reason for this is that this chart just shows 16 – 79 year olds (ignoring everyone 80+; these older people have a low participation rate).

 

Why the trend is down.  If you examine the trend LFPR (labor force participation rate), it has fallen 1.2% since 2000.  This is just under half of the 2.7% drop in the 16 – 79 year old LFPR.  The 1.2% drop is the result of the changing age distribution of our population.  Two-thirds of this drop in trend comes from a 4% increase in the fraction of the population out of prime working age (25 – 54).  See chart 4 below.  The remaining one-third is due to changes in gender and educational attainment within age groups as well as changes in labor force participation behavior within groups.  Again, a lot of this final 1/3 is from the drop in teen LFPR.

 

The future and why this matters.  The authors expect the LFPR (trend) will drop another 2.7% during the next decade.  To some extent, this is positive news because it means that we will not have to create jobs to re-employ people.   Of course, this is also bad news because it is a reminder of the demographics that are going to crush our entitlement programs.

 

Have a great week.

 

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There have been several papers written recently about whether federal employees are overpaid.  Recently, the CBO published a paper on the issue, “Comparing the Compensation of Federal and Private-Sector Employees.”  (Here’s the link.)  Before I tell you the results, let me give you a little background.

 

It’s obviously difficult to compare public and private workers.  The job requirements are different, the actual work is different, the motivation of employees may be different, the actual number of hours worked may be dissimilar, etc.  As a result, we have to try to compare “apples-to-apples.”  The biggest characteristic to use is education.  So, this is what the CBO did.  Here are some background facts and then the findings.

 

Background Facts

1. There are 2.3 million full-time employees.  This does not include the military (which also employs approximately 2.3 million people).

 

2. The number of federal employees has been relatively stagnant for 30 years.  At the same time, the private sector has grown.  As a result, the percentage of the labor force working for the federal government has shrunk from 2.3% (1980) to 1.7% in 2010.

 

3. The study does not include the 800,000 workers who are employed by government enterprises that pay compensation through sale of their services (rather than tax revenue).  The largest such employer is the Postal Service.  (Of course, the Post Office runs deficits and is eventually paid by our tax revenue.)  The study also excludes the military.

 

4. Approximately 57% of the federal civilian workforce is employed by the Department of Defense, Department of Veterans Affairs or the Department of Homeland Security.

 

5. The federal government workforce is much more educated than the private sector – 51% have a bachelor’s degree (vs. 31% of the private sector).

 

6. More of the federal employees work in professional occupations (33% vs. 18% in the private sector).

 

7. Approximately 21% of federal employees are members of unions (vs. 8% of private employees).

 

8. Nearly all federal employees work in entities (mostly departments) with at least 1,000 employees.  Only 40% of private employees work for large entities.

 

9. The study tried to account for differences (required education, type of work, size of employer).  The goal was to figure out how federal compensation would change if the average cost were the same as private employees.  Obviously, the study did not factor in the natural ability or motivation of employees.

 

The Results

1. Just Wages.  Federal workers with a high school diploma (or less) make 21% more than their private sector counterpart.  Federal workers with a bachelor’s degree make approximately the same (as the private sector).  Those with a doctorate or professional degree make 23% less.  On average, federal employees receive wages that are 2% higher.  There is more dispersion in the private sector (the top people make more and the bottom people make less).

 

2. Just Benefits.  The benefits for federal workers with a high school diploma (or less) are 72% higher than the private sector.  For those with a bachelor’s degree, they are 46% higher.  For employees with a doctorate or professional degree, the benefits are approximately the same as those in the private sector.  These differences are the result of defined benefits retirement plans (as opposed to the defined contribution plans that most private sector employees have) and subsidized health insurance to qualified retirees.

 

3. Total Compensation (Wages Plus Benefits).  Total compensation for federal employees is 36% higher for those with a high school diploma (or less) when compared to the private sector.  It is 15% higher for those with a bachelor’s degree.  It is 18% less for those with a professional degree or doctorate.  For all workers, the federal employees averaged total benefits that were 16% greater than private employees.

 

Some Final Thoughts

1. Differences would have been much larger if they were not factored on education.  Educated workers make more and federal employees have much more education.  Also, federal workers are in higher-paying occupations.

 

2. The assumption that almost all federal employees work for large entities was also crucial.  Without this adjustment, the average difference in wages would have been 9%, rather than 2%.  Working for large private entities has advantages and disadvantages.  As an example, large companies frequently restructure and this results in job uncertainty.  As a general rule, federal employees have much less job uncertainty.

 

3. The real advantage of being a federal employee (from a financial perspective) results from staying with the government for a long time.  This is where you see the real difference in benefits.

 

Below, you can see the chart that summarizes the findings.

 

 

Have a great week.

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How much country debt is too much? This is an issue of relativity. In this case relativity depends on the income flows from which debt service can be paid. Whether the debt belongs to the consumer or the government, the combined burden must be serviced from a country’s income stream.

While there is some economic growth theory that addresses a sustainable stock of capital assets relative to income, there is no similar theoretical basis for indicating how much debt is too much relative to income. However, the two should be related, as they represent the two sides of the balance sheet when debt is used to finance the accumulation of capital assets. The linkage between debt and capital starts to break down when much of the existing debt was funded in order to consume rather than generate productive assets. As a result, debt for the purpose of consumption hangs more heavily on the balance sheet as it does not generate any future output or income to sustain the debt.

Lacking a theoretical answer, the question of how much debt is too much has only been answered on an empirical level. Reinhart and Rogoff address the effects of government debt and find that a debt-to-income ratio of 0.9 is the threshold for when economic growth begins to slow down. But this estimate doesn’t include consumer debt or state and local government debt, which for the U.S. is also well above accustomed levels.

This still leaves open the question of how do over-indebted countries re-establish stock-flow balance. While it takes long periods of time to accumulate debt at a faster clip than income — and its fun while it builds and generates income —the reverse occurs when the debt-to-income ratio is shrinking.

If individuals and governments seek to “do the right thing” and save in order to reduce indebtedness, progress in de-leveraging is agonizingly slow. This prescription, better known as austerity, can only be successful if the economy has other means of support from business investment growth and/or net export growth. This roughly parallels a literature entitled “expansionary austerity.” Yes, as you would guess, expansionary austerity is an oxymoron. There are precious few successfully sustained episodes of income growth in the face of austere deleveraging. For example, take a look below at how Greece is faring with austerity as a de-leveraging policy.

But if the re-establishment of stock/flow balance through expansionary austerity is not successful (and we wish Europe the best of luck), the market alternative is default. This is the swift and painful market response.  While the debtors are relieved of their debt burden all at once, the owners of the debt are similarly relieved all at once of their corresponding assets. That is to say, there is an instantaneous wealth meltdown, and all bad things follow that. We got a scary preview as we witnessed the Lehman Brothers financial meltdown in 2008 based only on mortgage debt meltdown.

Some of the defaulted debt is individually owned and hence it’s clear who has suffered a loss in that event. But the greater asset and wealth write-downs come from what most think are sacrosanct institutions, but they are not. Our private and public pensions, including Social Security (as its trust fund is 100% invested in U.S. Treasuries) will not pay out as promised. Nor will private insurance company annuities pay by contract terms. Our bank deposits and money market mutual shares will not pay 100 cents on the dollar — and don’t forget the impaired ability of endowments, charities and other trust funds to continue providing services in the face of their assets being written down. It seems safe to say that a developed country, particularly a democratically empowered government, will seek to avoid the correction to the debt-to-income imbalance, whether it is swift and painful or prolonged and agonizing. So, how do they preserve it?

Preservation of the imbalance is the road that we have embarked on. It requires that the asset/debt bubble be maintained indefinitely or until growth can be stimulated at a rate that outgrows debt accumulation. I call this the Helium Express, as it keeps the balloon floating in order to avoid the hard landing below. The intent is to keep balance sheets from imploding.

The Helium Express is occurring via super expansionary monetary policy the world over. It has become the policy of choice to keep the debt overload carrying cost affordable and hence sustainable as outlined in The Unintended Consequences of Saving the Sovereign.

Debt affordability and sustainability requires the Fed to pursue a goal of zero interest rates over the long haul in order to provide cheap and sustainable debt service that both the consumer and the government can afford.

In a very indirect way, this says that the Fed is seeking to maintain the right-hand side of the balance sheets of the big debtors, the consumers and the government. In doing so society’s balance sheet has an asset side as well and the two must balance. Hence, debt support is also generalized asset support. But how does that happen?

Well, there are many channels by which this works. Since the Fed implements the policy of affordable interest rates by purchasing Treasury debt at prices higher than market (to drive rates downward to historical lows), it also provides a capital gain to the seller of the bonds to the Fed. In turn that seller must now find a replacement asset with the proceeds of the sale to the Fed. As they look at a reinvestment in Treasuries they see yields so low that it doesn’t support conservative institutions investment income needs so another income-producing asset with higher yield must be found.

Hence conservative investors are forced into the “risk on” trade. They are seeking assets with investment income to support the income needs of the institution and must reach for greater default risk and volatility than their liking.

Another pressure to turn to the “risk on” trade exists when investors hold bonds with prices elevated higher than the redemption value by the Fed’s price support program. This provides the owner with an unrealized gain on their bond holdings and a smile on their face until they realize they are on the horns of a dilemma.

If the Fed stops inflating the value of  Treasury bond in the market, the investor’s unrealized gain may never be realized if the Helium Express comes down to earth. Furthermore, even if the Fed’s price support is there for the long run — which is longer than the bond’s redemption date — the bond settles down to be worth only 100 cents on face value  at redemption time (which is normally a big relief). In this case it is a lost opportunity not to cash in on the Fed’s subsidy.

Now the pressure builds to sell Treasury bonds to the Fed and invest in a less inflated asset.

The risk-on investments could take many forms, and the channel by which the financial purchasing power spreads out is intricate. These risk-on pressures have sent purchasing power first to income-producing assets such as bonds up the rating scale, dividend paying stocks, and preferred stocks. Now with those assets more robustly priced, new flows are beginning to be deflected to the next reaches of risk — even to real estate, and even to rental homes.

One big change from a year ago, when QE2 was underway, is that the risk-on asset is no longer emerging nation equity or a Swiss bank deposit. The countries that experienced capital inflows as a result of similar pressures to take the Fed’s subsidy and run abroad are now off-bounds for investors, as those countries have reacted to burn the speculators who caused their currency to appreciate and reduce their trade competitiveness. So, the Fed subsidy is staying in the U.S., with perhaps some Euro bond market buying as an alternative where the ECB welcomes a market vote of confidence in its currency.

Additionally, once this risk-on process is underway, even if no one sees changes in fundamentals to warrant higher prices of, say, equities, there is the unquestioned Pavlovian response known as “Don’t fight the Fed”. In this case it is “Don’t fight the Fed to the 5th power,” as all major central banks are involved in the Helium Express.

Actually, what is being called the risk-on trade is actually risk-off in the sense that the Fed is not wanting the market to correct the debt/income imbalance via default or deleveraging, so it works to preserve the Helium Express.

It’s not your textbook economic expansion with Fed buying Treasuries that pumps up commercial banks. Instead the funds are moving through the shadow banking system to reach the far corners of the risk-on trade.

This ends up causing a great deal of hand wringing by asset value fundamentalists (especially as corporate profit have been declining), by those who do not take lightly the continued prospects for a contagious sovereign default, or by those who are fearful that no good comes of excess money except inflation.

Unless one of the financial traumatic events that is facing the world occurs — and don’t forget the potential for a middle east oil shut down — the Helium Express has the power to not just lift the risky financial prices but the economy as well, though it will take some heavy lifting. The Helium Express provides cheap financing to firms able to reach the public capital markets as well as a private wealth effect. The Fed is being only a little subtle in encouraging all to enjoy the balloon ride they are sustaining.

Before I get to today’s topic, a reader sent me a link that you might enjoy.  If you go to this site, you can hit the play button and watch how employment changes over the years (by area).  I found it interesting.  Here’s the link.  Now, on to today’s blog…

Several New York Fed economists (Meta Brown, Andrew Haughwout, Donhoon Lee, Maricar Mabutas and Wilbert van der Klaauw) wrote a short blog / article, titled “Grading Student Loans.”  Here’s the link.  (At the link, you will find charts that display the numbers I’m repeating here.)  Here are some of their key findings (this is lifted almost verbatim – so it’s their work and not mine):

 

1. Student loan balances are approximately $870 billion.  This is greater than credit card debt ($693 billion) and auto loans ($730 billion).

 

2. This debt is likely to continue to rise as enrollments increase, costs increase (especially as state funding drops), employment of recent graduates is weak and incomes are stagnant.  (Other than that, it’s a great time to be in college.)

 

3. From Q2 to Q3 (2011), the total outstanding student loan balance grew 2.1%.  Over the same time period, other types of consumer debt declined or remained flat.

 

4. Of the 241 million people in the US who have a credit report with Equifax, 15.4% (37 million) have outstanding student loan debt.

 

5. Among people under thirty years old, 40.1% have student loan debt.  Among people between the ages of thirty and thirty-nine, 25.1% have outstanding student loan debt.

 

6. The result is that $580 billion of the total $870 billion in student loan debt is owed by people younger than forty.

 

7. The average outstanding student loan balance is $23,300.  The median is $12,800.  That means that a small number of people have A LOT of student debt.

 

8. About one-quarter of borrowers owe ore than $28K; about 10% owe more than $54K.  Approximately 3.1% owe more than $100K and .45% (167,000 people) owe more than $200K.

 

9. Borrowers between the ages of 30 and 39 have the highest average outstanding loan balance ($28.5K), followed by borrowers between the ages of 40 and 49 ($26K).

 

10. Of the 37 million borrowers who have outstanding student loan balances in Q3, 14.4% (5.4 million borrowers) have at least one past due student loan amount.  This adds up to $85 billion (10% of the outstanding balance).  At first glance, this rate is no different than household debt, credit cards and auto loans.

 

11. The student loan delinquency rate is understated.  The majority of loans are federally backed and repayment is deferred until graduation (and then can be pushed back another six months).  This is why only 12.6% of borrowers under 30 are delinquent compared with 16.8% between the ages of 30 and 39.

 

12. The researchers tried to eliminate individuals who (they believe) are currently exempt from making payments.  As many as 47% appear to be in deferral or forbearance periods.  (Without examining the numbers, this sounds high to me.)  This is 17.6% of borrowers who had the same balance in Q3 as Q2 and 29.1% who increased their overall student loan balance by taking on new originations or accruing interest to the balance.

 

13. Excluding those who are currently exempt from payments, 27% have past due balances (higher than the 14%).

 

14. The adjusted proportion of student loan balances that is delinquent is 21% (much higher than the 10% stated).

 

 

Have a great week.

If you enjoy this blog, please forward it to others who may be interested.

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A few quick stories to share with you…

 

Calling DC and NY McCombs’ Alumni – I’ll be doing a short presentation in DC this Wednesday night and another presentation in NY on Thursday night.  Here’s the link for the DC event and here’s the link for the NY event.

 

The REALLY Big Stat of the Day.  The balance sheet of the central banks of the US, EU (specifically the ECB), England and Japan have reached a combined $8.76 trillion.

 

So This Protected Me?  I continue to be amazed by the fact that the haircut on Greek debt is “voluntary” and has not triggered credit default swaps.  I have not spent much time researching the rules on these swaps, but all we need is intuition.  You buy a credit default swap to protect yourself against loss on debt (or to speculate that debt will lose value).  Private investors are losing approximately 70% of the face value of their debt.  To date, the International Swaps and Derivatives Association has said that a credit event has not occurred and the swaps (insurance) have not been triggered.  If I were a participant in this market, I would now have to price in the possibility that the Association will not recognize credit events.   In other words, credit default swaps on sovereign debt are worth much less.

 

A Totally Different Perspective.  Here’s a great story that you should read.  It’s called “Broken Trust in God’s Country” and was in The New York Times.  It’s about an alleged Ponzi scheme in Ohio and it’s shocking from at least two perspectives.  The first shock is that it happened in the “Plain Community” – an area of Amish and Mennonite settlements.  But, the really shocking part of this story is to learn that the victims would prefer to handle the case outside of bankruptcy court.  They want to be sure that the poorest investors are taken care of first.

 

While their request (to remove the case from federal bankruptcy court) was denied, the sentiment was best summed up by a local resident.  He said, “a hundred years from now, what will be the difference about how much money we had here?”  He continued by saying, “but a hundred years from now, there will be a difference in how we responded to this from our moral being, from a moral level – the choices we made to forgive or not to forgive.”

 

It May Be Worse Now.  Bob Schieffer wrote a short piece about Olympia Snowe’s recent announcement that she wouldn’t run again for her Senate seat (which she was supposedly going to be able to easily retain).  Schieffer said that while he doesn’t like old people saying things were better a long time ago, it’s the truth.  He said that in the late 1960s, we were suffering through tumultuous times.  Earlier in that decade, President Kennedy had been shot.  Robert Kennedy and Martin Luther King were also assassinated.  We were involved in the Vietnam War.  But, all the same, Congress was still able to compromise and pass significant legislation.  They did this despite the fact that there were conservatives and liberals.  He said that we should be scared when people like Senator Snowe get sick and tired of the situation and give up on the hope of improvement.

 

How Do You Want to Go?  I remember when I was 15 years old and I was watching the news with my parents.  They reported that Nelson Rockefeller had died.  He was 70 years old and had died with his 27-year-old “friend.”  My parents looked somewhat shocked when I said, “that’s how I want to go.”  (Of course, at 15, I would probably would been willing to die that night, if that’s how I would have punched my ticket.)

 

Anyway, lest I digress, you should really read, “Why Doctors Die Differently” by Ken Murray.  It’s a short opinion piece that was in The Wall Street Journal.  Here’s the link.  In short, he argues that doctors receive much less medical care at the end of their life.  They know the limits of medical care and the physical pain of treatment.  While they fear death as much as we all do, they may have a better idea of the easiest way to exit this life.  It’s an interesting article and serves as a good reminder that we should all prepare a living will (also referred to as an “advance directive”).  Murray says that 20% of the population has a living will, but 64% of doctors have one.

 

(Of course, you could also argue that doctors know they can’t afford the treatment…)

 

 

Have a great week.

If you enjoy this blog, please forward it to others who may be interested.

If you want to receive these emails, here’s how:

 

1. click on this link  (or type www.leedsonfinance.com into your browser)
2. toward the top right corner is a place to click on for email service — click and enter your email address
3. you will receive an email which will require you to click on a link to confirm that you want to be on the list

IMPORTANT: if you don’t receive the email in step 3 or you don’t click on the link, you won’t be on the list.  Sometimes, people who use corporate emails get blocked (it’s probably 50% of the time).  So if you don’t get the email, you know you need to use a personal email.