Highlights from an Economist lecture

I attended an alumni event on Tuesday evening at which an economist from the Chicago Fed was the speaker. I assume that as a Federal Reserve economist, he considers it his duty to promote a sense of optimism and confidence, so I took his forecasts less seriously than some of the data he used. This post is simply some of the data and commentary that I found most interesting.

• A $.01 drop in the price of gasoline at the pump adds about $1 billion in aggregate to US consumer pockets. I had heard that before. His follow on point was that normally a price change would simply be viewed as a transference between parties in the US economy, but because we import so much of our oil, the price reduction is incrementally adding dollars to the US.
• I wish he would have provided more detail, but he said their models indicated that companies have been laying people off more aggressively than the economic conditions would dictate. Or, the unemployment spike has been bigger and sooner than it maybe should have been. He seemed to think that laid the groundwork for a material improvement in the monthly job loss numbers as we move forward. (I think I agree with this)
• Comparisons to the Great Depression are not realistic. This is the worst downturn most of us have experienced so we naturally compare it to the worst that we are aware of, but he argued the differences outweigh the similarities. One key similarity that may also explain the constant comparison is that both downturns were associated with a financial crisis, unlike most intervening downturns.
• The critical difference between the Great Depression and today is that in the 1930, the government held the philosophical view that it should balance its budget like a normal household would. As such, the response to the severe downturn was to raise taxes and cut government spending which simply compounded the downturn. (Even liberal Obama seems to understand that raising taxes right now is a bad idea and no one will accuse the current government of reducing spending)
• Speaking of other downturns, the inventory cycle has often been associated with milder downturns. He presented some data that although light auto sales have plunged, production has plunged with it an that auto inventories are not really in very bad shape. (As I think about this, the better synchronization of production and consumption may also explain why layoffs have been earlier and more aggressive than in prior cycles)
• In 1980, about 75% of cars sold in the US were made by the Big Three; the rest were imported. Today, the Big Three only account for about 45% of domestic production, but total domestic production is still around 75% because many "foreign nameplate" cars are built in the US.
• Foreclosures - The national average foreclosure rate in 2008 was 1.8%. New Jersey has the tenth highest foreclosure rate at 1.8%. So 40 of 50 states have average or below average foreclosure rates. The top ten highest states represent 40% of the population and foreclosures have been highly concentrated in four states (NV, FL, AZ, CA).
• New Housing supply - Roughly 1.4-1.6 million new households are formed every year which we can think of as the natural new demand for housing units. In response the the glut of inventory, housing starts have fallen to a rate of about 500k per year which is a record low since WWII. He estimated that about 300k homes are simply replacement stock for homes that either burn down or are torn down, so we are only adding about 200k net new housing units right now. (My view: this is clearly a critical component for finding a new base for housing prices)
• Housing affordability is at its highest level since 1990. The combination of low rates and lower prices has pushed this index up dramatically. (I think this index is valuable, but has to be used carefully. It doesn't capture the "artificial affordability" that was offered via exotic mortgages and loose underwriting during the boom, so beware of the caveats)
• He found it very interesting that both the deflation camp and the inflation camp seem equally worried and vocal about the dangers ahead. Usually one side or the other dominates the collective worry.

Finally, I'll include the Feds forecasts but take it all with a grain of salt and consider their motivations.

GDP Q1 2009 -4.8%, Q2 2009 -1.5%, Q3 2009 .9%, Q4 2009 2%, Q1 2010 2.3%, Q2 2010 2.9%, Q3 2010 3.1%, Q4 2010 3.1%.

Peak unemployment of 8.8%.

GFI Group Reports tough quarter

GFIG reported non-GAAP EPS of $.09 for the fourth quarter of 2008, versus analyst expectations of $.13. While the poor showing does not impact my reasons for owning the stock, I was hoping for a more resilient quarter despite the terrible environment. Brokerage revenue declined 19% from a year ago and can be broken out by segment: +3% in equities, -21% in credit, -37% in financial, and -30% in commodities. In constant currencies brokerage revenue was actually up $5 million, but FX was a very big drag this quarter.

Margins were under pressure as revenue declined meaningfully. Compensation was only down 9% in the face of the 19% decline in brokerage revenue. This was disappointing because I thought this line item would show more variability with revenue. The only hints from the earnings call were that they continue to amortized sign-on bonuses from the rebuild of their NYC credit desk and there has been a 10% mix shift away from electronic platforms (in Europe) which would effectively increase the pay-out ratio. I am inclined to agree with management that the mix shift is a product of the extreme volatility and disruption, not a longer term phenomenon. Non-comp expenses were down 3%. These expenses are harder to adjust, especially short-term, so I am less concerned here.

GFIG increased cash on their balance sheet by $100 million and announced their normal cash dividend for shareholders of record on March 17th.

In addition to the color on FX, the most significant part of the earnings call was their outlook for 2009. Micky Gooch described what he considers to be a "worst case" scenario - although I think he was using this term loosely - as $700 million in revenue at a 7-9% pretax margin. If you play that through you get about $.30 of EPS for a stock now trading at about $3 per share.

I still believe in this story. While I was hoping for a better quarter, they made money in a horrendous environment, have a solid balance sheet without the credit risk of most financials, and I think they are very well positioned to benefit from the normalization I expect in the credit markets. As I write this, I see my limit order just filled as I bought a few more shares at $2.94.

One last tidbit from the call. Mickey was asked if they would be expanding their client base given the weakness of the dealer community. I asked him the same question in September of 2008 and he didn't think so because he didn't want to risk antagonizing the dealers. Today, he said "Yes". No details, but I have thought they should do this for awhile now and it looks like management thinks so too now.

Two Big Speeches

Yesterday, President Obama laid out his housing plan in more detail and Fed Chairman Bernanke gave a speech and answered questions at a Press Club luncheon. Both speeches were significant.

First; Housing. I read through the factsheet on the Treasuries website as well and I think the plan has promise. From what I can tell there are two prongs. The government will use Fannie Mae and Freddie Mac (which they already control through conservatorship) to allow a wave of refinancing into lower monthly payments. They will get rid of the provision that these agencies can only guarantee a mortgage with at least 20% equity. Scrapping that provision will allow the agencies to refinance an estimated 4-5 million mortgages that were ineligible given the decline in home prices. This should prevent some homes from being foreclosed on, and it is likely to reduce monthly mortgage payments by a couple hundred dollars in many cases. Notably, speculators (who don't live in the home) and jumbo loans (referred to as "millionaire loans" in the Treasury factsheet) will not be eligible.

The second prong is a partnership with the banking industry to modify mortgage terms before a borrower goes into default. The government will lay-out a standardized set of criteria that banks must use if they want to participate in the TARP program. It sounded to me like this was really targeted at the subprime mortgage market since those loans were largely originated away from Fannie and Freddie, but it has the potential to impact the Alt-A mortgage market as well. This prong is estimated to impact another 3-4 million mortgages. You can read the specifics on the Treasuries website, but in summary the government will share the cost of lowering the interest rate on loans to bring them down to 31% of gross income. http://www.treas.gov/news/index2.html

Key point: We are all focused on whether this can stabilize housing prices, but I think the benefit to consumers' monthly cash flow is equally significant here. My rule of thumb is that a 1% reduction in the mortgage rate will reduce the monthly payment by 11%. The government is effectively lowering America's aggregate mortgage payment every month by allowing Fannie and Freddie to refinance loans they normally wouldn't and strong-arming the banking industry to do the same. The government will inject an additional $200 billion into preferred stock at the agencies to help absorb the potential losses and allow them to increase the size of their respective portfolios by another $50 billion, to $900 billion each.

Bernanke also spoke yesterday and addressed the issues of credit risk on the Fed's balance sheet and the question of whether the increase in the monetary base will necessarily lead to future inflation. I thought these comments were very timely and I was surprised the market didn't react more favorably.

As a quick background, the Federal Reserve has more than doubled the size of it's balance sheet to over $2 trillion dollars in the last year by adding a wide variety of new lending programs and asset guarantees. Bernanke pointed out that in addition to holding more collateral than they lend, they also have recourse to the institutions that borrow. So if the borrower can't repay the loan, the Fed has collateral and will have a claim against the institution as well if the collateral is not enough to cover the loan. The dollar swaps they have engaged in are with other central banks and here again, they received an equivalent amount of foreign currency at the time of the swap, so these are not uncollaterallized. Bernanke allowed that the transactions with AIG and Bear Stearns are riskier but they only represent 5% of the Fed's balance sheet and they felt the cost of allowing failures would have been higher.

The concern has been that the collateral the Fed accepts is much lower quality that they would normally have accepted. This is true of course and was deliberate as an attempt to help banks get short-term funding in a broken credit market. Bernanke's point is that if collectively we can save the banking sector, then the Fed will eventually be repaid even if the collateral has dropped in value because the claim. At the end of the day, if you think disaster and collapse are coming, then Bernanke's comments do not ease your concerns.

On the money supply: I know this is a topic of concern because I have heard the question come up many times over the last six months. Investors seem to understand that the Fed needs to increase the monetary base right now to offset the decline in leverage across the financial system, but will they be able to reduce it when the time comes or are we locked into a future of high inflation?

Bernanke had a few interesting things to say. The vast majority of Fed lending has a short maturity, so once the credit markets normalize they can simply let the loans run-off. He also said, and I thought this was especially helpful, that the terms of the loans are specifically written to be attractive now in a time of crisis, but unattractive in a normal credit environment. Or put another way, once things normalize, the banks themselves will not want to roll the loans because they will be able to get funding from the credit market at more favorable terms. And finally, he pointed out that several of the programs were instituted under 13(3) which requires that conditions in financial markets are "unusual and exigent". By law, these programs will have to be fazed out when the financial markets are functioning normally. I realize that these terms are subjective, but the point is that some of these programs are designed to be temporary and Congress could force them to be discontinued at some point.

For anyone wanting a great synopsis of what the Fed is doing, I highly recommend that you read the transcript to Bernanke's speech. http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm

One other great reminder from Bernanke's speech. The press has been fixated on whether the banks have been lending more or less since they received capital infusions, but Bernanke pointed out that the real reduction in lending has happened as a result of the securitization markets shutting down. The banks are effectively treading water trying to stay alive, but the securitization market has virtually dried up and it was a very large source of consumer lending. So while the press has distracted most of us (myself included), the Fed has been working hard on the TALF program to stimulate renewed securitization of consumer loans.

To beat a dead horse, make sure you think about all of this together: the Fed's aggressive actions to keep the system functioning, the Treasury recapitalizing the banking system and trying to remove the overhang of bad assets, and the Congress trying to stimulate the economy with tax breaks and job creation.

The Sky is not Falling

I watched Geithner's speech a couple days ago and had a very similar reaction to the market. Namely, I still can't believe how little detail was provided. As a quick aside, it reminded me of Lehman Brothers before they declared bankruptcy. Dick Fuld announced a conference call in which he would lay out their plan for getting through the crisis. Almost the entire investment community dialed in. Mr. Fuld proceeded to tell us about the steps they were thinking about taking. The market was shocked. They expected to hear something concrete and got a roadmap. It was uncomfortable watching the Geithner speech because I had the same sensation as during the Lehman call. As much as most investors cringe at all the government intervention, they generally want to believe that the government can successfully reverse the downward economic spiral. Most of us also think the government is terribly inefficient and so slow that most of their stimulus will kick in once the economy is already recovering. Sadly, Geithner did nothing to counter that belief.

Despite my own frustration with government intervention and the ugly political posturing, here is my argument for why I am optimistic that the government plan is finally on the right track and will prevent a doomsday outcome.

In a nutshell, we are finally attacking all the key problems. We are recapitalizing the banks AND trying to remove the overhang from bad assets AND trying to stop home price depreciation AND trying to slow consumer deleveraging AND trying to create jobs. It is easy to criticize the government in retrospect for not tackling all these issues from day one, but realistically, the cost of doing so is enormous and is only worth the risk now that we know how bad things are. Would you really have wanted your government committing trillions of dollars to a problem that might develop?

Banks: I understand that mainstreet hates the idea of bailing out the same institutions that contributed to the current mess, but I think it is silly to single out one group when so many are guilty (Banks, non-bank originators, Wall-street securitization engines, rating agencies, greedy borrowers, stupid investors, regulators, polititians, basically everyone) Even if you are still fixated on the banks, you have to come to terms with the reality that a modern economy requires an operating financial system that converts savings into credit. That means we need a functioning and healthy banking system and capital market.

I remember having a somewhat heated debate with a colleague when the TARP was first announced. My argument at the time was that we needed to help remove the overhang of the bad real-estate assets because banks need to know they are well capitalized before they can really start lending again. If we simply infused equity, the banks would still not know if they would be well-capitalized next quarter because the assets continued to deteriorate, so they wouldn't lend. My argument was that the government could help fix the bad asset problem, which would allow the banks to know how big the final losses were, which would quantify how much additional capital they needed to raise from the private sector. Ironically, Paulson reversed course and infused equity without solving the bad asset problem. The key point remains the same; the banking system needs to be recapitalized AND have the bad asset overhang removed. I would prefer that the the private sector provide the capital, but at least both issues are being addressed.

I don't know enough about the private/public bad bank proposal yet to have a guess about whether it will work, but that is not the only possible solution. The governement could guarantee assets after a first loss peice as they have already done with a few specific banks. The key is to stop separating the asset question from the equity question and recognize that they are intertwined.

Housing and Deleveraging: Geithner and Congress are also focused on stabilizing the housing market. Every foreclosure puts another home on the market (increasing supply and pushing prices down) and generates another loss for a bank or MBS investor. Every time housing prices go down, another stretched mortgage borrower owes more than they could sell for, which makes it almost impossible to refinance or sell. Addressing foreclosures attacks the supply side of the housing market. The government is also trying to generate new purchases on the demand side of the equation. I've said this before, but I think the government is essentially trying to artificially loosen mortgage underwriting standards to prevent a quick consumer deleveraging. We all know that consumers are making less money and spending less money. Part of the money we spend is from income and part is from borrowing. The fact that getting a mortgage is so difficult is in and of itself hurting spending and pushing up the "savings rate". We need households to be able to take out new mortgages (especially first time buyers) in order to slow the pace of aggregate deleveraging.

Jobs: And finally, the government stimulus package is designed to create jobs, which give households money to spend, which is good for business, which allows them to hire more people... This one is pretty obvious in my mind so I won't spend more time on it.

Fly in the ointment: One of the most common concerns I hear is that the government will be dramatically increasing its debt level; which seems manageable now given the rush to safety and the resulting ultra-low treasury rates. What if treasury investors get spooked and push rates up? For what it is worth, I am worried about this too but am struggling to think through all the dynamics and offsets. This line of thought very quickly becomes geo-political (will China keep buying treasuries etc.) in addition to financial and economic. I think what is missing from this debate is the likelihood that total US debt (including business and consumer debt) will continue to decline while government debt specifically goes up. In order to be really worried about this, I think you have to assume that demand for debt instruments will fall, in aggregate, faster than the supply of debt. If I want some of my money in a fixed income investment, I can choose between a government bond, a corporate bond, a consumer loan-based bond or other asset-backed instruments. Corporations and consumers have recently seen the damage that can come from too much leverage, so I find it hard to believe that those categories will be growing for several years. Unfortunately, I also think demand for debt instruments will decline in aggregate as risk appetites are re-discovered. I think predicting the relative magnitude of these trends is almost impossible, but I think it is a risk. Do I think Treasury yeilds are artificially low and are likely to go higher? Yes. Do think that they will go up so much that it forces a default or currency devaluation? Probably not, but this question is too hard for me right now.

Conclusion: Despite the lousy speech, Congress is set to pass the stimulus bill and the Treasury and Federal Reserve are focused on the right things. As an investor, my thesis is that we avert doomsday and start gradually pulling out of this recession.

Maybe China should control US banks...

I keep hearing people say things like, "if the government is giving the banks money then the government should be able to tell them what to do", and "this is taxpayer money going to bail out the banks so..." fill in the blank. Skipping to my conclusion, I do not think the government should be telling a business whether they can buy a corporate jet, or how much they are allowed to pay their people. Those are decision for the majority of common shareholders.

Two points.

First, the government has invested in preferred shares of these banks. The government is not a common share holder. If I invest a minority stake in the preferred shares of a company, I do not get to tell the CEO how to run his company. If the company goes into bankruptcy, then I have preference over the common shareholder as it relates to the bankruptcy outcome and a share of whatever is left. If the company is not in bankruptcy, then the common shareholders own the business and I just get my dividend. The government does not have a right to control these banks simply because it has become a preferred investor. If they want to exert control, they should exercise their warrants for common stock. If that gives them a majority then they are in control; if not they need to convince some other big shareholders to go along with their proposals or buy up enough additional shares to become the majority shareholder. If an incremental investor wants to exert control, they can tell the company that their capital infusion is contingent on specific actions. For example, if a company desperately needs capital and only one investor will step up, that investor might say "I will invest the $100 million you need as soon as you fire the current CEO because I don't think he is any good." But if that same investor put in the money a year ago, they cannot wake up one day and have the CEO fired. My bank does not have the right to force me to fix my roof unless I default on my mortgage.

Second, and I'm being facetious and playing out the logic I keep hearing, if the incremental investor in a US bank gets to control the bank, then the incremental investor that allows the US government to invest in the bank should control the US government. Guess what, the government already spent taxpayer money. The incremental spending they are making will be funded by borrowing. Since China is one of the biggest investors in US treasuries, maybe we should make the argument that they should get to control the entity they are invested in.

So returning to reality, I do not think China should get to tell the US government what to do simply because they have chosen to invest in Treasury bonds, and I do not think the US government should get to tell business what to do simply because they have chosen to invest in some preferred stock with un-exercised warrants.

The motivation for investing in the preferred stock should not be to allow government to take over business, it should be because the banking system needed to be recapitalized and the capital markets were in complete disarray. If the government wants to step in to a crisis and try to prevent a failure of the financial system, then the government is trying to fulfill its role of protecting and serving its citizens. It can end there. The government does not need get an acceptable return on its investment or gain incremental control of private enterprise.