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Housing Woes

May 15th, 2009 No comments

Okay, so we all know that the bursting of the housing bubble is one of the main catalysts of the current recession. Lenders got sloppy with their lending standards in an effort to make a quick buck on fees, home prices were bid up supporting lax lending standards (if the collateral to the loan – the home – appreciates really quickly, then a borrower with very little-to-no equity will all of a sudden have ample equity to support the loan), and people were leveraging themselves more and more by taking out loans against the equity they had in their homes. What no one saw coming was the fact that though borrowers may rapidly develop equity from home appreciation, if their incomes can’t support the low interest, adjustable rate mortgages when the rates go up, there will be mass defaulting, as we see today (and have seen for about two years now).

So, the metaphorical earthquake has already happened and we’re still watching the dust settle. The government is also trying to kick start the rebuilding, by kick starting the housing market. Home prices are down over 25% nationally from their high in fourth quarter of 2006 (see here for supporting stats). A lot of people have lost money in their homes as well as other investments (the S&P 500 is down about 45% from its high in October, 2007), and many others have lost their jobs. There is a glut of homes on the market, and no one wants to buy them for either: 1) not having the money or financial stability to support buying a home and paying a mortgage, or 2) persistent uncertainty about whether home prices have bottomed yet or not – after all, who wants to buy an asset that may still drop in value?

So, what does the government do to incentivize people to buy homes and try to turn this mammoth economy around? Well, first we drop the interest rate on mortgages to make home buying cheaper (it’s ironic how one of the main causes of the housing bubble itself was the availability of cheap credit and record low interest rates for too long a period, and that same thing is now the solution), and second we give people money (via the $8,000 tax creditfor first time home buyers) to make their decision to buy a home cheaper. Of these two solutions, I find the first - the artificial lowering of interest rates – to be the most worrisome. Though I understand that the government is trying to make borrowing cheaper so more people buy homes, I think it’ll have an unwanted side effect. Interest rates are at record lows now. Let’s suppose that Americans take advantage of this and buy homes (as the government hopes). This causes home sales to increase now, and for the economy to appear to be turning around. All is well and everyone is happy. Now, fast forward 10 years or so. Given that rates are at historical lows, they only have one direction to go from here – up. (Some argue that given all the financial stimulus the government has engaged in recently, they’ll have to inflate away some of the debt, causing rates to rise even faster than they otherwise would). So, ten years from now when the average American family goes to buy a new home, they’ll be faced with an unpleasant surprise: the rise in mortgage rates will be very prohibitive to buying a new home. Suppose they pay $100/month for their mortgage. Borrowing the same amount of money with higher rates will cause them to pay much more than $100/month. Couple that with their likely desire to move into a larger, more expensive home, and the whole proposition becomes very scary. Thus I would expect future home sales to fall relative to where they would have been had there not been such a large difference between the natural interest rate then and the artificially low rate now.

So, my conclusion  is that we may stimulate home purchases now by lowering rates to record lows, but this comes at the expense of housing sales in the future. So all we’re really doing is pushing the problem from now, into the future. Though that may be welcome for many right now, as investment portfolios are in tatters and many are unemployed, I would argue that if I have to suffer, let me do it now while I’m already suffering, not later after I’ve gotten over the bad times and am looking forward to enjoying prosperity. I can’t help but wonder if it wouldn’t make sense to just let interest rates float to their natural level right now and just give the economy time to work its way thorough the excess inventory of homes. Yes, this process will take longer than the lowering of interest rates approach, but at least we won’t have to deal with much more expensive homes in the future. Besides, I can’t help but feel that a lot of the economic issues we face now are the result of our band-aiding things so we don’t have to “face the music”. Maybe it’s finally time to live within our means, buy as much home as we can afford (which may be much less than what we may want), and build a strong financial and economic foundation for our children. Of course, that won’t get me votes with the public if I were running for any kind of office…

Categories: Economics Tags: , ,

Mark-to-market: not such a simple choice

February 9th, 2009 2 comments

Lloyd Blankfein, CEO of Goldman Sachs, wrote an op-ed article in today’s Financial Timesabout seven lessons from this crisis. Amongst his lessons, Mr. Blankfein addresses fair value accounting (a.k.a. mark-to-market accounting). I think his assertions are valid, but it’s important to consider the whole picture – which is often not as simple as an op-ed piece may suggest. I have included the text of the entire article at the bottom of the post if you’re interested in reading it (which I recommend).

Fair value accounting (a.k.a. mark-to-market accounting) says that all assets should be market to their market values (as opposed to acquisition cost, or other methods) on the firms financial statements. The objective here is to make the statements more transparent, and better reflective of the true firm value. For example, consider your personal balance sheet. You have some assets and some liabilities. Amongst those assets may be a home you own, and amongst those liabilities is likely the mortgage. For simplicity’s sake, let’s assume that the home is your only asset and the mortgage your only liability, and the difference between the two is your equity. Note, means that the fundamental accounting equation (assets = liabilities + equity) is satisfied. Now, let’s assume you bought your home for $100K, and took out a mortgage of $80K. A few years later, housing prices fall, and your home is now only worth $60K. Finally, let’s suppose you’re getting married, and your spouse-to-be, like any good investor, is trying to accurately value the asset (you) before buying (saying “yes”). (No, all us finance folks don’t see everything in life through such an economic lens – hopefully the example made you smile though!)

If you were using acquisition cost accounting, the value of the asset on your balance sheet would be $100K, the liability (mortgage) would be $80K (to keep the math simple, I’m assuming you haven’t paid down any of the mortgage yet), and your equity (the net value your spouse-to-be would be getting) would be $20K. You are sufficiently capitalized and all is well. If however you are using mark-to-market accounting, the value of your asset (the home) must be marked down to its market value, and so is set at $60K. Your mortgage hasn’t changed and so your liabilities are still $80K. So, in order for the accounting equation (which, like gravity, is a law you can’t mess with) to be satisfied, your equity must be -$20K. Wow! You’re undercapitalized and your spouse-to-be will likely say no so as to not absorb the $20K hit to her own equity. In fact, you’re effectively insolvent – your liabilities are greater than your assets and you should consider bankruptcy. As Mr. Blankfein points out, and as you can clearly see, the value of fair value accounting is that it shows the actual market value of your firm, not some other number that may not mean much anymore.

So, to understand what this means in terms of lessons learned from the financial crisis and risk management. Mr. Blankfein is saying that if all firms mark their assets to market value every day, then we have a true picture of what the firm’s value is, and we can better understand how fast we are creating or destroying economic value (i.e. if you see the damage certain positions are doing to your portfolio every day, you’re more likely to respond to it by taking defensive measures than if you only look at where you stand one a month). This in turn should lead to better risk management. Sounds good, right? So maybe Mr. Blankfein is right – we all switch to mark-to-market accounting and everything is clear.

Not exactly. There are some issues that make mark-to-market accounting not such a simple choice. Keep in mind, I’m not arguing against it (I don’t personally have a view on it), but I would like to shed some light on why others may argue against it and what challenges it faces.

Firstly, there’s the question of liquidity. In the example I gave earlier, I said the house had depreciated to $60K. But how do we know/assess that? Your house is not like a stock that’s traded on the market every day and a price is well understood. In fact, homes are very illiquid - their price is not well established and they can’t be sold quickly. Who’s to say the value of the house isn’t really $80K or $40K? Similarly when credit froze up in the market late last year many investors refused to buy anything. This lack of liquidity makes it hard to sell, and when assets can’t be sold easily, their prices fall (the basic idea here is that I try to sell something at $100, if no one buys, I go to $95, and so on. I keep dropping until someone buys). This type of price reaction is temporary. Once investors regain some market confidence, they are likely to come in an buy again, driving up asset prices. So, does it make sense in the mean time to value the firm at a temporarily low amount, even if there’s a good chance it’ll rebound in the near future?

Secondly, mark-to-market may not be relevant for assets held to maturity or other generally long term assets. Again, going back to the house example. Suppose the market value is indeed $60K. But if you don’t plan on selling the house for another 25 years (by when the housing market will likely recover), then does it make sense to mark you insolvent today? Does your spouse-to-be care if she knows that you’ll both live in the house a long time and when you do sell you’ll be solvent? Similarly, in mark-to-market accounting, firms would have to mark their assets to lower prices due to the current crisis. But, if their assets are well-rated bonds that they continue to receive interest on, does it make sense? Suppose the firm holds IBM bonds – IBM will continue to pay interest for the remaining 30 years on the bond, and at the end of the period, they’ll likely pay the amount they borrowed back. So then does it make sense to say the bond holder is in a loss position?

Finally, if we use mark-to-market accounting and we mark down the asset prices, and thus the equity of the firms, we create a self-fulfilling prophecy. If we note the firm as “in trouble” by saying the firm has lost a lot of money, or has become insolvent, then creditors of the firm, its customers, and other business partners will likely stop doing business with the firm because it’s “in trouble”. Furthermore the firm’s stock price may also drop, actually reducing the value of its equity (as opposed to any temporary reductions due to fair value accounting). Thus we have taken a firm that may have otherwise been okay if the crisis were given time to play out, and caused them to fail as a result of customers and creditors fleeing, and its stock tanking.

So, is it true that mark-to-market accounting depicts the fair value of the firm and can be used to better manage risk? Sometimes is the answer. Yes, seeing how fast your positions are shrinking on a daily basis does allow you to react faster from a risk management perspective. However, it’s important to understand which assets are being marked down, and what the characteristics of those assets are (duration, likelihood of recovery, etc). There’s not much value added by deflating asset prices and creating a panic even though the assets would like have recovered. In fact, this can have grave consequences because the mark-to-market can sometimes kill off the firm before the assets are given a chance to recover.

 

Do not destroy the essential catalyst of risk
By Lloyd Blankfein
Published: February 8, 2009, Financial Times

Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy.

Much of the past year has been deeply humbling for our industry. People are understandably angry and our industry has to account for its role in what has transpired.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system but we failed to raise enough questions about whether some of the trends and practices that had become commonplace really served the public’s long-term interests.

As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, I believe it is useful to reflect on some of the lessons from this crisis.

The first is that risk management should not be entirely predicated on historical data. In the past several months, we have heard the phrase “multiple standard deviation events” more than a few times. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it does not take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Second, too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.

This over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A. It is easy and appropriate to blame the rating agencies for lapses in their credit judgments. But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.

Third, size matters. For example, whether you owned $5bn or $50bn of (supposedly) low-risk super senior debt in a CDO, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.

Fourth, many risk models incorrectly assumed that positions could be fully hedged. After the collapse Long-Term Capital Management and the crisis in emerging markets in 1998, new products such as various basket indices and credit default swaps were created to help offset a number of risks. However, we did not, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fifth, risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.

Sixth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.

As a result of these lessons and others that will emerge from this financial crisis, we should consider important principles for our industry, for policymakers and for regulators. For the industry, we cannot let our ability to innovate exceed our capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report to is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts on the trading desks: if there is a question about the value of a position or a disagreement about a risk limit, the risk manager’s view should always prevail.

Understandably, compensation continues to generate a lot of anger and controversy. We recognise that having troubled asset relief programme money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a profit.

More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.

After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.

We collectively have a lot to do to regain the public’s trust and help mend our financial system to restore stability and vitality. Goldman Sachs is committed to doing so.

Auto Worker Compensation

December 15th, 2008 No comments

I came across this New York Times article, shedding some more light on the highly controversial $70+/hour ($150,000+ per year) that auto workers allegedly make.

The essence of the article is that the $70+/hour figure that has been the focus of much attention is not entirely correct – it’s actually lower than that. However, it’s still much higher than Japanese auto makers like Honda, Toyota, and Nissan. The average hourly cost of a Big Three unionized worker is $73. The chart below breaks it down for Ford (whose cost is $71/hour).

Auto Worker Compensation Break Down

Auto Worker Compensation Break Down

 The cash paid to a worker (i.e. the salary your paycheck reflects) is about $40/hour, and benefits (health insurance and pensions) add another $15/hour, bringing this component of compensation to $55/hour. This is about twice what the average American makes, which should serve as a key counter-point to Mr. Stein’s comments:

They are our brothers and sisters. They fight our wars. They maintain our middle class lives. Maybe they get paid a lot, but they have been giving back for years. When will it ever be enough?

The NYT article notes that the salary plus benefits cost at Japanese auto makers is about $45/hour, with the $10/hour difference coming mostly from the benefits, not the cash compensation.

The remaining $15/hour of the about $70/hour for Big Three employees comes from benefits for retirees. These are costs that must be paid since they were promised, and are independent of the number of cars sold. So, in economic times like these, the revenue from car sales falls sharply, but the costs don’t since they’re fixed – now you see one dimension of the auto industry’s issues. The article goes on to say that this cost is a function of both the generours benefits and the number of retirees – suggesting that as Honda and Toyota mature to where the Big Three are on the American manufacturing scene, they too will have many retirees and similar costs. Of course, there are a few key differences – the benefits at the Japanese makers aren’t as high, and I doubt they’ve hired as many people due to improvements in automation as well as leaner product lines (they’re not making as many varietys as GM, thus likely employing fewer people). Yes, retiree costs at Japanese costs will go up in the future, but I’d be surprised if it was anything like what we’re seeing at the Big Three today.

The NYT article makes a very important point: Even if we took away the $10 of the $15 for retiree benefits and trimmed down the cash compensation to $45, to match the Japanese auto manufacturers, we’d save the Big Three $800/vehicle. The article also mentions that the Big Three typically sell their cars for about $2,500 less than the equivalent cars from Japanese manufacturers, suggesting that the cost saving won’t fix the problem. The issue – that Americans just don’t want to buy American cars.

Quality and efficiency problems have plagued American cars for years. The Big Three claim they have learned their lesson, yet their sales numbers beg to differ. For the 25 years or so that Japanese cars have been selling here, they continue to gain market share.

There is no doubt that improving the cost structure for the auto makers will help - in a situation like this, every penny helps. But it alone will not be sufficient to solve Detroit’s problems. The Big Three have to completely reorganize their operations. And it seems to me that the best way to do that is some kind of organized bankruptcy (where they re-emerge as much smaller, more efficient operations), or some kind of organized sale to the Japanese brands (with obvious conditions around keeping American jobs and manufacturing).

Categories: Economics Tags: ,

Mr. Stein on the Auto Bailout

December 15th, 2008 No comments

I recently read a piece from Ben Stein titled “Bail Out Detroit – Now“. I’m not a regular follower of Mr. Stein, nor do I have an opinion on his writing – I just happened to see this on the Internet. However, I must say, this was utter garbage! I haven’t seen total crap like this in a while. Below are Mr. Stein’s comments, along with my thoughts:

First, we are on thin ice economically. To allow our largest heavy industrial component to fail at this delicate moment is suicidal. To put a couple of million more Americans into unemployment is just not sensible. Mr. Barack Obama is talking about public works projects to employ hundreds of thousands of Americans -bridge building, school building, airport building. These projects take time to start, disrupt local community life, and are famously wasteful.

Why not be smart about it and NOT LET AMERICANS GET UNEMPLOYED IN THE FIRST PLACE? (Please pardon the shouting.) There are millions of Americans already hard at work making great American made cars and trucks. Why not keep them on the job? Wouldn’t that be smarter than allowing the whole upper Midwest to fall into oblivion and then rescue it over a fifty year period?

Yes, I agree that these are trying economics times, and, in an ideal world, we would only have issues like the auto industry failing when everything else is hunky-dory (heck, in an ideal world, we wouldn’t have issues at all, but you get my point). However, we don’t live in an ideal world, we live in reality, where more than one problem can, and most certainly will, arise at a single point in time. These problems have to be dealt with – it is not acceptable to simply say “we have other problems right now, so let’s just throw money at this problem to make it go away for now”. Furthermore, I don’t see anything wrong with Mr. Obama’s plan to put Americans to work in public works projects. To be clear, I believe Mr. Obama is suggesting this plan to combat the rising unemployment in the U.S. (independent of the auto industry issues) and to create domestic economic growth (though the sustainability of this growth is another question altogether), not as an answer to what several thousand auto workers will do if the industry goes under. Thus, I think Mr. Stein’s assertion about not letting Americans get unemployed in the first place is unfounded. Finally, I disagree that millions of Americans are already hard at work making great cars. If these cars were so great, more Americans would be buying them and we wouldn’t be in this predicament. The problem is that these cars aren’t so great and haven’t kept up with the quality and efficiency improvements in the industry – thus leading to the companies current problems. I see no value in burning tax payer money so we can keep building these sub-par vehicles.

Somehow, we can give bailouts to investment banks where the top dogs make hundreds of millions a year for running the company into the ditch and wrecking the whole credit picture in America. Somehow we can have bailouts for Fannie Mae and Freddie Mac, whose bosses were trading on the credit of the taxpayers to make themselves rich while pumping up a serious housing bubble.

Amazingly, we can have whole fleets of C-130′s fly to remote areas of Iraq and Afghanistan with pallets of hundred dollar bills piled from floor to ceiling. Then we can pass them out to warlords who make tea for our soldiers one hour and blow their guts out the next. We can send CIA operatives into Somalia and give millions, maybe hundreds of millions, to warlords to fight other killers.

But we cannot find it in our hearts to save our fellow Americans in Ohio and Michigan and Indiana who make the cars and trucks that about half of us buy?

Okay, this is just plain old silly. I would hope that someone writing on economics would understand the difference between the bailout of the auto industry and the bailout of the financial services industry, and the underlying reasons behind each. The crisis in the financial services industry and the need for a bailout there is to address short-term liquidity issues. Yes, the real estate bubble burst and that created problems. But most of the carnage we’re seeing now is not directly caused by the actual decrease in real estate asset values, it’s caused by good old fear – the rising of the hairs on the back of your neck as you think about your portfolio value and risk exposure. Investors are scared, much like my toddler daughter when confronted by a new insect – she’s never seen it before, doesn’t understand it, and just wants to hide in a corner of safety until it goes away. The corner of safety for investors is cash, and they’re staying in it until there are clear signs that the insect known as the current crisis goes away. Until then, there’s no liquidity in the market, things don’t trade, and so asset prices fall. After this short-term fear has passed, investors will come out of the cash corner to play again, and we’ll see much more liquidity and an improvement in prices. So, in the meantime, the Fed is providing liquidity (think of it as your mom trying to catch the insect and throw it outside). When things return to normal and asset prices come back to a rational level, the Fed will get its money back.

The auto bailout is quite different. Here we have companies that have been run poorly with very bad cost structures. The impact of foreign cars on the industry has been known for about 25 years now, yet American auto manufacturers have failed to respond. Their labor costs are too high, innovation and sales too low, and understanding of the consumer virtually missing. Throwing money at them will not result in them having an epiphany and completely changing their operations overnight. Given that a bailout would reduce the risk (and thus pressure on mangment) of an imminent failure, the companies are very likely to continue operating as normal – meaning they’ll burn through the bailout money and likely face bankruptcy in the near future. The difference between the two bailouts is that one is akin to an investment, and the other is plain old foolishness.

By the way, I do completely agree with Mr. Stein’s thoughts on the billions we’re spending in Iraq while neglecting our country. But that’s a different topic…

And please don’t tell me how GM and Ford and Chrysler have made bad cars that people don’t want. I drive only American cars, only GM cars actually, and they are the best, coolest cars I have ever driven: my 1962 Red Corvette, my mighty Cadillacs whose potent engines and super brakes have saved my life many times on the freeway.

Sorry Mr. Stein – too late. Please see a few paragraphs above. By the way, I wish most Americans felt the same way about American cars, but they clearly don’t – hence the problem.

Why are we so angry at the unions? They negotiated their deals in good faith. It’s not their fault that roller coaster gasoline prices messed up their world.

Wait, let me get this straight – you’re saying that it’s not fair that an increase in fuel prices shed light on this inefficiently run industry and absurd compensation practices, and ultimately may cause unions to lose the ridiculously sweet deals they negotiated with poor management who should’ve known better? Wow.

Yes, they did negotiate a deal with management. That deal is between them and management. If management can turn these companies around and deliver on the deal, good for both parties. However, they did not negotiate a deal with the taxpayers, so why should the taxpayers get involved to deliver on the unfairly sweet deal?! What about the other hard-working Americans in this country? They don’t have nice fat pension plans and benefit plans – is it fair to them that tax revenue benefits the auto workers?

The bottom line is that these business were run inefficiently – the cost structure was too expensive, the products weren’t what consumers were looking for, and management was too slow to adapt to a changing industry. Just like any other company, its employees, and any deals these employees may have had with the company – the firm has to turn itself around, or become extinct.

I’d love to hear what other people think about this (Mr. Stein’s piece specifically, or the auto bailout in general). I’ll also be posting other things I’m reading and thoughts I have on the subject…

Categories: Economics Tags: ,

What should you do when you’re down? … Shop!

December 3rd, 2008 No comments

It’s a joke in our house now – “We have to shop to move the economy forward”. I’ve been saying it for weeks, maybe months, now. Since we moved back to the Chicago area earlier this year and bought a house, there have been a few large purchases. Every time my family asks why I’m blowing so much cash, I respond with the same “we have to move the economy forward”. Heck, even my folks say it when they buy a bunch of stuff on sale with prices so good they can’t say no (imagine this – $20 for a cart full of new clothes – as much as you can stuff in it).

Anyway, Dave Kansas (president of FiLife.com, a personal-finance Web site owned by Dow Jones & Co. and IAC Corp, and a columnist for The Wall Street Journal) agreed with me in his column in the online edition of the WSJ. I’ve pasted the text below.

As with everything, common sense should always be applied:

  1. The idea here is to splurge a little – not to go blow the next two months mortgage payment on a new flat screen TV and home theater system. Though we all should collectively breath life into the economy, our intent is not to mutilate our financial pictures. Taking on excessive debt to shop well beyond our means will only add to our misery and hurt the economy going forward.
  2. Related to the point above, this philosophy will not apply to everyone. Some will be in a position to shop, and some quite frankly won’t. If you’re just making ends meet and are concerned about a job loss, you should put away as much money as possible for the likely rainy day. But, if you have the fortune of having some money saved away, not being up to your eyeballs in debt, and have some disposable income, then you certainly should not put away your wallet in fear. Take advantage of your good fortune, buy yourself and your family members something nice to relax them in these gloomy times, and contribue to our country’s growth. Hoarding cash in fear won’t help us out of this hole.
  3. I don’t entirely agree with everything Dave says in his article – I think his idea of pretending gas is still $4/gallon and spending the difference is silly. When gas was $4/gallon people were much more stressed out about their financial situations than they are now, and cut back spending drastically. So, to pretend that gas is at a level where you curb your spending, just so you can beef up your spending account is counter-productive. I understand what he’s trying to say, I just think this is a poor example. It seems much easier to me to simply create a good budget. Since energy costs have dropped so much, that should create an extra  cash position in your budget – save part of this, and add the rest to your shopping fund – simple!

Dave’s elaboration on the fear that drives our current situation is spot on in my opinion. No doubt these are hard times and the country (heck, most of the world) is in a recession, but the gloom and fear that people and investors feel is probably exaggerated. I think stocks are likely over sold, and a lot of wealth has been destroyed for no good reason. This then becomes a self-fulfilling prophecy.

So, if you’re feeling down, rather than reaching for the ice-cream, go shopping!

The Christmas shopping season is fast approaching, and most of us face a stark dilemma: The economy needs us to spend, but we feel a need to save.

While it is crucial for individuals to have their houses in financial order — reducing debt and building savings — it is also crucial to not lose faith that things will eventually get better. This is a Christmas season where some small splurging could have an outsized impact on the economy by altering some of the gloomier thoughts dominating the national conversation.

Ultimately, there’s a crisis of confidence in the economy. Banks aren’t confident enough to lend money. Consumers aren’t confident enough in the future to spend money. Everyone is, to some degree, paralyzed by terrible headlines and uncertainty about the future.

Consumer fear is especially powerful, because consumer spending makes up about two-thirds of economic activity. That means a lack of confidence among consumers translates to less spending and weaker economic growth, as we’re seeing now. The retreat into recession is under way, largely because consumers aren’t spending.

World-wide Slowdown

And it’s not just our own economy that relies on U.S. consumers. Other economies, notably exporters like China and Japan, depend heavily on our open wallets. Because of the slowdown in the U.S., factories overseas are closing and tens of thousands of people in those countries are being thrown out of work.

It’s obviously true that consumers face tough head winds and have real reasons to cut back on their spending. High debt, reduced portfolios and concerns about job security are thorny issues facing many people. Prudence and thrift are rapidly becoming cultural watchwords.

A Small Surge

But this race back to thrift can get overdone. There’s a real risk that people will start thinking about going to the mattresses. Fear can reach a level where people store cash at home, cut back on all but the most necessary purchases and act as though the economy will never recover. This can become a self-fulfilling prophecy. Indeed, this level of fear curtailed economic activity during the Great Depression, making a recovery elusive. That’s just one more argument why a small splurge makes sense this season.

One reason that fear is racing ahead is the manifold comparisons to the Great Depression. While this makes for good headline copy, it overstates the reality of the situation. Fact is, unemployment, currently at 6.5%, may tick toward 8%. Some outliers predict an unemployment rate of 10%. During the 1930s, unemployment rates topped 25%.

Most people are safe in their homes, whereas in the ’30s huge numbers lost their homes. Some banks will fail, but not on the scale of failures seen back then.

There’s more fear in the air than the facts on the ground warrant. Much of the fear may flow from the recently ended election campaign. Politicians, especially nonincumbents, like to stoke the fear of economic Armageddon while positioning themselves as saviors.

A good deal of fear also comes from falling stock prices. Stock prices aren’t likely to rebound, however, until signs of confidence return to the economy.

Fight Fear

One way to reduce the fear suppressing the economy would be a stronger-than-expected holiday shopping season. This would send a signal that consumers have some confidence in the future and that not all is terribly bleak. Rather than bury money in the backyard, people are instead giving gifts to family and friends.

Since expectations for consumer spending over Christmas are vastly diminished, it wouldn’t take much to shop toward a positive surprise. So, what are some strategies for surprising the doomsayers while remaining prudent about your own financial situation?

First, take advantage of plunging gasoline prices. Gasoline prices, and energy prices overall, have plummeted since July. Already gas at the pump is below $2 a gallon in several states.

Pretend that gas remains at more than $4 a gallon and stash away the balance in your holiday shopping fund. This will give you a kicker of funds on top of what you’ve already budgeted for gifts. After the holiday season, you can begin diverting more of these savings to paying down debts or addressing other financial needs.

Shop Strategically

Second, stretch your dollars by hunting for discounts and cheap financing. Retailers have already started discounting aggressively, and they are likely to do so more in the coming weeks. Search strategically for sales; they’ll be plentiful.

Try to avoid financing purchases with high interest-rate credit cards. Now is not the time to add to that burden. Instead, pay with your gasoline slush fund or look for zero-percent financing options on big-ticket items.

Third, embrace utilitarian gift giving. By purchasing presents that help people with things that they need — food, kitchenware, a sweater — you can have a little splurge while remaining prudent and thrifty. This is not a time for frivolous gifts.

Another reason for stretching on your gift giving this year: It will lift spirits during a difficult time. The economic and financial markets have served up nothing but grim tidings during the past few months. You have a chance to reverse that trend, just a little. You’ll make someone smile and, who knows, you might help start the economy back down the right track.

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