Master of None

"Government officials, perhaps influenced by spending too much time with bankers, forgot that if you..."

Fri, 20 Nov 2009 08:28:38 -0500

“Government officials, perhaps influenced by spending too much time with bankers, forgot that if you want to govern effectively you have retain the trust of the people. And by treating the financial industry - which got us into this mess in the first place - with kid gloves, they have squandered that trust.”

- Paul Krugman, NY Times

"TBTF: Lost in Translation" (No Kidding)

Thu, 19 Nov 2009 22:15:37 -0500

Today The Huffington Post and other media reported that Morgan Stanley CEO John Mack is ready to embrace new regulation of financial companies. This follows a mea culpa from Goldman Sachs CEO Lloyd Blankfein. This is a beginning. However, we should be wary of trusting these self-interested actors when they lobby for or against certain provisions of new regulations.

The following is an excerpt from a investment report prepared by one of these two investment banks (I’ll let you figure out which, but it could have just as easily been either) - it was published on November 17th. This section, buried on page 7 and subtitled “Too Big to Fail: Lost in Translation”, offers an audaciously candid view of the narrative that Wall Street insiders have constructed:

We translate the concerns over “too big to fail” to mean that regulators want to limit moral hazard, and be able to reduce the put to the taxpayer presented by large, interconnected and complex institutions. Remedies include the authority to wind down bank holding companies in and orderly way and to put adequate capital buffers in place for more volatile businesses.

The “put to the taxpayer” means the de facto reality that TBTF banks get all of the reward from betting on investments without taking any of the risk. Regulators RIGHTLY want to limit this moral hazard. The “remedies” they list are indeed the major provisions of the regulations proposed by the Obama Administration. However, they are NOT the only remedies. Indeed, several economists and legislators (not to mention citizens) would add “breaking up the TBTF institutions” at the top of the list. Ah, but here they address that (emphasis added):

We do not think that [reform] means going back to Glass-Steagall, breaking up larger banks or shrinking larger banks. Contrary to perceptions about [FDIC Chair Sheila Bair]’s statements, we do not think there is any willingness to remove implicit support [for TBTF banks].

Translation: politicians are too scared to properly address the Too-Big-Too-Fail issue, so we’re stuck with these organizations that can continue to hold the public hostage when they screw up.

Investors point to ING as an example of the desire to break-up banks. However, we see that one of the reasons for this split was in part to retain capital and lending in the home country.

Translation: A significant developed nation decided breaking up its TBTF banks was the best course of action, but since it’s not exactly the same situation, we should just ignore that option.

Breaking up banks into their component parts would deliver new business models to investors to assess risk/return. This would likely raise the costs of equity for each component beyond current cost of equity for the current combined entity.

Translation: Bigger banks are better, and we shouldn’t break them up because the separate pieces might be worth less than the combined entity, even though historically this view is not necessarily accurate.

We don’t think [breaking up the banks] is in the interest of regulators, the administration or the economy.

Translation: Breaking up the banks might hurt the economy in the short run, but it will DEFINITELY hurt us, so don’t do it!

This, of course, is bullshit. It might be true that bigger banks are worth more; indeed, the “put to the taxpayer” that TBTF creates is of enormous value, both in terms of the explicit bailouts and the implicit subsidy that such firms achieve through a lower cost of borrowing. However, as many economists have pointed out, often the sum of the parts is greater than the whole (especially in super-sized institutions where economies of scale have been exhausted). The only ones who DEFINITELY benefit from the current arrangement are the senior executives at TBTF banks.

In other words, letting TBTF institutions exist (regardless of whether or not they’re banks) is how oligarchs and banana republics are made. And this is NOT in the long-term interests of the people of the United States. This alone is justification for taking aggressive steps to make TBTF a thing of the past. The surest way is the best way, and that means breaking them up.

Liberals need to learn this: 'If you want outsiders to believe you, then you don't get to choose their rationality standard.'

Thu, 19 Nov 2009 15:11:41 -0500

Liberals need to learn this: 'If you want outsiders to believe you, then you don't get to choose their rationality standard.'

Currencies & The (New) Global Asset Bubble

Mon, 16 Nov 2009 20:19:14 -0500

Many economists fear a new, larger, asset bubble that will dwarf the housing bubble of the 2000s in it’s destructive impact. It is possible that this is already underway, either in the US, with the Fed propping up prices with monetary stimulus, or in China, where investors are watching for currency appreciation, or both.

Bubble Scenario 1

Since the global financial markets were “saved” in early March 2009, almost every asset class has appreciated in nominal value. Housing, commercial real estate, and US government bonds are the only exceptions I can think of right now (though I’m sure there are others).

Part of this can be explained by the 20% devaluation of the US Dollar since that time. This is reflected in the appreciation of dollar-denominated assets, including commodities such as gold, oil, and steel; and also the stock market. However, while gold is up roughly as much as the dollar is down (~20%), the stock market is up more than 60% from it’s lows. Indeed, today it marked “13 month highs”, as newspapers reported. This appreciation of risky assets is part of the US Fed’s current policy stance.

It’s possible that US companies are worth that much more than they were in March, but there is a huge amount of money supply propping up asset prices, and if removed, those valuations could prove illusory. In any case, Gold looks like much less of a bubble to me than stocks.

Bubble Scenario 2

I’m also curious to see what happens if China agains lets it’s currency appreciate relative to the dollar; Chinese assets are 20-30% undervalued on a nominal basis. I could see a scenario where investors flood Chinese markets racing for a chance to get into the appreciating Chinese assets “before it’s too late”, but I could just as easily imagine a “sell the news” scenario where markets crash as investors exit a trade that’s already been priced in. There’s no evidence that China is keen to change it’s protectionist currency strategy, though, and most don’t expect a change until the US begins to withdraw its monetary stimulus (ahh, the two are linked, after all).

Either of these bubbles, or both, could run a long way yet. With large governements increasingly taking a hand in setting market prices (which the US and China are both doing in their own way), it’s tough to take a high-conviction view based on the fundamentals. So I guess I’m riding the gravy train until it starts to run out of steam (and buying 3 month rolling 10% out-of-the money puts on risky assets).

Is it Sarah Palin proof?

Mon, 16 Nov 2009 17:08:37 -0500

Is it Sarah Palin proof?

The idea of breaking up the megabanks is becoming mainstream

Tue, 10 Nov 2009 07:04:36 -0500

The idea of breaking up the megabanks is becoming mainstream

They don't call him Dr. Doom for nothing

Mon, 02 Nov 2009 22:31:17 -0500

They don't call him Dr. Doom for nothing:

Nouriel Roubini paints a terrifying portrait of the global capital markets, just in time for Halloween

What should I be taking away from this meeting?

Mon, 02 Nov 2009 12:15:00 -0500

Last week, I met with the management team of a $16 billion market cap NYSE listed company. CEO, business unit heads, and CFO.

Near the end of the meetings, the CFO suggested that we should use an 8% long-term growth rate in our financial models. His argument was that the industry had grown at an 8% rate over the last 50 years, and since 50 years is a long time, we can assume it will grow 8% for the next 50 years. Leaving aside how simplistic this argument is for a second, the audacity that I was supposed to believe that 8% growth is sustainable, for any company, was almost insulting.

For reference, the CFA Institute materials say that as a rule of thumb, long term growth in inflation-adjusted terms above 5% is generally not plausible. This is inline with academic studies that show large successful companies’ returns on capital generally converge with the market average over time. Assuming an average cost of capital of 10%, the 5% rule would put the maximum valuation of a company at “steady state” earnings growth at 20x. This is just the standard dividend discount formula: Price / Cash flow = 1 / (Cost of Capital - Growth Rate)

Now, this CFO tells me to use 8% for long term growth. I didn’t challenge this openly, but I did ask, offhand, what cost of capital the team assumed for business decisions. His answer was 8-9%, which compares with the 8.3% weighted-average cost of capital that I computed using market rates and a 5-year monthly Beta. Let’s use 8.5% for the sake of round(ish) numbers.

Now, if we plug in the CFO’s estimates to our DDM formula, we get Price / Cash flow = 1 / (8.5% - 8%) = 200x earnings! Even if we increase the WACC to the standard 10% assumption, that results in a valuation of 50x steady-state earnings.

If the CFO of this company went before a group of investors and said that his company is worth 50x earnings (let alone 200x) he would be laughed out of the room. Yet, effectively, that is what he said to me. What should I take away from this meeting?

For the record, this company has traded at an average of 18x earnings over the last 17 years. I would guess it trades around 18x on average, or lower, over the next 17 years. That, by the way, implies a 3-4.5% long-term growth rate, depending on our cost of capital assumptions. Which is much more reasonable.

"The circularity in the housing market, whereby Washington provides tax-breaks to first-time buyers,..."

Thu, 29 Oct 2009 15:12:39 -0400

“The circularity in the housing market, whereby Washington provides tax-breaks to first-time buyers, guarantees most of the mortgages written, and then buys most of those, beggars belief — and suggests a worrying case of amnesia following the bursting of the housing bubble.”

- Wall Street Journal, 10/30/09, on the eve of a vote to enact a second, broader, housing tax credit

[Among other things] I predict the equity premium will go up. - Tyler Cowen, Marginal Revolution

Tue, 27 Oct 2009 12:54:00 -0400

[Among other things] I predict the equity premium will go up. - Tyler Cowen, Marginal Revolution

Both of them will be right

Mon, 26 Oct 2009 08:55:00 -0400

Today in the New York Times, two economists both acknowledge the inevitability of health reform in the United States and it’s potential shortfalls on the cost side of the equation. A close read suggests that their conclusions aren’t actually that far apart, but the tone and focus of each is in stark contrast.

Paul Krugman, house economist of the Times, has been a champion of universal healthcare, and his columns suggest that any step in this direction is a good one. He says of the current legislation: “This thing is going to work.”

http://www.nytimes.com/2009/10/26/opinion/26krugman.html

Tyler Cowen is an Econ professor at George Mason University, and a Libertarian. He says: “We’re often told that America should copy the health care institutions of Western Europe. Yet we’re failing to copy the single most important lesson from those systems - namely, to put cost control first. Instead, we’re putting our foot on the gas pedal and ratcheting up the fiscal pressures on the system, in the hope that someday, somehow, it will all work out.”

http://www.nytimes.com/2009/10/25/health/policy/25view.html?ref=business

A hopeful post from Simon Johnson! Great way to start the weekend!

Fri, 23 Oct 2009 08:56:01 -0400

A hopeful post from Simon Johnson! Great way to start the weekend!:

ts/

Credit where it's due: Obama is trying to close the feedback loop

Thu, 22 Oct 2009 13:10:36 -0400

Credit where it's due: Obama is trying to close the feedback loop:

-Boards-and-Commissions/

"The only viable solution, in the Volcker view, is to break up the giants."

Wed, 21 Oct 2009 09:34:51 -0400

“The only viable solution, in the Volcker view, is to break up the giants.”

- NY Times, 10/21/2009

What does this mean for pricing power in higher education? Evidence of the long-term trend of democratization of information (i.e. the internet makes us way smarter)

Wed, 21 Oct 2009 09:25:46 -0400

What does this mean for pricing power in higher education? Evidence of the long-term trend of democratization of information (i.e. the internet makes us way smarter):

rything-changed.html

It's becoming harder and harder to justify identifying oneself with the Republican Party; This is a net positive for humanity

Tue, 20 Oct 2009 17:27:16 -0400

It's becoming harder and harder to justify identifying oneself with the Republican Party; This is a net positive for humanity

Bernanke is breaking the US side of the bargain; expect to start hearing complaints from China about the US fiscal dilemma

Tue, 20 Oct 2009 13:14:15 -0400

Bernanke is breaking the US side of the bargain; expect to start hearing complaints from China about the US fiscal dilemma:

-quite-what-you-think/

NY Times Editorial: If some company is too big to fail, then it's too big to exist. Break it up.

Tue, 20 Oct 2009 13:09:31 -0400

NY Times Editorial: If some company is too big to fail, then it's too big to exist. Break it up.

Top people in the Obama administration now begin to understand what they have wrought.

Mon, 19 Oct 2009 09:40:13 -0400

Top people in the Obama administration now begin to understand what they have wrought.

Princeton academics tell us what we already know: you cannot trust securitized products

Fri, 16 Oct 2009 13:04:00 -0400

Princeton academics tell us what we already know: you cannot trust securitized products