Credit Crisis Solution

To predict the future, it’s important to understand the past. The evolution of industry in China and other developing nations highlights a short period of massive investment and adoption. China will be lagging technologically in manufacturing to established nations for a long period, but to put it into perspective, their typical electronic production 10 years ago was a bug zapper or parts to larger electronic items, now they fabricate entire computers and motor vehicles. They continue to accumulate assets and technologies used in manufacturing, educate their society, and receive foreign contracts.

In the US and other developed nations, we have our domestic industries, primarily: trades that require on site skilled labor, extract our domestic natural resources, or services which require specific skill sets or are difficult to outsource. It’s important that create new industry or further innovate existing ones to stay ahead of the curve, especially those that pay homage to our domestic resources, and can be exported globally. Two of these industries that are continually promoted, but their importance isn’t reflected in the investment are Biotech and Clean Technology. These two industries have globally recognized value and need, and the US arguably has the best foundation to lead the way.  The intrinsic nature of these industries would also provide a bump in skilled labor and production while offering global selling opportunities.

This concept does not endorse protectionism, but rather much needed innovation as we continue to lose manufacturing and service industries by improved communication technologies.

The stimulus package of the great depression was arguably the best use of monetary resources in the last century. The concept is being used today with several rounds of stimulus, the first of which was the tax credit enacted by Bush, the second was the Financial System bail out, and the most recent is the multi-stage efforts to reduce unemployment.

It’s important to note the fundament differences in the context of labor and industry between then and now.  The technology of a century ago required limited imported resources, and we lead the world in innovation and production, affording us the ability to make the investments. Today, these core competencies have been either damaged or destroyed, yet we are still following the aged protocol.

Our ignorant perception is that it’s beneficial, but the inherent nature of corruption and waste, and weak fundamentals make it unwise. A prime example of a program that is said successful and in theory could be good, as it promotes both consumerism and environmental respect is the “Cash for Clunkers” program. A program allowing owners to trade in old inefficient automobiles for newer more efficient ones.

Disregarding the pricey tag, and Edmund’s estimates that it costs the government $20,000-$45,000 each car, it remains fundamentally flawed for the following reasons:

Criticism: $4,500 is an enticing offer for a car on its last leg, but the contingency of buying a new car ostracizes the target demographic. Many of the people driving the “clunkers” drive them as a result of limited income and inability to afford upgrades. Accordingly, many of the “clunkers” received were actually mechanically sound automobiles traded in by drivers who saw a great selling opportunity.

Improvement: Allow drivers to purchase used cars as well at a reduced value. Even at half the incentive, many eligible buyers would be able to retain a price greater than market value, promoting the environmental cause, serving the target demographic, and continuing to help the auto industry..

Criticism: The top 10 traded in cars were Ford Explorer, Jeep Cherokee, Ford Windstar, and Dodge Caravan. These SUV’s and vans are rendered un-drivable and scrapped.

Improvement: The scrapping implies the cars were useless, where as many of them were mechanically sound. Many organizations could have used the automobiles including: schools, churches, and farms. These auto’s would be used by organizations in need and for just causes.

Criticism: Most new car purchases are done through debt financing, a primary cause of the financial crisis. We are setting ourselves up again for greater future financial burden.

Improvement: None.

The notion that “Cash for Clunker” was a great use of resources is wrong. It’s important to note that this was considered one of the better programs in the stimulus package, if one extrapolates the concept throughout the package as a whole, one can better understand the scope of government waste.

The media has been progressively covering the threats in the bond markets, primarily the threat of increasing interest rates and the corresponding negative consequences on investment as a result of further deterioration of capital investments due to the increased borrowing costs. Asian and Middle Eastern countries, which are highly invested in US securities have vocally expressed concern about the value of their investments, and taken precautionary measures including: investing in equities, diversification of industrial materials, proposing an alternative world reserve currency, and holding a lot of their investments in short term holdings.

As the danger of the US economy further struggling increases, the amount of treasury investors will decrease and interest rates being a reflection of risk will increase. Acknowledgement is being given to the unprecedented increase in deficit spending and decreased revenues, however, there is limited action, and with the necessary health care reform on the agenda the prospect of further economic peril is ever increasing.

There is a theoretical silver lining to all of this, US manufacturing orders are up for the second straight month, this correlates with the continuing and prospect of further devaluation (with the threat of hyper-flation) and as long as the dollar continues to depreciate the positive trend should continue, albeit with the effect of inflation. The attraction of foreign investment will help to maintain the business investment on a global scope, but consumer credit should remain weak, countering the problematic American consumer debt culture. Additionally, if we are able to create government surpluses, we will be able to pay off our debts at a lower real value.

Though there will be ache, it’s important to understand the size of the US economy, and their obligation to provide necessary services to the poor. Moreover, the increase in foreign investments should help to keep relatively low unemployment, and help us create a stable foundation to move forward.

Next discussion will be about the technology industries which we have a head start in against developing countries like China, and the need and strategy to remain the global leaders.

The Future of Fraud

If it looks like a fraud, smells like fraud, and smells like fraud…it is fraud? Is it legal?

Below this post are a few notes on mark to market, the FASB changing the rules, and the banks buying more of the “toxic assets” to mark up their earnings. CITI bank issued a statement stating that the accounting changes would not affect their Q1 earnings, this says one of two things 1) the rule change wasn’t necessary, or 2) CITI banks lying, which would lead to better than expected earnings.

Like the potential fraud in the mark to market, credit default swaps (CDS) may not be what we thought they were. Ritholtz.com did an investigation on CDS and AIG and made some surprising finds:

1) There was a significant diverge between the risk assumed and the premium paid for CDS.

2) There were indications that AIG believed that a lot of the companies CDS’s were issued for were beyond going concerns.

3) Indicators show that AIG may not have had any original intention to make good on the CDS contracts.

4) As a result of the regulation on mark to market, essentially these securities would be “dressed up” to fool regulators and meet liquidity ratio’s. Replacing the revocable “side letters” of the past.

5) It was essentially a global ponzi scheme.

The government is assuming 100% of the risk, on these CDS, however knowledge is power, and once this information is more popular, there will be action.

The FASB is easing the rules on Mark to Market accounting. As the rules are now, assets are currently valued at their market price, demand of “toxic” mortgage assets were down which lead to a decrease in value. Many of these assets are still generating cash flows and banks often use internal valuation to place “more realistic” value on the assets internally. Under the proposed changes, the valuation would be done based on internal company models vs. the market price.

Proponents believe that the easing in the rules will allow banks to true up the balance sheets allowing them to lend more based because of better ratio’s. Which has a good amount of validity because a lot of these held to maturity assets suffered other than temporary impairment (OTI), which cannot be trued up if market conditions change. Additionally, their liquidity and debt ratios will become more favorable allowing more lending.

Conversely, many of the large banks have been covertly buying up these assets on the inactive markets under the expectation of these changes. This completely undermines the efforts of the government to rid the banks of the “toxic assets”. The point of market to market accounting is transparency and for the banks to do this will potentially lead to inflated balance sheets, part of the original problem.

Note: Keep in mind that the Fed put out a plan to rid the bank of the assets discussed. This will potentially have a significant impact on the value of those assets, benefiting the banks beyond their share price.

“The key to change… is to let go of fear.” ~ Rosanne Cash

Barrack Obama promised change, that was a forgone conclusion. These changes are going to be: obvious and/or unintended, long term and/or short term, good and/or bad, small and/or big, and inevitable.

The macro-economy:

1) Inflation and interest rates- The money supply and interest rates share a cause and effect relationship. As the money supply increases (current situation) law of supply and demand dictates a decrease in value. Additionally, interest rates are at near all time lows, thus increasing access to money. Masked by the recession and oversupply of goods being discounted, there will be inflation, and pressure to increase interest rates. The G-20 is convening later this week, and among their discussion topics is reform of the current global financial structure, including a global reserve currency, which would have significant impact on interest rates.

2) Inflation and interest will slow growth rates within the economy; credit access will be limited for consumer spending, access to higher education, and investment, companies will adjust to meet consumer demands, and survive accordingly. This trend will continue domestically, but eventually be mitigated by global demand. Highly leveraged corporations will be the first to fall, lowering the barriers to entry, and creating opportunities for the ambitious unemployed to create new companies.

3) The decrease in the dollar will make goods more attractive abroad, significantly impacting exports, and foreign investment in the US. This will give way to emergence of new industries, more stable financial structure, and stable long-term growth.

4) The financial crisis was primarily a result of poor regulation and greed. Assuming we learn from our mistakes, there will be more appropriate dispersion of wealth, and reemergence of a strong middle class, and increased focus on small business.

End of the golden years

Those nearing retirement are the most vulnerable, many lost 40% of their investment in real estate equity and growth investments. Promised life lines including the unfunded liabilities of medicade/medicare, and social security are going to face reform. Experienced workers are going to look to work longer than expected, increasing the unemployment levels, and causing downward pressure on real wages.

Real Estate

Real estate demand was fueled by increased accessibility to loans (unqualified buyers, low interests rates, deregulation, etc.), this caused a steep increase in housing supply. The markets are still correcting, and there is still a significant diverge between where real estate prices were expected to be, and where they are now. This diverge will be exacerbated by the increase in supply, decrease in demand, and future decrease in real wages. Home “real” values will continue to adjust until full occupancy is met, primarily impacting the suburbs; off-set by inflation.

Commodity Prices, Investment in Clean Technology, Development of Cities

Currently most commodities are traded in USD, assuming the G-20 proceeds as expected to develop a global currency, there will be a shift in how commodities (precious medals, energy, etc.) are traded. The devaluation of the dollar, regulatory changes, demand from developing countries, and limited supply will create significant price increases against the dollar. Energy commodities will be most susceptible, which will lead to investment in efficiency and sustainability 1) Economies of scale will lead to increased investment in metropolitan area’s, most notably public transportation 2) Market forces will lead increased investment in Clean Technology (much like the one $150 oil created).

Suburbia and Time

America will remain a productive nation; people will most likely shift into part-time work to ease unemployment levels. Additionally, market forces will dictate changes in spending habits and shift focus to needs vs. wants. As there has been a significant increase in agricultural dependence from other nations, suburban homes will begin to convert to farming because of decreases in value caused the shift to the cities and efficient use of resources, “act local, think global mentality’.

Increased Government Power and Reliance

The most appropriate way the measure the power of the government is the taxes collected relative to the GDP. The contraction of the GDP and the increase in debt will result in a significant increase in the GDP to tax ratio. The affects of increased government power will lead to increased expectations as a nations and eventual conversion to socialism.

Conflict followed by peace

On the micro and macro level, self-interest is king. The co-dependency of nations is slowly revealing itself, and as alliances develop, self-interest will be debated. There will be a period of conflict, as needs and desires are contradictory, and power and influence is more evenly distributed. The agreements will eventually be worked out and enforced through the dependance, leading to peace and growth as a world.

Note:

These expectations are based on the assumption of fiscal responsibility.

In Asia, if your business fails you either apologize or commit suicide to preserve your honor. I was outraged at the announcement of the AIG bonuses a few weeks ago, but I stumbled on this New York Times copy of a resignation letter from an AIG VP giving insight to the psyche of employees. This completely shifted my paradigm.