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SUBSIDIZING STUPIDITY By Mike Gasior As the issue number of this month's edition suggests, I am STILL determined to get "caught up" with these newsletters before the year runs out on me. Trust me that the issue has been a lack of time and not any shortage of things to write about, and this month has several interesting and timely hooks in it. Hopefully there will be something you will find either insightful or interesting to read, but you'll be the judge of that. Let me get right to the business at hand. REMAINING 2007 SEMINAR SCHEDULE I'd just like to remind you quickly of the terrific sessions I'll be presenting before the end of the year in New York, Grand Cayman and Bermuda. Below are the seminars, their dates and the link, to retrieve more information. Because of all the recent developments in the CDO marketplace, I will be augmenting that component of "CMO, ABS & CMBS Securities" program in November. If you have a need to better understand these very complex securities this is a day of training you should not miss. The New York Sessions are as follows: Introduction To Securities & Markets Securities Operations, Processing & Accounting CMO, ABS & CMBS Securities Advanced Securities & Markets The Offshore Sessions are: Providing Services to the Hedge Fund Industry Securities Operations, Processing & Accounting Fixed Income Calculations and Principals I hope to see you or your colleagues there. Also, please visit my video commentary page to view two clips that have been added since my last edition of this newsletter on the subjects of Syndicated Bank Loans and the blurring line between Hedge/Private Equity/Venture Capital funds. The link is: http://www.afs-seminars.com/v-commentary.html A BRIEF COMMENT ON THE CURRENT MARKETS Plenty of people seem to be in some degree of panic and various markets are reflecting this sort of emotion. Although difficult to do in the midst of chaos, it is worthwhile to step back from what is going on and look at the current situation from a historic perspective. I may be more able than lots of people given that I have a very small component of my personal net worth in the stock market, nor do I own any investment/speculative real estate. I've also witnessed more than my share of lunacy and turmoil during the 27 years I've been watching this. First I'll give you my take on the real estate marketplace by telling you I cannot see or smell the bottom of it yet. Many of you remember my newsletter of March 2005 that I titled "Real Estate is Over": http://www.afs-seminars.com/newsletter_Mar_2005.html While I think I called the top pretty much on a dime, I think we still have some time to wait prior to me trying to call the bottom. Do you remember back when many people were predicting that 2008 was going to mark the bottom of the housing market? And then it got moved out to 2009. Well, the day before the Dow Jones Industrial Average fell 311 points last week, the chief economist of the National Association of Home Builders put a rebound off into 2010 or 2011. Prices for existing homes, down 3% between last fall and the end of June, are projected to fall an additional 5% by the end of 2007, according to the home-builders association. They also predicted that prices would continue to fall in 2008. If these are the predictions of an organization with an extreme bias to be optimistic regarding the outlook for the real estate market, you can only ask yourself how bad it might get? Home prices have got to keep falling due to many factors, but one pressing issue are all the adjustable-rate mortgages due to reset at higher interest rates and higher monthly payments. About $1 trillion in mortgages are due for a reset by the end of 2007 alone. Simple economics dictates that fewer and fewer of the most financially stressed homeowners will be able to refinance, and fewer still will have an incentive to hold on to a home that is falling in value even as mortgage payments are climbing. This means that more mortgages will go delinquent or into default and foreclosures will rise. These facts are indisputable and non-negotiable. Anyone predicting otherwise is a liar, fool or both. What is driving the downward drift of stock, bond and real estate markets can be explained by a classic buyers strike. Currently there is a struggle by buyers in all of the above-mentioned markets to gauge the price they should pay on all sorts of different assets The stock market damage we just witnessed is a reaction primarily to the bond market and the worries about subprime mortgages as well as corporate debt and the derivatives that are based on them. There is very often no correlation between the equity and the debt markets, but this is a moment when the two seem intricately entwined. Imagine how bad the situation must be for the CFO of Bear Stearns, Sam Molinaro, who has as good a vantage point as anyone on Wall Street, to say that the current situation in the bond market may be a worse predicament than the 1987 stock market crash and Internet stock bubble bursting. Those are extremely strong words from a very smart guy who you would expect to gauge his comments. In a conference call with analysts last week he said "These times are pretty significant in the fixed income market. It's as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme." While I agree with aspects of Mr. Molinaro's comments, I've seen some fairly ugly stuff in the past and I'm not exactly certain I could say that this is the worst time that I've EVER seen in the bond market. Based on conversations with people I know all over Wall Street and the institutional investor marketplace globally, this is certainly one of the worst times. Much worse than the mainstream media, the Federal Reserve or the U.S. Treasury Department are making it out to be. With a bit more unraveling, Main Street might become very attune to the bleeding currently occurring on Wall Street. In any buyers strike, the spreads between what
buyers are willing to pay and what sellers are asking get wider
and wider. In some cases the buyers will disappear altogether. This
is exactly what happened last week. Sellers who were trying to get
out of positions in mortgage-backed bonds, in paper backed by What causes such a buyers strike? Think of it as a deer-caught-in-the-headlights moment for a financial market. Buyers are so uncertain about the validity of current prices that they freeze into inactivity, buying nothing, until they think they can trust prices again.For instance, why would anybody buy financial assets having anything to do with subprime mortgages right now? The prices the market has established recently indicate that bonds and derivatives based on these mortgages may be worth as little as 45 cents on the dollar. But the real problem is that few potential buyers trust those prices either. They took note at how rapidly two Bear Stearns hedge funds got liquidated after they went from a 2% monthly profit to a 19% monthly loss to a 28% monthly loss (same month, different accounting) to the loss of almost all of a $14-$20 billion portfolio. In an environment like that, with one of Wall Street's most sophisticated investors being the centerpiece of the story, then who knows what any of this stuff is really worth? Buyer's strikes aren't a one-day phenomenon, but neither do they stretch on for months and months (with exception of perhaps the real estate market). The strike will end when buyers think they again know what assets are worth and stop sitting on their hands in fear that any price they pay today will seem like way too much tomorrow. These situations in the stock and fixed income markets will work themselves out over the next few months. Each of the asset classes that are the focus of worry right now; subprime mortgages and the bonds and derivatives based on them, along with the debt used to finance buyouts have to get re-priced, and we aren't close to that being done yet. So remain patient and stay out of the fray right now. Real estate is going to take quite a bit longer
unfortunately. A bit of gasoline was poured onto the simmering situation
last week when several large mortgage lenders announced they would
be tightening the underwriting standards and raising the interest
rate on jumbo and other kinds of mortgages.Keep your eye on the
Florida real estate market, since I, and other economists, view
it as sort of a microcosm of the U.S. market. As I write this the
inventory of real estate for sale in Florida has more than doubled
in the previous 12 months. More frightening to this writer is the
fact that nearly 5% SUBSIDIZING STUPIDITY My title topic for this newsletter involves literally all of my favorite components for an interesting story: economics, politicians, alternative fuels and taxes. How can you not have a good story when all of those things are involved? While the story is interesting and perhaps even amusing, it is yet another sad chapter in how the wisdom of the government will once again fail the public, the economy and the environment. A trifecta of failure if you will. This story begins with yours truly reading an article
in the New York Times that explained that "a powerful roster
of Democrats and Republicans" are pushing a package of subsidies
to help the coal industry produce liquid fuels, such as coal-based
diesel. Now, many of you might remember the newsletter I wrote in
September of 2006 telling everyone of what a scam the whole ethanol
revolution http://www.afs-seminars.com/newsletter_Sep_2006.html The subsidy package being suggested by the collection of Democrats and Republicans includes loan guarantees, a pre-commitment by the government to buy certain quantities of coal-based fuels, a tax credit of 51 cents for every gallon of coal-based fuel sold through 2020, and so on. Not a bad offer for someone thinking of building a coal to liquid fuel plant for themselves. In short, what the government is offering the coal industry is lots of financial support to make liquid fuel out of coal, which apparently wouldn't make any economic sense without such a government subsidy. On the surface this doesn't seem like a particularly bad idea, but it most certainly is. I'll count the ways for you. PUBLICLY FUNDED LUNACY First, let me start with the most obvious problem from an economic perspective. The purpose of any government subsidy is to encourage normally rational and profit motivated firms to do something that wouldn't otherwise be rational or profitable. (If any business activity makes economic sense without a subsidy, then obviously it wouldn't need one in order to proceed.) So if you would strip away the fancy political rhetoric, the coal companies are simply saying to Washington, "Pay us to make liquid fuel from coal, because without a lot of government money, this would be the stupidest thing ever and we aren't willing to risk our own capital to try it." I'm positive there are profit-hungry firms that would make diesel fuel out of old tennis shoes if we paid them enough. However that doesn't mean that this is something that public tax revenues should finance.It is certainly true that subsidies are a good idea if they induce behavior that has some significant social benefit, such as subsidizing pharmaceutical companies to produce drugs for rare diseases; without that subsidy, the firms might not recoup their research-and-development costs, and some life-improving drugs might never appear. But coal is arguably as bad (or worse) for the environment as oil so it is difficult for me to see the social benefit of using public money to induce such a switch. (Yes. I'll admit that making energy from coal reduces our demand for foreign oil, but I'll address that in a minute.) REBATING RECKLESSNESS Secondarily, subsidies for alternative energy make less sense as the price of oil goes up. Right now it would be very profitable to convert coal to oil, yet no profit motivated firm is rushing to build a plant to do it. High energy prices are exactly what will cause the marketplace to find alternatives on its own without the government having to offer incentives. By using government money to hold fuel prices artificially low, we kill the incentive for entrepreneurs to develop alternative energy sources that don't need subsidies. Third, if you are of the camp that believes global warming is caused by the burning of fossil fuel and the emission of CO2, we should be making an effort to reduce this situation. To reduce our CO2 emissions, we're going to have to give up or change some of our behaviors that contribute to this. From an economic point of view, the best way to change behavior is to raise the price of the activities that we want to discourage. Curiously, this subsidy policy would do just the opposite. Anyone would have to agree that it's bad for the planet when someone commutes alone 62 miles to work in a Chevy Suburban. Instead of discouraging that activity, the coal subsidy would actually make it cheaper. Almost like a government rebate. And worse, the more you drive, the bigger the government check. I understand that we're talking about politicians here, but does this make any sense? IT ALSO MAKES US MORE FOREIGN DEPENDENT Fourth, using government money to hold down fuel prices isn't actually going to save you any money. Certainly, you might get lower-priced fuel when filling up the car, but be real here. Where do you think those subsidies come from? From your taxes of course. But consider how this will make us more foreign dependent. The United States government has been operating in deficit for many years in a row now and has actually increased its outstanding debt by over $1.3 trillion since 2000. Also consider what I wrote about several newsletters ago when I explained that since 2000, ALL new U.S. Treasury debt had been bought by non-U.S. investors along with $300 billion of existing debt. So in reality, the government wouldn't even be
funding this coal subsidy from the revenue side of the balance sheet
(your tax dollars). They'd actually be financing it with debt and
we would then be paying interest to the Japanese, Chinese and others
for generations to come for purpose of subsidizing the coal Finally, subsidizing coal is an amazingly inefficient way to reduce our dependence on foreign oil. It would be the analogy of trying to reduce coffee consumption by offering Starbucks wads of cash to lower the price of tea. Would it work? Yes, probably a little. But if you really want to reduce coffee consumption, wouldn't it make more sense to raise the price of coffee? BIPARTISAN SOLIDARITY On the positive side, this proposal is one that is truly bipartisan. What is particularly funny and sad is that it requires both parties to abandon one of their core principles. Democrats like to be thought of as serious about the environment. Subsidizing activities that potentially contribute CO2 emissions and to global warming will likely not make Al Gore happy at all. And Republicans are supposed to be the party that believes that the market, rather than the government, should determine what kind of fuel we put in our cars. If firms can make money by turning coal into diesel, then they'll turn coal into diesel. And if they can't earn a profit, they won't do it. Yet Democrats and Republicans (from coal-producing states) have found a way to work together on this one. It's inspiring in a sad, pathetic kind of way. The truth is that I have absolutely nothing against the idea and the technology of converting coal to a liquid fuel. It actually seems like an outstanding idea. What is keeping private industry from gambling any of its own capital is that the enterprise is only going to be profitable for the companies if oil prices remain above the $50 to $60 range per barrel. It is common knowledge that OPEC has the capacity to flood the world markets with oil effortlessly and drop the price of oil back to below $20 if it chose to do so. No corporation is going to risk the billions it will take to build a coal to liquid fuel plant with that piano hanging over its head. This is why the only large, viable such plant is in South Africa and was built with massive government subsidies there. So if congress wants to commit public money to easing the energy crisis they should direct the cash toward renewable resources that have little environmental impact. These would include wind, solar, hydro and yes...even nuclear power, which has evolved tremendously in the past 30 years. MAKING A DIFFERENCE AND A PROFIT In stark contrast to the lunacy described above comes a simple idea of pure genius from a German firm named SkySails, headquartered in Hamburg. The next time you fill up the fuel tank of your vehicle and lament the expense, imagine if your were instead driving one of the world's 50,000 diesel powered cargo-container ships that transport almost 90% of the all import/export goods. Those are some pretty darn big fuel tanks and a gigantic expense to the shipping industry. What SkySails has just put into service with German shipping giant, Beluga, is the first modern, commercially viable, wind-assisted sail to reduce fuel consumption of these massive ships. It's basically a giant kite flown off the bow of the ship on an automatic, telescoping mast at altitudes reaching 1,000 feet. While it doesn't replace the diesel power, it can reduce consumption by as much as 30%. Considering that fuel consumption and carbon emissions by the shipping industry are expected to rise almost 75% by the year 2027, this idea is exactly what the U.S. congress just doesn't get because it is once again blinded by special interests. If something makes economic sense, it doesn't need subsidies. All I can hope is that the 33 year-old founder of SkySails, Stephan Wrange, becomes an extremely wealthy man due to timely and useful technology. Besides cargo vessels, he's also targeting oil tankers, fishing trawlers and large yachts, including the biggest yachts of all, cruise ships. Imagine that...12,000 ton hybrid vehicles. Now if some other enterprising entrepreneurs can come up with equally genius ideas, we'll really be getting somewhere. YOUR MARCH BRAINTEASER This month's brainteaser is unlike anything I've offered you in previous editions. In all honesty, it made my head hurt the first couple of times I read it through and tried to piece it together for myself. So take a couple of Advil and give it try yourself. Here it is: "Pat went to visit her husband's only sister's mother's only husband's mother. Who was she to Pat?" Good luck, and when you can't take it anymore you will find the answer at the following link: http://www.afs-seminars.com/brainteaser_Mar2007.html Copyright 2007, Michael Gasior. All Rights Reserved |
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March 2007 Newsletter
