Monday, November 24, 2008

A REAL Rich Man's Opinion

The last time I met with somebody who made Forbes' list of 500 Wealthiest Americans, the individual walked away with my pen. I was somewhat agitated since my pen cost about $6.00 (which I would usually have to disclose to my wife) and he probably has a dozen pens each worth ten-times the value of mine. Granted, this 'perp' was number 200something on the list, you know, not THAT wealthy, only worth a few hundred million--so I should expect him to be fairly thrifty.

Last week I had to meet with another one, this time higher on the list (I didn't bring a pen to the appointment). He handed me his card and I noticed he had one of those nifty nicknames people make up and put on their cards that have nothing to do with their real name. Like Larry "Buck" Smith, or Fernando "Hank" Velazquez. But, in this case, I thought it was deserved since he was probably beat up time and again on the playground because of his first name. Good call.

I won't disclose his name since I didn't inform him that potentially up to TEN people might read about his comments on my blog, so it will have to suffice to say he is the CEO of a publicly traded company. He graduated from Harvard Magna Cum Laude with multiple honors (no "gentleman's" C here), which means he's a legitimate smarty-pants.

Here's what HE thinks (emphasis here on his THOUGHTS not the fact that the individual is a MALE)

Q: Why has your stock price gone from $36/share to $4/share in just a few months?
A: I'm not entirely sure, when we went public I put on the cover of our shareholder report that our daily stock price would not be an accurate reflection on the underlying, long-term economic value of the firm. So we don't manage around our stock price. Also, I don't think the majority of the public understands what we do. Believe me, I watch the stock price but there is little more I can do other than provide some level of comfort to investors.

Q: How do you think the government is handling the current crisis?
A: On the whole, doing a good job. They've obviously made some mistakes. For example they tried too hard to help individual companies without figuring out how to help the broader economy at first. It's like a pack of wolves attacking Caribou and once a Caribou is injured and goes down, the government tries to revive it, while they're doing that, another one goes down and they have to run over and help that one. But what they didn't do, is stop and figure out how to get the wolves from attacking the heard. I think now they're on the right track. But they blew it when they let Lehman go under. In my opinion, Lehman posed a greater risk than AIG. In fact, the organization that stood to lose the most amount of money from Lehman's bankruptcy was the government. Now, AIG's biggest counter-party (in other words, the biggest loser if AIG goes under) is Goldman Sachs. And by the way, Hank Paulson is an ex-Goldman banker and the Treasury is swarming with ex-Goldman employees who still probably own a good chunk of Goldman stock. But, that book hasn't been written. I'm only speculating here.

Q: So you think what they're doing with the TARP, in all it's variety, is the right thing?
A: For the most part. Buying the troubled loans never made any sense to me. Here's why. If you buy something from the Bank for one dollar (as an example), all that bank gets is one dollar. If however, you provide them with one dollar of equity (which is now the goal of the TARP) they can turn around and get 15 dollars of additional capital since banks are leveraged 15:1. This is how credit and lending resumes. Without that outside capital, banks will not be able to lend.

Q: So are you saying we should see liquidity and lending start to come back in the next few months?
A: No. That's what the treasury screwed up. We should have followed Europe. In Europe, when central banks had to step in they provided not only equity but added that the new capital had to be tied to increased levels of lending. We didn't ask for that in the U.S. The treasury should tie the equity infusion to resumption of lending, but either we won't, or have not to this point but may in the future.

Q: What opportunities do you see over the next year?
A: Bonds! Debt! That's where the money will be made. I have no idea why anyone would want to take equity, or stock, in any company when the bonds will get you 20%. From a geographic perspective, we really like China because they have a very robust national balance sheet and there is a lot of organic growth. GDP estimates over the next year put China at 7 or 8%, which is huge given what's going on in the world today.

Q: Where do you see our economy in three years?
A: Dealing with inflation. I think the government will continue to pour billions of dollars in new stimulus packages and will continue to do so until they overshoot. Since there is a lag, it will be impossible for the government to see the benefits of their stimulus packages and that will create inflation which will be exacerbated by high commodity prices, especially oil.

Q: The latest question on everyone's mind is what to do with Detroit. Why are automakers being asked to come back with a plan when the Treasury is giving money away to institutions without any plan?
A: Automakers are further down in the food chain. They benefit from increased credit access. Although it wouldn't be pretty, we could do without automakers, we can't do without banks.

So there you have it. The pride of Harvard. Any thoughts?

Tuesday, November 11, 2008

My Economic Agenda for President-Elect Obama

The other day someone asked me, half jokingly, what I would do to fix the economy. I blurted something incoherent because I'm not very good on my feet and went back to work. Then I started thinking a little bit more and decided I would share my conclusions with the ten people that read my blog. I've given it a good day's worth of pondering, so, clearly, my opinions are very broad. Here are three thoughts, in no particular order.

1. Create a principles-based rather than rules-based economy. This is no surprise to accountants. Most of them have had long philosophical discussions late into the night regarding the benefits and drawbacks of principles-based accounting (remember I spent a summer with a bunch of them). I'll share an example from the accounting world that will help illustrate my point. International accounting standards have a principles-based rule for the accounting of leases while the U.S. standards (according to GAAP) favor a rules-based standard. According to international accounting, leases must be booked as capital leases (nevermind the terminology here, that's not the point) "if it transfers substantially all the risks and rewards incident to ownership." However, U.S. accounting standards lay out four different criteria for differentiating the different types of leases. If the lease meets one of the four criteria, it must be classified as a capital lease. The international standard is based on a principle, while the U.S. standard is based on several rules. There are obvious advantages and disadvantages to both. We generally like rules because they're easier to communicate and understand. They also create standardization. Conversely, while rules are better for communicating, we generally see that principles are better for compliance and forces one to use judgment. Broad principles avoid the pitfall of creating specific requirements that allow contracts to manipulate their intent. It's emphasizing form over substance. I'm not arguing we shouldn't have any rules, just that it currently seems a bit excessive and most savvy individuals and firms are quite good at finding ways around the rules.

2. Lower Corporate Tax Rates. Currently the U.S. has the second highest corporate tax-rate (behind Japan) for developed nations. The tax rate, combined with the increasingly onerous regulatory environment (i.e. Sarbanes-Oxley) decreases the relative attraction of establishing businesses in the U.S. It also de-incentivizes companies currently headquartered in the U.S. to maintain operations, or a public listing. So this repels business investment, and creates both un- and under-employment. But there is yet another disadvantage of high corporate tax rates. Interest from debt is tax-deductible. The higher the tax rate, the greater the savings from the interest write-off (which eventually increases your firm's value, and, thus, share price). Therefore, elevated tax rates create an economic incentive to obtain leverage. This will come as no surprise to anyone in finance familiar with the "optimal capital structure." At it's core is a theorem which basically states in a world with no taxes, the amount of debt you have is irrelevant (from the standpoint of the value of your business and shareholder wealth, although it does increase risk) but as rates increase, so does the corresponding incentive to obtain debt since the tax savings from the interest write-off will be greater than the cost of the debt. The theorem states that there is an optimal amount of debt a company should have where it maximizes the risk adjusted return to shareholders. So decreasing tax rates will correspondingly decrease the economic incentive to lever a business. As a nation I think it's fair to say we are over-levered.

3. Boost Government Spending in Infrastructure, Health Care, and Education. It may be good to introduce how GDP is calculated. GDP = C + I + (G-T) + X where GDP equals the sum of consumer spending C, Private Sector Investment (corporate spending) I, fiscal stimulus (netting government spending G minus what they bring in taxes T) and net exports X.

How can GDP increase when consumer spending is down C, businesses are investing less I, and exports are decreasing because of the global recession X? That leaves fiscal stimulus. And, according to our equation above, if GDP is to remain constant, the fiscal stimulus (G-T) must be great enough to offset the losses in the other three categories. So we focus on G and T. Certainly decreasing taxes, both consumer and business, or creating tax credits will increase aggregate consumption in both (C and I). But many overlook the importance of government spending. Whatever the government spends will obviously increase the overall deficit. But the deficit will be a smaller problem if the money is spent on infrastructure rather than fettered away into adult film consumption (which, by the way, is very resilient in a recession). Instead of sending out more stimulus checks to Joe the Plumber (I'm referring here to the average American, not the actual guy that's been identified) the government should think longer term and invest to decrease the cost of education, increase access to Health Care, and update our ailing 30-year old infrastructure (highways, roads, and utilities). If my children are going to be responsible for the deficit the government creates, then I want them to benefit.

As I said at the onset, I haven't given this a great deal of thought, but enough to perhaps elucidate where I think our economy should look over the next ten to fifteen years. I'm sure I've left some vital piece of information out, but blogs are obviously imperfect (afterall, you get what you pay for). I think some of these changes will create a more intelligent, agile, and sustainable economy. And one last suggestion, I don't think Obama should run for re-election. He needs to be able to make decisions without the subconscious desire to please potential supporters in 2012 .