Thursday, February 26, 2009

Don't Judge a Book By Its Cover (or a Story By Its Headline)

From the Desk of Joe Rollins

This may be surprising to some of you, but many years ago I had a career outside of public accounting in private industry. One of the accounts I worked on at an accounting practice was a company that erected elevated water tanks throughout the United States, and when they offered me a job, I took them up on it. I was there for several years, working my way up through the ranks to be the president of the company.

At some point, I became interested in buying an ownership interest in the company, but when I realized that wasn’t going to happen I decided to start my own CPA practice. I left that company under great terms, with the company becoming my first client and the owner remaining one of my best friends for thirty years until he passed away in late 2006.

When I worked for the water tank company, I often had to go to the job sites where water tanks were under construction. We would spend anywhere from a few days to two weeks in the field, hanging around the job sites, getting in the way and asking questions that irritated the tank builders.

Back then, tank builders were akin to circus performers; there jobs were extremely dangerous and could be devastating if they made even the most minor mistake. The workers made a lot of money for taking on such risk, and most tank builders never had any problems getting dates. In fact, when a tank crew moved into town for a job, it wasn’t unusual for spectators to come out and watch them construct the tanks, where they would hang upside-down 150-feet off the ground while welding the bottom of a water tank.

In order to save money on a hotel room, a tank worker would sometimes shack up with a local girl. That way, he could use his hotel per diems for more nighttime entertainment. Believe me, these guys were the most skilled and courageous construction workers I’ve ever had the pleasure of knowing.

There’s a particular memory I have of working for the water tank construction company that really stuck in my mind. For the most part, the tank workers consisted of very young men. As the tanks got higher and higher, it became more difficult for older men to climb the tanks. It was relatively rare to actually see a tank builder over the age of 40. But on a particular job I worked on for over a week, there was a crew member that was close to 65-years old. He was a hoist operator and usually did not climb the tanks; he job was to hoist workers and materials up and down the tower. When he wasn’t doing that, he would hang around the bottom of the tank and clean up the debris.

As with most tank builders, this fellow worked hard and played hard. He tended to drink too much and too often, and he looked much older than his 65 years. I got to know him very well, as I was usually hanging around on the ground and watching while the tank builders did all the hard work. At night we would all go out to dinner, and this particular guy was always the first to order. Notwithstanding the restaurant where we went to dinner, he always ordered fried shrimp, never looking at the menu.

Several years later, I heard that he had tragically died in a car accident on a rainy day outside of Bruce, Mississippi, his hometown. When I was reminiscing about him to my friend who was the construction superintendent, he informed me of something I had never heard before. Apparently, this gentleman could not read or write, which explains why he always ordered fried shrimp and never looked at a menu. I suppose we were lucky to always go to restaurants that offered that Southern delicacy.

The reason I am relaying this story actually does have something to do with finance. Basically, I wanted to point out that there are people who just read the headlines without ever reading the actual article. I am blown away by the lack of information I see in the financial press and how it’s misinterpreted. In this particular post, I wanted to provide a few specific examples of how news today has been so misinterpreted by the financial press, and while things are surely grim, they are certainly not as bleak as it’s being reported.

A good example of how reading a headline but not the story can further negatively impact sentiment is as follows. On Friday, February 19th, the Federal Reserve cut its forecast for 2009 GDP growth in the United States. The Fed is now projecting a drop in the economy for 2009 in the range of 0.5% to 1.3%. In January, they had forecasted that the economy might even grow in the range of 0.2 to 1.1% in 2009. Therefore, the Fed basically downgraded the economy by approximately 2% from their previous estimates. But the headlines only indicated that the U.S. Federal Reserve forecasted negative GDP for the U.S. economy in 2009, which really shouldn’t have come as any surprise.

What was confusing to me about this headline was that so many people took this headline at face value without seeing the underlying positive news. As I’m sure you’re aware, the Fed has announced that the GDP declined for the 4th quarter of 2008, and its first revision was at 3.8%. Almost all respected economists are forecasting that the loss in GDP for the first quarter of 2009 will likely be in the range of 3.5% to 5.5%. These are certainly large and frightening percentages. However, if you really think about the Fed’s projection of a drop in GDP growth for 2009, hopefully you’ll see my point regarding the embedded good news.

On Friday of last week, the Federal Reserve was forecasting that the 2009 total year GDP decline would be 1.3%. If you take into consideration that the first quarter loss would be 4%, how could you possibly arrive at only a loss of 1.3% when you start out with a loss in the first quarter of 4%. Doesn’t that imply that there will be some extraordinarily good quarters in our future this year?

Perhaps I have grown so accustomed to sensationalized headlines that I always read entire articles with a fine tooth comb. The article regarding the Fed’s lowering of its forecast for the U.S. economy set out that the projected GDP would have positive growth in the third quarter of 2009 and substantial positive growth in the fourth quarter of 2009. This makes it clear to me that there will be high growth in GDP in the last two quarter of 2009 in order to overcome the two very negative first quarters of 2009.

The article progressed by setting out more of what I deem is also good news. The Federal Reserve is forecasting GDP growth in 2010 at 2.5% to 3.3%, with even higher growth in 2011 at 3.8% to 5%. Accordingly, it should be fairly clear to everyone who read the entire article that the negative headline failed to describe the actual content of the article. A more appropriate headline would’ve pointed out that the Fed is forecasting a significant turnaround in the economy only six months from now, which should progressively increase to extraordinarily high growth by 2011.

Once again, I implore you to read beyond the headlines. These days, you just won’t get the full story without reading the entire article. With all due respect to my tank worker buddy who was a smart guy in spite of his inability to read an write, if you can read the menu, you might find that there are other things to order than just fried shrimp.

On Monday, the stock market took a severe turn downward, and at the end of the day, stock prices were essentially at the same level they were in 1997. It’s hard to believe that a 12-year period has basically been evaporated by the fear and the constant selling that the professionals are doing on Wall Street. Many investors are now losing face in the financial systems because the professionals are manipulating the numbers and making the fundamental analysis of investing meaningless.

Rather than cry in my beer (which I have been known to do these days), I decided to try to objectively evaluate whether there was any validity to stock prices being at the same level today as they were at in 1997. I must admit that some of the so-called experts espousing their theories on the financial news are not only discouraging but most of them are just incorrect. I can’t help but think that the pundits on TV who are saying all the banks are insolvent and need to be nationalized are the same people who are shorting the very stock they’re criticizing. There’s absolutely no indication anywhere that the U.S. government wants to nationalize banks, but this is what we’re hearing ad nauseam on the financial news.

In an attempt to determine whether stock prices are fair right now, I decided to review the most basic information regarding the U.S. economy. As I have often mentioned, profitability is the most important component of investing. Obviously, the U.S. economy and interest rates have a major impact, but by far the most important component of stock values is profits. So I must wonder whether profits and the GDP in the United States are better or worse than they were in 1997. The answer would be whether stock prices are properly valued today based upon economic data.

I reviewed the following charts to try to assess this information. I didn’t have the information going back to 1997, so I began my study at the beginning of 2001. As a point of reference, please remember that this was before September 11, 2001, and before the Federal Reserve started cutting interest rates to stimulate the economy in early 2001. It was also before the major meltdown in the tech bubble. All-in-all, it was actually a pretty good time for the U.S. economy.

As my chart indicates, the GDP in the United States at the beginning of 2001 was essentially at $10 trillion. As of today, the U.S. GDP is at approximately $14.3 trillion. Therefore, the GDP has grown over the intervening eight years by a stunning 43%. Pundits that want to criticize everything probably didn’t notice that our economy grew by almost 50% during the George W. Bush years.

Again, the most important component is corporate profits. So what has the effect of corporate profits been in the same relevant timeframe? As the following chart indicates, corporate profits at the beginning of 2001 were roughly $550 billion. Even with the significant reduction in corporate profits due to the bank implosion, corporate profits were most recently reported at $1.1 trillion, just off the all-time high of $1.23 trillion. So I don’t overstate my case, while corporate profits have essentially doubled over the last eight years, stock prices have remained flat.

I question whether the people reporting all of the negative sentiments in the financial news have ever researched the facts represented in the chart above. It just seems like all we hear is negative news when the news is better than what is being reported by the financial press.

Like most everyone, I cannot forecast when the stock market will turn around. However, basic textbook principles of investing tell you that the stock market turns around approximately six months before the economy. This is because stock prices are driven by improving corporate profits. We’re only a week away from March – almost exactly six months from the anticipated start of the turnaround in the U.S. economy. If the Federal Reserve is correct, 2010 and 2011 are going to be great growth years.

Corporate profits are double what they were in 2001, but have certainly been reduced within the last 12 months. With the economy improving and GDP growing, it would seem that corporate profits would start accelerating. I don’t know for sure, but based upon everything I’ve learned over the years, there certainly is ample fundamental ground for the stock market to start performing better soon.

As always, these are just some of my thoughts. I could be wrong…

Thursday, February 19, 2009

"Mark-to-Market" - More Than You Ever Wanted to Know

From the Desk of Joe Rollins

I have a beautiful, large tree in my backyard that hangs over my deck. I’m not sure what kind of tree it is, but it is an incredibly accurate gauge for spring’s arrival. This tree goes dormant in the winter every year, losing all of its leaves. Throughout winter, it stands starkly naked against the dreary sky. Only in spring does it come to life, first with white petals that quickly fall off to be followed by dark green foliage that canopies the yard. It’s always somewhat exciting when this tree comes to life after being asleep all winter.

We’ve had about two good weeks of warm weather here in Atlanta and my yard is beginning to show its thanks. When I got home from work last night, my back deck was covered with white petals, giving it the illusion of a light dusting of snow. It’s amazing to me that winter’s end is drawing near already, and we’re only a few weeks away from a more moderate temperature. The roses in my yard, which are my pride and joy, along with the azaleas, are on their way to a beautiful unveiling of blooms at the beginning of April.

The metamorphosis from winter to spring typically brings a smile to most faces, but alas, our current economic situation has seemingly put a damper on our happiness. In watching the news this morning, I was overwhelmed by the incredible pessimism being reported by the national news. It’s really going to be hard for the United States to start moving forward unless someone convinces us that the world really isn’t in a tailspin and that we’re only suffering through a correction. Hopefully we will see the news take a more positive tone now that President Obama has signed the stimulus package. Until consumer confidence improves, it is going to be hard for the country to pull itself up by its bootstraps and go to work with a better attitude. Hopefully, like spring, those days aren’t far away.

I got into a lively discussion with a client the other day regarding mark-to-market accounting. I indicated that I had wanted to write a blog on the subject, but that most people were either ambivalent about the topic or that most eyes tended to gloss over out of boredom when I discussed accounting terms. But the more I hear on TV and the more information we receive from the financial press, the more I think I need to take a shot at explaining it. Maybe a rudimental explanation of a complex subject will at least get people thinking.

I continue to be outraged by our elected officials’ inability to understand – or even attempt to understand – complex issues. Two administrative moves have been made over the last two years that have directly led to the poor performance of the financial markets and indirectly, the performance of the U.S. economy. They are so simple and so basic that it’s amazing we continue debating the same subjects ad nauseam. A reversal of these two policies would not only focus the market, but it would also relieve the pressure on our banking community.

The first of these policies that need to be reversed is the very famous uptick rule. On our blog, we have often opined that the uptick rule needs to be reinstated. It was administratively deleted on July 1, 2007, at the height of the strong market, when the SEC indicated it was unnecessary. I will not go into a long-winded explanation of why the uptick rule is necessary because its importance is well documented throughout history.

After the uptick rule was suspended in July of 2007, there were no barriers to the people that short the market (sell before they purchase the stock) or elect to force a company out of business by coercion. They, in concert with others (which is illegal), can essentially sell down a stock until it’s worthless. Notwithstanding the financial performance of that stock, short sellers are not taking on any risk by continuing to short it since there are no administrative means to prevent them from doing so. Look at Fannie Mae and Freddie Mac, Bears Stearns & Company, Lehman Brothers, Wachovia, and (almost) CitiBank and how not having the uptick rule in place has damaged those companies that were once the backbone of American finance.

The uptick rule worked for the first 78 years that the stock market was open, but since it was suspended almost two years ago, investors have been destroyed due to a lack of administrative oversight. A tremendous amount of damage has been done to the financial institutions of our country due to this lack of oversight, and a tremendous amount of assistance could be offered to this group of companies if only someone would take the time to determine what would be in the best interest of the country as a whole.

The stock market opened on October 9, 2007 at its height of 14,163. Today, the Dow Industrial Average stands at 7,500, down a whopping 47% in the intervening 18 months. The accounting profession dictated that the financial instruments held by banks were required to be valued on a mark-to-market basis for publicly traded companies effective November 15, 2007. Therefore, essentially all banks and financial institutions were required to revalue these long-term assets effective January 1, 2008.

If you believe that the decline in the stock market and the implementation of the mark-to-market rules is just an unfortunate and ugly coincidence, then I wonder if you have also purchased beachfront land in Arizona and still believe in the Tooth Fairy. Unfortunately, the suspension of the uptick rule and the implementation of the mark-to-market rules have very much temporarily destroyed the financial security of many investors.

There’s a simple example to illustrate the mark-to-market issue: A company owns a building that leases to a third party and it receives rent on that building. For general accounting rules, this building would be amortized over its available life and the value would be marked down based upon general depreciation rules of 40 years or so since it is a long-term asset. At the end of its depreciation life, its value would be determined based on what it can be sold for in the open market.

Now, assume that next door to that building is another building that’s exactly the same and that is rented out for exactly the same rent amount. The only difference is that the second building is owned by a distressed landlord. Due to financial circumstances beyond the landlord’s control, he is required to sell that building at a 40% discount to the true underlying fair market value of that particular building. Even though the first landlord had nothing whatsoever to do with the actions of the second landlord, what if the first landlord is required under current accounting rules to take a 40% loss on his building, even though the true value of that building has not been diminished and he had done nothing?

Here’s another example using a financial instrument: Let’s say that we have two identical holders of a 30-year bond from the country XYZ. This bond requires that interest be paid on a semi-annual basis, and the financial stability of the debtor is not in question. However, this bond is very rarely traded, and in fact, due to its limited trading activity, it has virtually no market value. The underlying interest rate on this bond is 5%.

During the bond’s life, its value moves up and down dramatically based upon current interest rates in the market. If current market interest rates jump up to 10%, the implicit value of the bond would have to fall to match its 5% coupon rate. However, the owner of this bond has the capacity and the desire to hold the bond until maturity when he will receive the full value of the principal invested along with the annual 5% interest for the entire 30 years.

As with the building example, another holder of this bond gets into financial difficulty and sells his bond on the open market at a 40% discount. Does the first bond owner really incur a loss of 40% of his principal even though he has received all of the interest payments and has good assurances that he will receive his full principal at maturity?

As the two foregoing examples illustrate, valuing long-term assets is an inexact science. For the holder of the stock of a company that holds either of these assets, I would vigorously argue that neither of their values has been diminished by the actions of the other similar holders. However, this is exactly what has happened to the banks in our country since January 1, 2008.

For those in the financial markets who continue to argue that it is important for us to know the exact value of the underlying assets, it is interesting to note that in the first 200 years of our existence, we got along just fine under the old accounting rules. There were almost no banks that went out of business in the United States from 1996 through 2006. However, we are now up to approximately 30 banks that have failed in just an 18-month period. These bank failures correspond almost exactly with the implementation of the mark-to-market rules on November 15, 2007. Coincidence? Unequivocally not.

Beginning January 1, 2008, the banks were under a completely different set of accounting rules. Their cash flow had not been impacted, their liquidity was exactly the same and their financial positions on a long-term basis were just as stable as they were on December 31, 2007. However, beginning on that day, they were required to write-down billions of dollars of assets that they fully intended to hold to maturity. These assets weren’t bad; there was just no market for them. Additionally, the bonds in question continued to perform favorably, but the banks were now required to write them down 30% to 50% based upon an illiquid market where the bonds could not be openly sold.

First, it’s important to realize the impact of this transaction on banking in general. Since the banks can essentially lend 10 times their capital, the lending capabilities of the entire financial structure in the United States were immediately and dramatically diminished. If banks wrote down $500 billion in these assets, the U.S. lost $5 trillion in lending capacity. Nothing had changed, but since their capital had eroded they could no longer lend as much money as they were able to only one year (or even one month) previous. One minor change in the rules essentially made the banks insolvent. I guess that’s the axiom of unintended consequences, and if it were not so serious, it might even be funny.

The financial markets immediately began reeling on the effect of this transaction. Financial commentators throughout the world commented that all the banks were now insolvent and had no ability to carry on. I’m betting they were shorting the stock or did not understanding basic accounting. What is interesting is that nothing had actually happened and then the banks go from having excess financial capital on December 31, 2007 to being insolvent (at least by this definition) at January 1, 2008. One day does not equal insolvency. Many of our banking institutions have been destroyed due to an ill-informed, ill-applied and overly-cautious accounting rule.

There’s a simple solution to this issue, and it’s one that could be signed by Congress, the Chairman of the FDIC or the Federal Reserve Chairman tomorrow. It would require no special legislation, no specific Congressional approval or any type of intuitive thinking. We could allow the accountants to take their pessimistic and gloomy analyses and continue to reflect them on the financial statements for the world to know. This information could be disclosed in massive detail that only the nerdiest of nerds would understand. We could create transparency of information unlike any ever created before, and we could make this information available to each and every person who wanted to evaluate it, understand it, and act on it if anyone actually cared. However, we would not charge these write-downs against their regulatory capital and therefore, not reduce the bank’s lending capacity.

For those of you who continue to argue that it is important to value your assets on a fair market value basis, I want to point out that we have never done so before, so why is it so important now? This solution would solve everyone’s issues. The accountants and financial analysts would still have the information they need to evaluate the specific banks. However, the banks would have the regulatory capital to continue to lend, which ultimately supports the U.S. economy and how they make money. It’s amazing to me that a solution this simple seems so foreign to a government that has become too big to function.

If you think that mark-to-market has not been detrimental, just think about Wachovia and CitiBank. These are two of the most successful banking enterprises of our lifetimes, and they’ve essentially been put out of business due to this simple accounting mistake. I, for one, believe that the banks are little changed from where they were a few years ago. While it’s true that they’ll have bad debts due to the recession, I think these amounts are fully accounted for in their reserves for bad debts. These banks have gone through many recessions before and survived. What’s different now?

In fact, I believe that the banks are little different than they were on December 31, 2007, except the owners of these financial instrument’s common stock have lost 90% of their value due to the combination of bad accounting under the mark-to-market rule and the inability of our government to enforce guidelines on short selling and the uptick rule.

I think that if the simple solutions I’ve suggested are implemented, this big problem would be easily solved. Questions by inept, uneducated and overly political government officials and administrators welcome…

Wednesday, February 18, 2009

Did a U.S. Congressman Really Ask Jamie Dimon, J.P. Morgan Chase's Chairman, Whether His Banks Have ATM's?

From the Desk of Joe Rollins

It was surreal last week watching eight chairmen from the largest financial institutions in the United States being questioned by members of the U.S. Congress. For the large part, Congress seemed uninformed as they posed unintelligible questions to some of our country’s brightest entrepreneurs. This should be an embarrassment to all Americans. It is disappointing that we elected such unqualified representatives for the tasks with which they seemingly have no clue.

The rest of the world must’ve been more than mildly amused when Congress asked some of the most educated and intelligent financial minds in the world irrelevant questions, like whether or not they had anti-virus software. What was their point? I don’t know about you, but I didn’t feel much patriotic pride when watching those hearings last week.

I’m also completely blown away by Congress’s misremembering when recalling the past. Last week, Congressman Barney Frank of Massachusetts stated on CNBC that he had absolutely nothing to do with the problems concerning Fannie Mae and Freddie Mac. He stated that he had only become Chairman of the House Financial Services Committee in January of 2007, and that all of the problems were directly traceable to the Republican Party. He further declared that he had lobbied to rein in Fannie and Freddie during his years in Congress. I must’ve really startled Shaft, Daisy and Sam when I jumped completely out of my chair from hearing Barney Frank’s outrageous comments.

To see if my memory was serving me correctly, I checked YouTube to see if I could find anything to prove Barney Frank’s statements to be incorrect. Low and behold, I found footage of Barney Frank proclaiming that Fannie and Freddie were on strong financial ground and that the government should do nothing to restrict them from loaning all the money they could to potential homebuyers. I’m beginning to wonder if members of Congress believe that if they say things enough, the public will soon believe something other than the truth. How stupid do they think we are?

The Senate passed the economic stimulus package this past Friday, and President Obama is expected to sign it this Tuesday. While I have vast disagreements with many provisions of the bill, there is no question that it will do a lot more good than harm. Unfortunately, due to the nature of the new stimulus package, not much of it will have much of an impact during this year, when it is most needed. For example, it is unfortunate that our representatives did not approve a payroll tax decrease that would positively affect all American individuals and businesses immediately. So much for bipartisan politics in Washington! There couldn’t have been a more partisan pork barrel bill than what was approved.

We can disagree on where the money is spent, but there really can be no disagreement that any money spent helps the economy. It’s unfortunate that many of the provisions approved will not be spent for years to come, but I suppose to get anything passed, the spending bills that couldn’t be approved over the last eight years had to be thrown into this stimulus package. We will see if the stimulus package is effective or not as the years progress, but at least it’s off dead center and we can start moving forward.

It’s amazing how immune we have become to the word, “billion.” As Senator Everett Dirksen (1896-1969) is so famously attributed to saying, “A billion here, a billion there, pretty soon adds up to real money.” No one should ever lose sight of the sheer volume that’s involved in this stimulus package. Nothing before this stimulus package, and likely nothing after, will ever reach this massive scale. I am not in the least bit concerned that this amount of money will not stimulate the economy. Clearly, I disagree with some of the provisions is includes, but I still believe that it will be successful in the long run.

The troublesome part of the stimulus bills is its direction. There’s significantly more money allocated in this bill for the arts than there is for small businesses that create three out of four new jobs in this country. In any event, the bill has been enacted and now it’s time to move forward.

To try to determine the magnitude that this amount of spending entails, I performed some research. As I have written previously, it was not the New Deal that pulled America out of the recession in the 1930’s; it was the beginning of the arming up for World War II. The United States first incurred deficit spending to provide the military armaments and personnel for World War II which pulled the sluggish U.S. economy back into positive GDP growth. It is well documented that the entire cost of World War II was $288 billion. To put that amount in perspective, it’s important to realize that the new stimulus bill is $800 billion – four times the actual amount of money spent over the entire duration of World War II.

In response to those who might point out that money in 1941 does not equal that of 2009, I have already taken that into account. The $288 billion spent in World War II would be $5 trillion in today’s dollars. However, the money spent on World War II was over a five-year period, so basically in 2009 dollars, $1 trillion per year was spent from 1941 through 1946. With the new stimulus of approximately $800 billion, along with the TARP ($700 billion) and all the other money dedicated to fixing the banking issues (about $2 trillion), we are talking about injecting almost as much money into our economy in one year than what was injected in the entire U.S. economy for the entire duration of World War II. Wow! These amounts are almost unbelievable!

One of the most encouraging provisions of the tax bill was a major help to the residential real estate sector. A provision was included in the stimulus package that provided a $15,000 tax credit for each and every home purchased in the United States. I have personal knowledge of three closings that have been delayed because they are awaiting the passage of this particular provision of the stimulus package. In the hearings, this provision was downsized to allow first-time homebuyers only to be eligible for a tax credit of $8,000.

It’s a shame that Congress did not approve the $15,000 tax credit, since it would’ve been an immediate help to most Americans as it pertains to homeownership. In fact, bills like protecting the wetlands outside of San Francisco – which has no stimulating impact on the economy – were instead approved. Likewise, while provisions to give money to colleges are worthwhile and noteworthy, they really has no effect on stimulating the economy. In any case, Congress had the opportunity to approve a helpful bipartisan economic stimulus bill, and they elected to pass.

It is somewhat discouraging that President Obama has become such a negative critic of the U.S. economy recently. For running his campaign on an agenda of hope and change, I think his desire to pass the stimulus package has hurt consumer confidence. Over the last several weeks he has been forecasting that a catastrophe would occur to the U.S. economy if the stimulus package was not passed. In fact, it is rare that you ever hear a sitting president be so over-the-top in a negative manner regarding the U.S. economy. I sure wish we had a cheerleader rather than a critic. I can’t help but think that over the last several weeks, this avalanche of negativism coming from the Obama Administration has further prolonged the recession by further diminishing consumer confidence. Hopefully we will start hearing a more positive spin out of Washington now that the bill has passed.

On the other hand, I was encouraged when the Obama Administration appointed some strong, smart individuals to be a part of the finance team. Many of these individuals have been around government and finance for decades and they have prior experience in economic chaos; their seasoned opinions are well-respected by the business community. However, I’m starting to question whether President Obama is following their advice.

I couldn’t help but be concerned by President Obama’s quote from last week when asked about additional tax cuts to be added to the stimulus bill: “We have tried that strategy time and time again of tax cuts for the wealthiest few Americans. It only helped us lead to the crisis we face right now.” I can only hope that the President’s comments were based on his lack of knowledge on the subject, because if it was anything other than that, it was a complete untruth. Any study of the U.S. economy regarding the effect of lower taxes has always yielded the opposite result. Giving President Obama the benefit of the doubt, hopefully his new finance team will advise him of this mistake – or maybe he’ll figure it out by reading our blog!

The facts are fairly easy to document: Since World War I, the United States has suffered five major downturns. In four of them, the government cut tax rates. In each of the four out of five, an economic boom ensued after the tax cuts. There was only one major downturn when the government responded by raising taxes, erecting trade barriers and enacting massive spending programs to get out of the slump. Today we characterize that period of time as “The Great Depression.” These facts are not economic hyperbole. While it may seem intuitive that increasing tax rates would increase revenues to the government, this has never held to be true. Hopefully President Obama will get that economic axiom correct.

The most clear example of how cutting tax rates positively impacts the economy was in 1963 when President John F. Kennedy (incidentally, a Democrat) said that lower taxes meant higher growth. He even proposed cutting the highest marginal tax rate in the United States from 91% to 70%. After his death, these cuts were enacted and the country enjoyed an economic boom through 1970. Due to lower tax rates, the economy was very robust from 1961 through 1970.

During the 1980’s, Ronald Reagan took over an economy with a 21% prime rate of interest, double-digit inflation and staggering unemployment. Due to his implementation of lower tax rates, the economy quickly picked up to a GDP growth that averaged 3.2% in his eight years in office.

Even more interesting is that the economy continued on an upward trend until George H.W. Bush (“Bush Part I”) increased taxes in the late 1980’s, throwing the country into a recession. Of course, this ultimately led to his failure to be reelected. Even during the 1990’s we had great economic years under President Bill Clinton. But once again, he fell for the axiom that higher taxes meant higher revenues to the government. Late in his second term, he pushed through massive tax rate increases which, in fact, did balance the federal budget, but threw the country into a recession by 2000, his last year in office.

Even going back to 1921 through 1925, the same economic axiom held true. Under Presidents Harding and Coolidge, tax rates were slashed 25% and GDP rose at an annual rate of 3.4% in the four years after the tax cut versus 2% with higher taxes. As you may recall, the Roaring Twenties were strong economic years with GDP going up almost 50% through the latter part of the 1920’s.

A closer time period proves this axiom once again. When President George W. Bush (“Bush Part II”) took office in 2001, the country was already suffering a serious recession due to President Clinton’s tax increases. This coupled with the tragic attacks on September 11, 2001 threatened the economic stability of the United States. Due to massive tax cuts instituted by President Bush, the economy only suffered a minor one-quarter negative GDP growth and turned up for a significant and large economic boom all the way through the end of his final year in office. The economic evidence is so overwhelmingly crystal clear that for anyone to assert anything different indicates an improper education in reality.

I am often questioned as to how we will ever balance the federal budget if taxes are constantly being lowered. I see enormous hand-wringing and consternation by Americans regarding the increasing deficit, and not once have I heard a politician discuss the real answer to the deficit issue. Frankly, diminishing the deficit is easily attainable through reduced governmental spending. If our government would quit talking about higher taxes and address reduced spending, budget surpluses could quickly be attained. However, not until government officials honestly discuss government waste will we ever have a chance to stop burdening Americans with higher taxes year after year.

There are many troublesome aspects to the new stimulus package. One of the most troublesome is the federal government’s intervention in local school districts and federal subsidies of state deficits. There are a few things that our federal government should not get involved in. One, in my opinion, is that the federal government should not be making decisions for local school districts. I also believe it’s not the federal government’s job to bail out states that have unscrupulously and unwisely controlled their own budgets.

There is no question that turning federal money over to local school systems and state governments will stimulate the economy. I have no doubt that each will figure out a way to spend that money as quickly as possible. The question on my mind is if that is appropriate, smart and if the taxpayers throughout the entire U.S. should be subsidizing local economic projects.

In closing, I want to put the usefulness of this bill in context. It’s not exactly what we needed, and as President Obama has said, “It’s not perfect a perfect bill,” but notwithstanding its shortcomings, it will stimulate the economy. By this time next year, we should all be back on solid economic ground. I just wish everyone would take a deep breath and allow these numerous governmental programs to take effect.

The economic recovery will come, but it won’t be overnight. Give it a chance; I strongly believe it’s definitely in the cards in the coming months.

Friday, February 6, 2009

Smoot-Hawley & Me

From the Desk of Joe Rollins

I wanted to give my readers a little history lesson and discuss the Smoot-Hawley Tariff Act that was enacted on June 17, 1930. By many accounts, this law was one of the largest – if not the single largest – catalysts of the Great Depression. I was reminded of the Smoot-Hawley Tariff Act when I was reviewing the stimulus act currently being debated by the Senate and noted that it contains strict “Buy American” provisions.

When asked about the “Buy American” provisions in an ABC interview last night, President Obama said, “I don’t want provisions that are going to be a violation of World Trade Organization agreements or in other ways signal protectionism. I think that would be a mistake right now. That is a potential source of trade wars that we can't afford at a time when trade is sinking all across the globe.” It will be interesting to see whether the Democratic-controlled Congress will pass the bill over President Obama’s objection.

You might remember H. Ross Perot, who sought the office of President of the United States in the 1992 and 1996 elections. Perot was a funny little Texan who ran on the 1992 ticket as an independent candidate. Of course, during that time period the country was in a recession and Arkansas governor Bill Clinton was running on his, “It’s the economy, stupid,” slogan. In the end, Ross Perot took enough votes away from President George H.W. Bush to allow Bill Clinton to win the election. We all know that President Clinton went on to serve for two terms.

What brings Ross Perot to mind is that in the mid 1990’s, he ran a strong anti-NAFTA campaign. I can still remember him standing behind the podium, exclaiming that if NAFTA were approved, you’d hear a great “sucking” sound from jobs being sucked out of the United States and into Mexico. At that time, Bill Clinton and Al Gore were actively campaigning for NAFTA’s passage. Additionally, Ross Perot made the blanket statement that if NAFTA was approved, we would have over 1,000 banks fail in the United States in the coming year. It’s interesting to note that less than 100 banks have failed in the United States from 1992 through 2009.

In any case, Ross Perot was dead wrong on NAFTA. In fact, NAFTA created jobs not only in the United States but also in Mexico. This illustrates that free trade is the most important aspect we can have as a country. It allows us to export our goods and technology to foreign countries and allows those countries to export their products to the United States without the burden of tariffs.

During the Presidential campaign, it was interesting that President Obama was critical of NAFTA and is dead-set against the Columbia free-trade provisions. I cannot help but think that President Obama’s thoughts on those issues relates to his strong support by labor unions during the campaign. The provisions that are contained within the new stimulus act principally state that infrastructure projects carried out under the program use U.S.-made steel and iron ore. Once again, this is a bill sponsored and financed by the American labor unions to protect American jobs. President Obama has already pushed through and signed two major labor union-sponsored bills that clearly will be a detriment to business. I don’t know about taking the influence out of government, but clearly these were passed as payback for campaign contributions.

There’s important new legislation coming up that will test President Obama’s campaign pledges. Even though only 12.4% of the U.S. workers are under labor union contracts, those same unions provided enormous support for the Obama campaign. There’s a new bill that will be introduced shortly called The Employee Free Choice Act, more commonly referred to as the “card check” bill. Basically, it’s designed to promote unionism in American industry.

Rather than have a secret-ballot election by the workers as to whether or not they want a union, a union would be able to declare representation of the employees without the employer’s ability to object. It is a bill so un-American and so ultimately destructive to American industry that it’s hard to fathom anyone supporting it.

President Obama supported the bill before he was elected, although he hasn’t said whether or not he continues to support it in its current form. His decision, whatever it will be, will either put him in odds with the vast majority of the American industry or the unions that provided significant support to his campaign. It will be interesting to see whether President Obama is true to his word that he will not be influenced by campaign supporters by withdrawing his support from a bill that could encumber businesses.

If union representation was such a good thing, then why do only 12.4% of American workers unionize? I think the answer is obvious, and any bill that promotes unions would hurt our business opportunities in international commerce.

In any case, it’s important that we learn from our prior mistakes. Smoot-Hawley created very strict import duties for goods imported into the United States. In response, the rest of the world also created tariffs, which prevented U.S. companies from exporting into foreign markets. There has been no single bill that has universally been acknowledged as hurting the U.S. economy any more than the protectionist Smoot-Hawley Tariff Act in the 1930’s.

It was interesting to read recently what Dallas Federal Reserve President Richard Fisher had to say about the “Buy American” provisions in the current proposal: “Protectionism is the crack cocaine of economics. It provides an immediate high that leads to economic death. We cannot afford to go down that route.” Fisher is a nonvoting member of the Federal Reserve’s policy setting committee this year.

I only hope that when the Senate revises the stimulus act, any protectionist provisions are eliminated. While it is intuitive to indicate that we should buy American, it’s important to consider the consequences. While it may benefit union members in the United States, they are currently a vast minority. That means that 87.6% of the U.S. population would have to pay a higher price only to protect the jobs of the 12.4% that are covered under labor union contracts.

The worst thing about protectionism is that it may cause other countries to institute their own form of tariffs. Given the current economic softness in the economy, we cannot afford for us not to be able to sell exports.

The devastating effect of the Smoot-Hawley Tariff Act is well-documented. Let’s not make the same mistake.

It was interesting to read about the elections in Iraq last weekend. I saw very little information on the news regarding the elections, but I was able to read the full accounts in the New York Times. The New York Times has had reporters in Iraq during the entire war. I often thought the coverage was biased, but frankly, it was the only source of information on what was really happening on the ground in Iraq. It was a breath or fresh air to see the Kurds, Sunni and Shiites casting their votes throughout the country. It’s reported now that only 50% of registered voters voted in the election – about the same as in the U.S. Perhaps voters in Iraq has become just as apathetic as voters have been in years past in the United States.

Additionally, it is not unsurprising that there were many challenges to the votes. I suppose this is typical for most democracies – just look at West Palm Beach, Florida in the 2000 U.S. Presidential election!

What I find strange about the election in Iraq and the minimal corresponding press coverage is the incredible importance of the event. Perhaps it didn’t sink in that a nationwide election was occurring in an Arab country for a freely elected government. It’s hard to even imagine that after the generations of dictatorships and infighting in Iraq that it is possible they could govern themselves on a democratic basis.

There was one clear loser in this election – Iran. Iran did everything in its power to influence the election and put in Muqtada al-Sadr as the de facto influence in Iraq. For the most part, Iran’s actions were unsuccessful. As Iran falls further into economic chaos due to the low price of oil and their young population protests more violently against the radical Islamic administration, it cannot be anything but positive to see a freely elected democracy next door.

For all of those who declared Iraq to be an ultimate failure and a disaster, the democratic voting should disprove those statements. While it may not be a perfect democracy, Iraq is certainly significantly better than it was under Saddam Hussein’s dictatorship. While we all could debate whether or not it was prudent to ever begin the war in Iraq, no unbiased person could say now that we did not give the 28 million Iraqis an opportunity for a better way of life. Congratulations to them, and now let’s get out of their way so they can succeed (or fail) on their own without the U.S.’s involvement.

Thursday, February 5, 2009

Where Did All the Money Go?

From the Desk of Joe Rollins

We received some interesting questions from a Rollins Financial client over the weekend that we think our blog readers have also likely wondered about over the past few months. He asked what happened to all the money that used to be in the money supply. Since at some point life was good, stocks were up, property values were strong and people had money to spend, why and how is the world is now broke? Where did all the money go?

He also wondered what happens when the government pumps a bunch of money into the economy (like they’re doing with the stimulus package). Once it starts gaining traction, would we not be at risk for inflation? He also inquired why any asset wouldn’t be a good investment in a pre-inflationary environment.

Lastly, he asked how long it took for our economy to recover after the Great Depression. These are all great questions that I’ll try to answer in this post.

First, the money supply is basically fixed. There are two basic types of money supply (cash): the money supply held by non-governmental sources and the money supply held by the government itself. When you read about various forms of money supplies, they are typically referred to as M1, M2, and in prior years, M3. These are the different types of money in circulation at any point in time. It does not refer to the amount of money held by the government, which is periodically drained out of the system to better control inflation.

When the government wants to inspire further growth in the economy, they flood the money supply with excess money (I will explain this in greater detail later in this post). Conversely, when the government wants to restrict growth, they’ll drain cash out of the system, strangling the economy for the lack of cash.

The way the government handles the money supply can be thought of much the same way as adding kindling to a fire: Kindling is placed on a flickering fire to make it more robust, but if your goal is for the fire to burn out, then you wouldn’t add any fuel (or kindling) to it. This is essentially what the government does with cash.

While there is a fixed amount of cash in the money supply, there is a difference between the cash held by the public and the cash held by the government. Even though you may not realize it, there’s an enormous amount of cash in the U.S. economy at the current time. At one time, the U.S. stock market was twice as large as the cash in available money market accounts. Due to investors getting out of the stock market and conserving their cash, commercial money markets today exceed the total value of the listed securities on all of the exchanges.

This is an unusual circumstance, particularly in this era of historically low interest rates. Even though many forms of securities provide returns two to three times the total rate of return on cash from money market accounts, many investors are unwilling to take the risk associated with seeking those higher yields. I referred to this in Tuesday’s post, when I noted that investors were finally getting more comfortable with taking on risk in the marketplace. When investors feel comfortable accepting higher risk, they will move from the money market accounts back into higher yielding securities.

While it may seem that people suddenly have no money, this is somewhat of an exaggeration. During September of 2008, our government scared us back to reality. Due to their loud and continuous exclamations that the banking system was facing failure, consumers shut down their spending habits. It was just reported that for the month of December, consumer savings increased 3.2%. What is particularly unusual about this action by consumers is that it occurred during the Christmas season.

For the last decade, consumers have been hesitant to save money. They’ve basically continued to spend money which, of course, promotes additional commerce. In fact, by using credit cards and home equity loans, consumers have leveraged up and used those available resources to spend additional sums of money for things they could not live without. From September through today, consumers have been unwilling to take those same risks. Instead, they are accumulating cash in money market accounts and paying down their debts.

As pointed out previously, this risk aversion to spending money and paying off consumer debt has helped the consumer at the economy’s expense. Accordingly, the consumer is in a better financial condition today than in some time; they’ve saved money, paid off debts and now hold cash reserves for potential further economic downturns.

We have now gone through about four months where consumers have not utilized cash they earned from their employers to buy consumer goods. At some points, consumers will revert to using that cash to buy products which will, in turn, stimulate the economy.

The main problem with the auto companies in the U.S. (and arguably, with auto companies around the world) is that consumers are unwilling to enter into a long-term financing arrangement to purchase a new automobile. It was recently reported that the average age of cars in the United States is older than it’s ever been – 9.5 years. Never before have Americans continued driving cars that are this old. Some of this is because cars produced today are of higher quality than in prior years, but I suspect much of it has more to do with consumer skepticism on incurring new debt.

Additionally, I don’t think the average person takes into consideration the cash held by major corporations when thinking about the economy. The last decade has been an extraordinarily profitable time for major corporations. Many of these corporations have accumulated vast amounts of cash in their operations. For example, Microsoft, Merck, Exxon Mobil and many other corporations have vast cash holdings. Each of the corporations mentioned have current available cash well in excess of $20 billion each. This enormous amount of stashed cash is not reflected in any reports regarding money market accounts.

In short, the amount of cash in the system today is not any less than it was when times were good. It’s just that the cash is allocated differently and to more conservative sectors.

The foregoing doesn’t, however, explain the reduction in wealth for hard assets. Cash is cash, which everyone understands. It’s essentially worth about the same year-in and year-out. However, asset values are an entirely different matter.

Take, for example, a block of identical houses, where every house on the block has the exact same features, qualities and amenities and are all valued at $100,000. However, due to circumstances beyond anyone’s control, one of the homeowners is forced to sell their house under extreme conditions and finds an opportunistic buyer who pays them $80,000. Even though none of the other houses on the block had any part of this transaction, each and every remaining homeowner will take a steep downward valuation of their net worth of 20%. Of course, the same thing happens on the upside, but that’s not what’s been occurring recently.

The same thing happens with listed securities. When one buyer sells a stock at a reduced price, then all holders of that security suffer. Even though the remaining holders were not a part of that transaction, they all suffer proportionate to the person selling the stock at a reduced price. Over the last year and a half, we have seen a massive reduction in the value of assets due to the revaluation of real estate and the downward valuation of listed securities.

One of the most frustrating aspects of watching the national financial news is the tendency to over-extrapolate. I hear all the time that if prices continue to go down, they will one day reach zero. While this may be true from a mathematical standpoint, the explanation is wrought with a lack of financial reality. I’m often asked how low house prices can go. While there is certainly a limit to how far down prices can go, it all has to do with the available supply and demand. As long as there are more houses for sale than people buying them, housing prices can continue to go down. As explained above, each time prices go down, every other similar house will take on an equal or lesser value.

As defined under the economic theory of supply and demand, at some point the supply of homes will equal or be less than the number of corresponding buyers. When builders can no longer build homes for a price that buyers are willing to spend, they will stop building. This is exactly what’s happening in the U.S. today; there are very little new homes being built. As the chart entitled, “U.S. Houses for Sale: Thousands: NSA” illustrates, we are now sitting on an inventory of homes equal to the amount of homes we had in 2004, which was a very robust economic year.

I recognize that those who are pessimistic about the real estate market would say that this does not address the issue of the new homes entering the market due to foreclosure. My thought is that at some point, even those homes will be acquired by ready buyers. With the government’s proposed housing stimulation credit of $15,000 and the potential for government-guaranteed loans at 4%, we will soon see homeownership available to almost anyone who can afford an apartment. Since the government will be furnishing the down payment in the form of a tax credit and interest rates will be at all-time historic lows, every renting person with good credit should be able to afford a home. Click here to review my “Fixing the Housing Crisis” blog posted on for more details. Interestingly, the proposal that the government is now considering is exactly what I proposed in that post. It just goes to show that the private sector moves at warp speed compared to government bureaucracy.

While no one can exactly predict when a bottom in the real estate market will occur, you cannot help but think those days are drawing near. With the downturn in the number of new homes being built along with the current extraordinary and favorable buying terms, inventory levels will quickly be exhausted and new home construction will recommence.

The more important part of the question relates to how the flood of money the government is pushing into the economy affects future economic activity. As discussed previously, the Federal Reserve goes directly to the banks they control under the Federal Reserve System and buys government securities from them. Essentially, all the banks are covered up in cash today. Contrary to what you read, the issues with the banks have never been about liquidity. They all have plenty of available cash to loan. However, they’ve taken such large hits on the write-downs of their unmarketable securities that it’s affected their statutory capital requirements. Therefore, they could not lend even if they wanted to do so.

In an ironic twist of accounting, the SEC has required the banks to write-down these illiquid securities to a level far below their fair market value. By virtue of writing them down, they’ve reduced their regulatory capital and restricted their ability to lend. On one hand you hear Congress saying that banks should be forced to lend, yet a government division is restricting the banks’ lending ability. While the write-downs make big news in the financial press, they do not affect cash flow. This is because it strictly has to do with bookkeeping and has nothing to do with profits.

Banks are currently covered up in cash that they can do very little with. CD and money market interest rates are falling off a cliff. Banks simply do not care whether they write new CD’s and gain more money market assets. There’s virtually nothing they can do with these assets to earn anything, and therefore, holding them is detrimental to their financial situation. In fact, the banks are paying back to the U.S. Treasury TARP money at a 5% rate. If they are just holding that cash in the bank, it is impossible for them to earn 5%. At some point the banks will be forced, for their own self-preservation, to begin lending money. The so-called experts who pontificate about banks being unwilling to lend just do not understand the profit motivation of current banks.

When I was researching Bank of America yesterday, I noticed that they currently have on their balance sheet one-quarter of a trillion dollars on deposit in non-interest bearing checking accounts. Essentially, they have a quarter of a trillion dollars of client money that they are not paying a single dime for that is available for lending. If a bank could lend that money at even the prime rate, they would make a spread between the cost of money and its earning ability at a rate higher than has been earned by banks in decades. I forecast explosive bank profits in the coming years. They’ll have the potential to make more money in the coming years than ever in their history.

The other component of fiscal stimulation by the government is represented by the new $900 billion stimulus bill currently being debated. Notwithstanding my criticisms and recommendations, it’s almost absolutely clear that some version of this bill will be passed within the next two weeks. A very simple illustration of the magnitude of this bill is in order.

You may recall that in the early part of 2008, Congress passed a stimulus bill wherein approximately $150 billion was pumped into the economy via tax refunds. While this is certainly a lot of money, it was arguably not enough money to make a huge difference. The problem with that stimulus bill is that it went to many higher paid people who saved it or paid down debt instead of spending it. Many of the provisions in the current stimulus bill solve that problem by putting tax refunds in the hands of people who are more likely to spend than save.

There is an economic term called the “velocity of money,” which states that money is spent seven times before it’s exhausted. For example, if you purchased $100 of goods from the grocery store, that is the first step in the velocity of money. The grocery store would take that money to help pay its employees and vendors. In turn, the employees would buy consumer goods, proliferating the money cycle. Therefore, for each dollar spent in the economy causes a compounding effect of seven times that original amount spent, creating seven times that amount in new GDP.

If you realize the magnitude of the numbers we are discussing, you can see the issue. If the bill is approved at $900 billion and the velocity of money is seven times, then the resulting GDP would be $6.3 trillion. The expected GDP when dealing with numbers this large is almost incomprehensible. If GDP increased by $6.3 trillion due to this stimulus package, that would be an economy larger than every economy in the entire world except the United States. We are talking about a number that would potentially increase GDP by an amount greater than the economies of Japan, China and all of the European countries.

A new term has entered the vernacular recently. You may have read where the government is purchasing $500 billion in governmental and mortgage-backed securities. Their goal is to reduce interest rates by buying these securities and holding them in the Treasury. I often read in the financial press that the money buying up these securities has been “monetized.” This is “Fed talk” for them going out and printing new money. The Federal Reserve is usually reluctant to print money because of the potential of future inflation. But in this particular case, they thought the need justified the risk.

Basically, the government prints new dollars and then uses them to purchase bonds and securities. This newly printed money is in addition to the TARP money and the new stimulus money. If you’ve lost count, that’s $700 billion (TARP) + $900 billion (new stimulus) + $500 billion (monetized) = $2.1 trillion. The person who sold those securities now has cash, and the investment opportunity and earning capacity of cash is extraordinarily low. Eventually those who have traded in their securities for cash will seek higher returns. This taking on of additional risk by the holders of cash will generate higher returns which will force-up equity values.

My client asked how this money will help the economy and when we will see some positive results. These tax reductions in the stimulus package will almost immediately positively impact the economy. Taxpayers will have available cash to spend on consumer goods; retailers will see an uptick in business and will have to hire more employers, and all of this will generate additional cash flow into the economy. First-time homebuyers will be able to purchase inexpensive homes with the government providing the down payment and they will also have very low interest rates. The owners of the homes being sold will move up to middle level houses and those in the middle level houses will move up to higher level houses. Since the number of people able to afford homes is being vastly increased, shortly thereafter there will be a scarcity of new homes, creating new homebuilding.

The banks will be awash in money at unprecedented levels. They will be forced for their own self-preservation to loan this money, impacting the economy. As small businesses get this money they will be able to build new plants and purchase equipment, pay employees and suppliers. The answer is forcing the money into the economy, and it is coming like a freight train and will be in the economy over the next six months.

Most economists are forecasting the economy to get better in the second half of 2009. As we sit here today, we are only six months away from their projected better economy. I find it distressful to hear forecasts of a recession that will go on for a decade. Either they are not educated in economic terms or they believe we are in a new era where traditional economics no longer works. Obviously, having gone through many economic cycles in my professional career, I am unwilling and unprepared to assume that economics no longer works and that capitalism needs to be abandoned.

Finally, there is no question that all this money will create inflation. In all likelihood, this inflation is several years down the road, but it will come at some point. All of this money sloshing around in the economy and seeking out new consumer goods and assets under the most basic economic term of supply and demand will increase their values. Home prices will go up, equity prices will go up, and virtually everything will cost more.

While inflation can be damaging to an economy, it can also be productive. For example, a business that holds a large inventory of goods for sale gets an increase in net worth when inflation makes the stock inventory more valuable. However, as with anything, too much inflation is a negative. When the government determines that inflation is too high, it will drain the cash it is currently investing away from the economy. Frankly, given the difficult economic era in which we live, I look forward to the day when the government begins draining away liquidity rather than injecting it.

The last question was how long it took the U.S. economy to recover from the Great Depression. I pointed out in my post, “Reminders of My Father’s Sermons,” for many years I incorrectly thought that the FDR’s “New Deal” was a raving success. My incorrect belief was that the economy’s recovery was due to FDR’s spending under the New Deal. After reviewing this matter in detail, I discovered that the economy did not improve until about 1941. Therefore, the Great Depression lasted an entire decade. Even as the U.S. began gearing up for World War II, the unemployment rate at that time was still 17%.

However, it’s impossible to compare the Great Depression to today’s U.S. economy. There were no backstops to the economy in the 1930’s – there was no unemployment insurance, no Medicare, and no Social Security. Welfare and food stamp programs did not exist. Therefore, when people were laid off from work, they had nothing to fall back on to help with their finances. People who were old, sick or unable to work were basically left to be begging on the streets.

Many of the troubles during the 1930’s were solved for today’s world because of the financial backstops that were subsequently instituted such as unemployment insurance, welfare and food stamp programs and Social Security. Even today, the Congress is moving to extend unemployment insurance to a full two years after an employee is terminated. While all of us can argue whether that is a good or bad thing, none of us could argue that it’s not a good thing for the person who lost their job and is struggling to find work.

The main reason that the New Deal didn’t work under FDR was because he refused to incur deficits in governmental spending. He was willing to spend the available money, but did not want to spend anything more. In contrast, the current bill being debated by the Senate, 100% of the $900 billion price tag of the new stimulus bill will be deficit spending. As pointed out before, if the velocity of money is truly seven times the GDP that will be created under this single bill is vastly greater than the GDP of the entire United States in the 1930’s.

While it’s true that it took 10 years for the economy to improve from the Great Depression, what we have now is completely different. With the massive influx of cash into the economy, I would anticipate a significant recovery in the economy within the next 12 months.

I did not set out to write a long dissertation on economics, but since it is so important to today’s economic environment I elected to go through the entire explanation. For those of you who do not believe economics works anymore, I highly recommend you refer back to this posting in 12 months to determine the credibility of the information I have provided. While we receive a lot of questions from our blog readers, it’s not practical for us to address all of them on a national blog. We usually answer questions on an individual basis, but this time I thought the questions were important enough to all of my readers that I wanted to take the time to fully answer them.

As always, thanks for taking the time to read the Rollins Financial blog. Please let us know if you have any questions or comments. Best regards.

Wednesday, February 4, 2009

The Pork Train

From the Desk of Joe Rollins

I don’t think many of us could argue that the economy needs some form of stimulation right now. However, the bill currently being debated in Congress is completely misplaced. First, it is way too big. It also isn’t concentrating on the areas it needs to be and, unfortunately, it’s loaded down with too much government pork.

We all had great hope that President Obama would bring a new accountability to government. He campaigned on the concept of transparency in government and would eliminate pork barrel projects and government favoritism. Unfortunately, this bill belies that campaign rhetoric.

Unlike many of the commentators in the press, I want President Obama to be the most successful president ever. Actually, that’s how I feel when every new president enters office, even those with whom I disagree. I was raised to respect the office and to support the cause. I believe the cause is greater than any petty feelings individuals may have.

You may have read Rush Limbaugh’s famous quotes from last week, when he exclaimed that he wanted President Obama to fail. When I first read those comments, I was outraged. How could any American, regardless of political leanings, want any sitting president to fail? In re-reading what Rush Limbaugh actually said, it became clear to me that the quote was taken out of context. In fact, Rush said that he wanted liberalism to fail. This is still a strong statement made by someone who is inarguably a jackass, but it certainly isn’t the same as wanting a president to fail.

I have often argued in these posts that the TARP was not an expense to the Treasury. I truly believe that the Treasury will get if not all a vast majority of the TARP money plus the income it earns. To characterize that $700 billion as an expenditure that will create future deficits is done solely for negative and uninformed emphasis. The reality is that in all likelihood, that expenditure of funds, when finally expended, will not create a negative to the budget. Remember that to date, only 27.9% of the TARP money has actually been turned over to the banks (view the list in PDF format).

However, the new stimulus act of close to $900 billion will be harmful to the budget. First and foremost, the real problem with this proposal is that it is untimely. In fact, some of these programs will not even be funded until the last year in President Obama’s first term. I suppose the questions all taxpayers need to pose is why we are approving on an emergency basis an expenditure of funds that will not occur for three years? We have years to debate and approve those expenditures. Why do we have to do it in three weeks?

I have no real problem with the $250 billion in immediate tax refunds to lower income taxpayers. These funds will enter taxpayer pockets relatively quickly, and since it is focused on lower income people, the money will be spent immediately. The problem we had with the last similar rebate in 2008 was that much of the money was saved or used to pay off debt. I think it’s fairly clear that this $250 billion will be immediately expended, creating commerce and jobs. I suppose no one could have any real disagreement with the disbursement of these funds.

I do have many concerns regarding the disbursement side of the stimulus act. First, there is the issue of selecting who or what receives the funds. By virtue of these funds being approved by Congress, you have the inevitable concern regarding whether there are special interest groups supporting the money. Clearly this has happened in this appropriation. Many estimate that the amount of pure selective pork in this bill borders on a quarter of a trillion dollars. That’s not to say that these projects wouldn’t provide some benefit to the counties where the money is spent, it’s just that it raises the question as to whether the money is being spent in the right place and if it provides the economic stimulus we seek.

There were two very interesting opinion articles posted in The Wall Street Journal last weekend. The first, “How About a Payroll Tax Stimulus?” was written by Lawrence B. Lindsay, former Director of the National Economics Council and the Assistant to President George W. Bush on Economic Policy. His idea is to immediately reduce payroll taxes by 3% for both the employee and the employer. By doing so, there would be an immediate increase in the take-home pay of the employee and of the company’s employing them. This simple proposal would immediately stimulate the economy without any selectivity and would help employees and employers alike. There would be no question that everyone would benefit, since everyone pays Social Security tax. It would help employers hire people and not lay off their existing employee base. I think it’s a brilliant proposal without all the politics that the current stimulus bill proposes.

There was also an opinion article in The Wall Street Journal from Rush Limbaugh entitled, “My Bipartisan Stimulus.” The point he makes regarding corporate taxation is particularly important, although the rest of the article is silly. The United States has become totally out of touch with corporate taxation in the world. Many companies and employers avoid the U.S. due to its high tax rates and regressive litigation for employers. A significant reduction of the corporate tax rate would easily encourage new employers to come to this country, employ people and create a new economic vitality that is needed.

If you want to read an interesting concept, I suggest you read Neil Boortz and John Linder’s book, The FairTax Book as it pertains to corporate taxation. Their theory is that corporations pay no taxes anyway, and by reducing them to zero, all Americans would benefit. If we had zero tax rates by corporations, there would be a flood of companies located outside the United States that would come here and employ people. Additionally, there would not be the billions spent trying to avoid taxes and the litigation that follows since there would be no taxes. This concept would work for all Americans.

The main problem concerning today’s economy is the lack of consumers. The answer to that problem is putting people to work. By virtue of bringing new employers to the country, we could get people employed. This would increase consumer spending and correspondingly increase the economy.

The other major issue regarding the proposed stimulus act is the funding of state and local governments. I have always believed that there needs to be a separation between State and Federal funding. This proposed bill essentially rewards counties and states that have run their municipalities poorly. Why should Georgia suffer when the economy is run well while California benefits when their economy has been run into bankruptcy by their totally irresponsible social spending. I understand that it would be great for the Federal government to fund a building project in Gwinnett County, but that’s not the Federal government’s responsibility. That is the responsibility of the taxpayers who benefit from the school.

Secondly, I question whether any school could be built in the period of time that would benefit us now and would help employ people. More importantly, why should the Federal government fund a project that would have been funded anyway? There are many Americans who no longer have children in the education system, but as taxpayers to the Federal government, they are funding a high school project in a city or town that is far removed from their local community. Frankly, I think this entire part of the stimulus bill is misplaced.

There is no question that a stimulus bill of some size and description will be approved shortly. The worst thing that could possibly happen would be that the stimulus bill takes on a life of its own. If the economy improves in the second half of 2009, will we even need this extra expenditure of money in 2010 and 2011? There is an infinite risk that this money will come into the system when the system is already robust. This increase in flow of funds will create inflation and negative economic aspects. The stimulus bill needs to encompass a short period of time and be highly correlated to giving people extra spending money. The bureaucracy that will be created to disburse this gigantic sum of money over many years is misplaced in its economic effect.

Since the beginning of former President Jimmy Carter’s administration in 1976, the number of federal and state employees has exploded. Please see the chart below entitled, “Government’s Productivity Problem.” Even though the rest of America has used computers, state-of-the-art technology and other resources to increase productivity, the local, state and federal governments have no incentive to be even remotely productive. In fact, due to the bureaucracy, hiring policies and an inability to terminate for incompetence, most governmental agencies thrive on their lack of productivity and only add more staff. If the government was truly interested in reducing costs, they would stop this disgraceful climb in governmental employees.

The solution to the government’s problems is very simple. Virtually every division of government could be privatized. There is absolutely no reason why we have 22.5 million people working for the government and being paid by taxpayer dollars. If these bureaus and divisions were privatized, then there would be accountability to the taxpayers and productivity would rise dramatically. Except for our military, there is a high likelihood that well over half of these government employees could be privatized tomorrow. If any politician really wanted to address the issue of bloated costs, they could attack this problem tomorrow.

Isn’t it interesting that as more and more workers are laid off in the private sector during the economic downturn that the government continues to add more and more jobs, which are dependent upon higher and higher taxes? Additionally, each of those jobs is irrefutably destined to become non-productive and a drain on American resources.

I am not a fan of commentary where the writer only criticizes but never offers solutions. It is relatively simple to see that the government should return to the taxpayers their money for them to spend however they want. Yes, the economy needs a quick burst of funds, and the tax refunds will accomplish that immediately. The last thing it needs is a creation of a governmental bureaucracy to disburse funds in a political way to recipients who probably don’t need it, and certainly not in a relevant timeframe.

There is plenty of time to properly debate and discuss the spending appropriations in the coming months. Approve the tax refunds now for a quarter of a billion dollars and let the rest wait three, six or nine months to see whether they’re actually needed. I am highly uncertain as to whether, come September or October of 2009, we will need this type of spending to stimulate the economy. Notwithstanding whatever the economy is doing at that time, I am positive that paying off the debts created by this misplaced bill will affect all of us for generations to come.

It is now time for all of us to remember the advice given by President John F. Kennedy. As he said in his inaugural speech, “Ask not what your country can do for you – ask what you can do for your country.” It seems that our current financial situation has that phrase in reverse. The entire country is lined up for governmental handouts and bailouts. Now is the time for us to correct the problems of the past rather than look to the government for assistance.

Spending by the government will certainly stimulate the economy, but it will do so in a biased and political way, causing waste to the taxpayers to the tune of literally billions of dollars. In my opinion, a much smaller and simpler stimulus bill will accomplish the goal of stimulating the economy without these forms of political abuse.

Hopefully once the Senate takes up the bill this week improvements will be made and our taxes will not be increased to fund a bill that will go on for years after it is needed.

Of course, these are just my thoughts. I could be wrong.

Tuesday, February 3, 2009

It Was Fannie Mae and Freddie Mac, But Now It's "Crappy Mac"

From the Desk of Joe Rollins

First, several readers from my "No One Warned Me That Old Yeller Was Going To Die!" post a few weeks ago wondered why I only discussed my Labs, Shaft and Daisy, and made no mention of my Siamese cat, Sam. All of my pets, including silly Sam, are a huge part of my family. In an effort to smooth things over with Sam, here’s a picture of him with his adopted mama, Daisy. He’s a funny little guy, and he brings all of us a lot of joy.

This week, I want to discuss how most people experience things throughout their lifetimes that force them to open their eyes to what’s going on around them. These are not always earthshaking events – sometimes things happen that simply make people view their surroundings in a different light. An instance of eye-opening experience happened to me when I was playing high school football.

In my high school, boys were required to play in every sport offered, which meant I played basketball, football, baseball, and track. In many cases, we played both offense and defense in football. In those days, it was not considered to be a disadvantage or a burden to play both directions. I wanted to play all the time, whenever I could get on the field.

I was lucky that during my entire high school and college career playing sports, I was never hurt. I never broke a bone, and as far as I can recall, I never missed a minute of playing time because of an injury. I suppose that’s why this event is etched in my mind forever…

On my high school football team, I was both a defensive end and a wide receiver. I may be slow to move now, but back in those days I could actually run faster than anyone else on the team. The fact that I was taller than most defensive backs made me a ready-target to catch passes.

I was also the “gunner” when the team was punting, which meant that I had to position myself far outside the main line and be the first to get down the field and cover the punt. Since I was generally faster than the defensive backs, that proved to be a relatively easy task, and I actually got to be good at punt coverage. I cherished the position – it was just too much fun running down the field to hit the guy who was distracted in his attempt to catch the punt.

One time, when playing our local rival high school, I was covering a long punt. Usually, when I broke through the defensive backfield, I could run unimpeded to the catcher of the ball. But that particular night, I watched the ball from behind through the bright lights to the south of me while running towards the catcher to the north. Almost instantly I ran into what felt like a brick wall – it was the most crushing blow I had ever received on the football field. One minute I was running at full speed, but the next moment I found myself laid out on the playing field with birds and stars circling my head.

As I dazedly looked over, I was certain I was hit by the biggest, meanest defensive lineman in the entire world. I had never been carried off a football field before, but as I lay in pain barely unable to move, that possibility suddenly seemed very real. I thought it was an enormous player that knocked me down so severely, and although I could hardly move my head, I was able to see the player that had hit me so hard. It was a 5’7” runt, who couldn’t have weighed more than 140 pounds dripping wet! I couldn’t believe that a kid of such small stature could inflict so much pain on me.

After I realized who had delivered the blow, I quickly jumped to my feet and ran off the field. I had no intention of giving the other team the satisfaction of knowing that such a small teammate inflicted that much pain on an opposing player. This incident was a wake-up call that impacted the rest of my football playing days. Never again did I run down the field while looking over my shoulder to cover a punt.

First, let me say that I am not a conspiracy theorist. I’ve always thought that Lee Harvey Oswald was singularly responsible for JFK’s assassination. Likewise, I am totally convinced that Elvis Presley died on August 16, 1977 (quite unceremoniously while having a private moment in his bathroom.) I also believe that the Apollo 11 mission actually happened, and that lunar-landing footage wasn’t created in Hollywood by our government. Lastly, I have never for a second believed that a UFO crashed in Roswell, New Mexico in 1947. Perhaps I’m too pragmatic to believe in conspiracy theories.

Something I do believe, based on personal experience, is that the government is often completely incompetent. As a CPA, I have had to work on IRS matters my entire professional life. Those experiences have undoubtedly shaped my opinion that the government is all too often totally inept. I’m not necessarily talking about the people working for governmental agencies as much as the system itself.

It seems that the way to get ahead when working in government is by never saying yes. If they say yes, then they’ll be held accountable. For most government workers, that means never giving a straight answer. If you think that’s cynical, then try calling your local DMV to ask a simple question. If you’re able to get through, I bet you don’t get a simple answer. The same thing applies if you call the Social Security Administration. No one in that organization ever seems to be able to concisely answer even the simplest question. The government does things the same way day-in and day-out, not because they’re right or wrong, but because that’s the way things have always been done in the past. Innovation and creativity are not sought-after qualities for governmental employees.

There is so much going on now in our government that it’s hard for me to even begin addressing the issues. However, I’m sure most of the readers of the Rollins Financial Blog are more concerned about the stock market than my thoughts on our current government, but since they are so intertwined regarding economic reality that I feel I need to address them both.

The title of today’s post refers to the “bad bank” concept currently being discussed by the new Obama financial team. Some think that the way to overcome toxic assets is by the government buying them all and selling them to the private sector systematically over time. While this isn’t a novel idea – and is actually one that was originally proposed under the original TARP plan – it is totally unnecessary in my opinion.

The banking sector is already experiencing a significant improvement and we just need to give it more time to work. My opinion is that we all need to take a deep breath and use common logic before committing to governmentally run projects that we will spend a lifetime unraveling. As I am sure all of you are aware, once a governmental project is in place it is difficult, if not impossible, to eliminate it. However, if the project is not needed anyway, it might just be better to avoid it altogether.

As for the financial markets, they were a disaster in January. However, there is no question in my mind that the market makers are attempting to hold down this market – not for economic reasons, but for selfish reasons – to generate wealth for themselves. While this isn’t illegal, I question whether the damage they are doing will not be long-term.

For the month of January, the Dow Industrial Average was down a whopping 9.6%; this represents the worst January performance ever in the Dow’s history. The Standard & Poor’s Index of 500 Stocks was down 8.4%, the NASDAQ Composite was down 6.3% and the Small Cap Russell 2000 was down an enormous 11%. While there is no question that these numbers are terrible, they are somewhat questionable. It’s unusual and depressing that for the last two trading days in January, the indices were off over 5% each. It’s no coincidence that the Dow Industrial Average ended at exactly 8,000 in January’s final trading day.

In previous posts, we discussed how the commercial credit markets are now opening up. The important three-month Libor rate is now stable and within acceptable levels to the Federal Reserve. For the first time in a several months, January showed a very positive return in many bond positions. The junk bond market showed a swift upward movement, making approximately 6% for the month. This is the first month in about eight months that investors sought higher yields in riskier investments. Correspondingly, the long-term Treasury bond returns made a significant negative return, losing over 8% for the month. The very important 10-year Treasury bond has gone from a yield close to 2% only three weeks ago to an incredible move to 2.8% on Friday. There is clearly something positive going on where investors are seeking higher returns.

In tomorrow’s post, I will discuss the new stimulus tax act and why it is misplaced and excessive, but today I want to focus on the issues regarding the movement by investors from risk-free investments like Treasury bonds and into high-yield investments like long-term bonds. There is clearly a rotation occurring, and when it’s complete it will eventually impact equity prices.

It’s also clear that the redemptions from equity mutual funds have slowed or stopped. Supposedly, the infamous hedge funds have now completed their redemption and their deleveraging clearly reflects positively on an upcoming better equity market.

The reason I feel the current stimulus bill is misplaced and exaggerated is because it hasn’t given the original TARP bill enough time to function. Below is the cover of last week’s BusinessWeek, entitled, “BROKEN BANKS: The Bailout is a Bust [and the Sooner We Realize It, the Better.] The title is certainly attention-grabbing, but its truthfulness is questionable.

So you know the exact intent of the original TARP bill, I will reflect upon its history. It was originally approved during the height of the credit squeeze to pump $700 billion into banks to stabilize them for the future. While that feels like a lifetime ago, we’ve actually not given the TARP enough time to work. Many readers of this post may be shocked to discover that as of today, only $194 billion of the original TARP funds have been deposited in the banks, and a large sum of that amount was only deposited recently. The very first payment out of the TARP occurred on October 28, 2008. Basically, the program has only been functioning for 90 days, and within those 90 days were the Christmas holidays, a time where historically very little business transacts in the U.S.

Are you as shocked as I am that BusinessWeek has proclaimed the program a failure when it has only had 90 days to work and only 27% of the money has been put into the system? It is hard for me to believe that the press is so anxious to write a story that they completely refuse to research the facts before making such aggressive allegations.

The single complaint I hear time and time again in the news and at cocktail parties is that the banks are not loaning money. That statement is just not supported by the facts. You can personally check the Federal Reserve website to see the actual lending that has occurred, and that it is ongoing and increasing. Additionally, J.P. Morgan Chase recently took out a full-page ad in the New York Times to set the record straight. This bank received $25 billion in TARP funds in late October, 2008, but made over $100 billion in new loans during the fourth quarter of 2008. That is exactly what the TARP was designed to accomplish, and it is working. To consider it a failure on 90 days worth of results is premature.

The other reason for my optimism is that we are reaching a level in the credit market where more and more banks are telling the TARP, “Thanks, but No Thanks.” The Wall Street Journal reported on January 31st that over 50 banks have rejected aid from the government. Many banks are basically saying that they do not need the money and they clearly do not want the government establishing policies that would be detrimental to their shareholders.

Aside from military defense, the government does virtually everything worse than the private sector. The last thing most independent businessmen want is the government running of their operations. The reason that I believe that the “Crappy Mac” bad bank concept will not work is based on this exact same theory. First, many of the banks will not even participate (J.P. Morgan Chase has already publicly announced that they would not). The issues regarding obtaining these assets and managing them would be a task the government is imminently unqualified to perform.

While the assets held by the bank are worth less than face value, almost no economist believes they are worth as little as they are currently recorded on the banks’ books. The best thing for all banks and for Americans in general would be to allow the banks to deal with their own issues, do the best to collect these payments and suffer the losses if losses are to occur. The banks have clearly the best people to manage these assets and the government has no one. The taxpayers should not be put in the position of having the government deal with these assets by putting politicians who are clearly incompetent in charge of evaluating them.

It is troublesome that so many people are overreacting to the current financial situation. When the GDP was announced on Friday to be down 3.8%, it was also revealed that it was better than many expected. While it will possibly be further reduced, in all honesty this is not an awful percentage. The move to completely scrap capitalism in the face of a 3.8% negative GDP is discouraging. The U.S. economy has had an extraordinary run, and to believe that we would not ever suffer a down quarter is naïve.

Focusing on the GDP from the fourth quarter of 1982 through the fourth quarter of 2008, you will see that the economy has actually been very robust. In fact, during those 26 years, there have only been five down quarters. This means that out of 106 quarters, 101 of them have been up. One of the down quarters, of course, was due to September 11, 2001, and the other down quarters were minor in nature.

The pundits that now want to abandon capitalism after one of the greatest economic runs in the history of developed countries need to rethink policies. Even with the criticisms surrounding former President George W. Bush, the economy operated in a positive GDP up until the most recent quarter. Economic activity has been extremely strong and this short bump in the road should not push us into making economic decisions that we will regret for generations to come.

If you read the fourth quarter GDP report closely, you will see that the culprit to the economy’s downfall was consumers. There was a major drop-off in consumer spending during the fourth quarter of 2008. Given that our government scared us into thinking we were looking at potential economic disaster, would anyone question why consumers failed to spend? As soon as consumer spending is stabilized, which will occur simultaneously with consumer confidence, the economy will rebound. My belief is that those days are just around the corner.

I marvel every day at the low levels of bank stocks. On a client’s behalf I recently reviewed the financial information for Bank of America. As of December 31, 2008, Bank of America had a book net worth of in excess of $200 billion. They now have a market value of $30 billion. The combined companies of Bank of America and Merrill Lynch have the potential to make $10 billion in net profits to $20 billion annually. It is clear to me that fundamental investing has lost track with reality.

My point is that market makers have forced the market down in the face of a bad economic situation. This aggressive selling and indiscriminate manipulation of the financial companies have made average investors fearful and with no desire to invest. The total S&P 500 companies that have reported for the fourth quarter of 2008 clearly reflect a case of haves and have-nots. If you exclude the financial companies from this reporting cycle, all of the other companies have reported a net increase in earnings of 4%. I know that you likely have not heard that news elsewhere, so I thought I would report it here.

Later this week I will post some other thoughts on the economy, the stimulus bill and other matters I find interesting. In the meantime, I have figured out an easy way for me to get on television: exclaim in the loudest voice possible that everything the government is doing to help is bad! It appears that we have lost our faith in the American way of life, which is sad and distressing. There is nothing wrong in the economy today that consumers going back to spending wouldn’t cure. Once people start spending money again, they will buy cars and clothing. Once that confidence level reappears, people will be reemployed and the economy will turn up.

I will also discuss later in the week the flood of money that the government is putting into the system. This increase in money supply will create many jobs and promote lending and spending by consumers. I am not sure when the economy will turn upward, but I believe we are close to that finally happening. For now, I simply wish everyone would sit back, take a deep breath and allow the programs that are already in place to work before mortgaging all of our futures on a bad program and a lack of faith in capitalism.