The Inversion of Finance

There's an interivew with FedEx's CEO Fred Smith in the Wall Street Journal online, and he makes one of the most intelligent and perceptive comments about the financial services industry that I've yet to see:

He attributes the financial crisis to "the intersection of four long-term developments." Reckless mortgage lending policies; high energy prices; mark-to-market accounting rules; and national policies that favor what he calls "the financial sector over the industrial sector."

"Rather than in our business where you have to have a dollar of equity for, 10 cents or 15 cents of debt," he explains, "it's exactly the opposite in the financial sector where you have one dollar of equity for 10, 25, 50 times risk." "Things became so flipped upside down," he explains, that "the assets at these banks became the liabilities and the liabilities became the assets. These people were making these fantastic returns -- at places like Fannie Mae and Freddie Mac -- but in reality they weren't adding a lot of value. I have said time and again that there is a fundamental tendency in good times in the financial sector to over-leverage. Our national policies actively encouraged all this debt."

The concept of assets becoming liabilities and liabilities becoming assets is so completely apt as to be startling in its simplicity.

I'm not sure I agree with his appeal to change the tax structure allowing capital purchases to be treated as out-of-pocket expenses. The question is whether you drive accounting rules by tax policy or tax policy by accounting rules. The reason for amortization is to more throughly match up expenses with revenues. At the same time, to be fair, once you've paid for that Boeing 777, you're not getting to return it and the money is gone. But what if it's financed and you're paying over time. It doesn't seem reasonable to allow the immediate expensing of the entire amount.

He mentions that he things the corporate tax rate should be lowered, and that at 38% it's even higher than Germany's 25%. My question would be not what the tax rate is on the books, but what the average realized tax rate is. I have a suspicion that most large corporations are managing to write off enough that the effective tax rate is far lower.

Credit Ratings Firms Spun Tales to Spin Gold

In case you think truth never comes to light in Congress, then look at the Washington Post story about how the credit rating agencies knew for at least a year that they helped fuel the financial meltdown.

In one of the confidential documents obtained by the committee, Raymond W. McDaniel, chief executive of ratings firm Moody's, said analysts and executives are "continually 'pitched' by bankers, issuers, investors . . . whose views can color credit judgment."

"we 'drink the kool-aid,' " he wrote in a Oct. 21, 2007, memo to the board. "Unchecked, competition on this basis can place the entire financial system at risk."

I think this shows that their claims of "getting to the bottom" of programming errors in their risk management systems was so many lies and an attempt to slide a knife in the backs of technicians for what was primiarily an issue of their own greed.

Frankly, this has been true for many years and is exactly the same type of situation as faced the accounting firms that wanted to provide consulting and auditing services at the same time. You can't do it fairly because there's an inherent conflict of interest. Your vast income is the result of kissing the plump rear of those who run the client companies. People will always act in accordance with their personal financial incentives.

In short, I think this means that no one can believe a single word coming from any of the rating agencies. If they are willing to pump up ratings based on rewards, why wouldn't they knock down ratings because of the lack of them. I suspect that will come out at some point because it's part of the same human nature: If you won't look out for me, then screw you.

Now consider the extent of this. You can't trust the ratings on securities. On banks. On insurance carriers. On bonds. On anything. It might be that the ratings are often accurate, but how can you know? The morally reprehensible action of all these executives who knew of the problems and did nothing was that they destroyed any sense of trust in the system. Not blind belief, but the trust that institutions will do more or less what they are supposed to do. When that goes, so does the willingness to invest.

"We have to earn our credibility back," said Deven Sharma, president of Standard & Poor's.

Mr. Sharma, you simply cannot. No one with any sense will ever believe any of you, because you've all proven what you are willing to do to line your pockets. There's no reason to expect that you would be any less willing in the future so long as you thought that you wouldn't be caught. I'd call all of them a pack of swine, but it would be degrading to pigs.

Keeping Perspective During Panic

The entire financial world seems to be in panic, lurching from one side of the economic ship to the other, rocking the whole thing. It's all madness, becasue it equates stock prices, or the vlaue that people place on companies, with the performance of the companies themselves. But look at IBM, a strong quarter and emphasis that management expects to hit its previous guidance for the rest of the year. Johnson & Johnson beat expectations. To get lost in the running crowd is to miss where you are, and that means missing the opportunities around you.

Credit Swaps are Old Friend

Virtually everyone going on in the media about the credit crisis keeps talking about the subprime mortgages, but there's little talk about the credit swaps which were the real force in knocking everything over. At his blog, billionaire investor Mark Cuban pointed out that the crash of 1987 also was triggered by schemes to insure leveraged investments. In each case, the sudden requirement to pay up as things went south was why companies had to "dump everything AND sell stock index futures to raise cash, which in turn lead to a crisis of confidence and deleveraging." And he makes an additional interesting point:

Which is the genesis of our problem in the US. Its not wrong to run with bull markets and leverage to the hilt. That can be a very good thing. But we have to make the upside based on investments, rather than financial engineering. Which is exactly why we have to change our tax code. We want to encourage investment, not financial engineering.

He suggests having zero capital gains tax on selling stocks and bonds bought during an IPO and held for five or more years, and if sold early it would become taxes as regular income. Cuban also would not allow stock to be borrowed against, requiring a sale instead. I understand the impulse, but it's my understanding that there are already types of financial deals that effectively transfer ownership of stock for periods of time. Although I see the impulse, I suspect this would be as easily walked around as other blockades that regulators and legislators have tried to erect. How can you keep legislators from loosening things up over time because they get entirely too much money from the financial services industries?

Bailout: Just the Beginning

Ah, should have known this was going to happen. According to the Financial Times, all sorts of people are pressuing the U.S. Treasury and the Federal Reserve to provide further help to the economy, possibly a mix of a rate cut, letting money markets borrow money to fund their holdings, and maybe even offering unsecured loans to regulated banks. In other words, the U.S. government is going to become like a parent who always bails out the troubled child until things get so bad that it's no longer possible. I'm sure some would liken the current situation to the intervention of a doctor, but unfortunately the illness was the result of the stupidity of the institutions in danger. How is curing the symptoms going to change the underlying behavior? It's not, and chances are that the cash is not going to travel much farther than the banks and their largest customers - the ones they want to keep happy. I'm already hearing stories from small business owners suddenly finding their credit lines pulled. Many will make it through, but when you remember that the majority of employment in the country comes from small businesses, it makes you wonder whether it's the economy that's getting a bailout, or the most elite piece.