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.

When the Best Marketing Is Keeping Your Mouth Shut

I've run into a couple of interesting stories of marketing. In one, an organization sponsored a class at Hunter College, with the class content being a covert marketing campaign. The other came from a friend who owns an HP computer and who recently received something about extending the warranty - but said invitation explicitly excluded hardware. Leaving what? Telling her to reload software in case of trouble?

There are times that companies make the most horrendously stupid mucks of marketing communications. They lie, they twist things, they try being clever, and the upshot of all that effort is egg on their faces. If marketing isn't about the customer, then it's essentially a con game, in which the company tries to extract revenue without providing any benefit. And if a company's marketing communications is designed along such practices of trickery, it is probably costing the company more in good will and long term financial value than company management will ever realize. If the managers did get it, they'd replace the marketing staff immediately.

The Next Big Financial Debacle?

Some experts on a risk management mailing list I'm on are guessing that there's a new finanical bugaboo on the horizon, credit default swaps derivatives, that could make the sub-prime problems look like small change. Two parties enter into an agreement. One pays the other a fixed sum periodically though a coupon bond - which means that the second has purchased the bond from the first. The second doesn't have to pay anything else, and keeps collecting interest over the life of the bond (and, presumably, recaptures the initial investment) unless some pre-determined credit event - such as a debt restructuring, bankruptcy, or a drop in credit rating - occurs. In such a situation, the second party pays a fixed sum to the first and then the entire arrangement is terminated.

The derivates can become a form of credit insurance, with the second party being the insurer. However, they can also allow third parties to speculate on an entity's ability to repay a debt - legalized gambling, I think it should be called. So long as you only have the occasional credit explosion, the system can work. But what happens when you have one comapny after another in trouble? Now you have to wonder whether the insurers actually have the money to cough up - and some of the big players in that market are the very financial institutions that have been pouring money out because of the sub-prime mess.

According to an article in Wikipedia (link above), these are the most widely traded credit derivative product. More so than mortgage-backed bonds. The outstanding swaps currently top $46 trillion - with a t. To add some perspective, the US stock market is only $22 trillion, with mortgate securites hitting a mere $7 trillion. And an article in Bloomberg notes that this is the fastest-growing form of derivative on the market.

This could bear out Warren Buffet's remarks from 2003, in which he called derivatives in general "financial weapons of mass destruction" that could hurt the entire global financial system, and not just the people involved with the specific transactions.

Waiting For the Shoe to Drop

We usually hear that we should wait for the other shoe to drop - that one event has happened, and its completion will catch up with us as certainly as reading glasses chase the middle-aged. But there is an assumption that people are cognizant enough to recognize that forces beyond their control are at work. This comes from experience and an interest in avoiding as much pain and suffering as possible.

Unfortunately, business has become an area where people prefer to remain blissfully unaware becasue they're after the Big Kill. They think that some things are too good to be true, but they want them anyway, and so plunge head first and will hear nothing of the rocks sitting at the bottom of the shallow pool below.

It would seem foolish that all these people with a library of degrees among them and more money than people can conceive of move on in such ways. But we are all creatures of emotion, and the dark side that drives greed and desire is exactly the part that harbors other weaknesses. So they ignore reason and move ahead, no matter what their experience tells them.

That's why we're waiting for the first shoe to drop - or at least for the echoes to catch up with us. Everyone seems to be watching each other for a clue. The US market is down, so Asia and Europe reacts, but then the US says, "Well, maybe it's not that bad after all." But Bank of America's earnings are down something like 95%. This is not the sign of a mild recession, but rather the a sign that something is seriously wrong. The banks have made unbelievably foolish mistakes and they now want to hide under a rock and not take chances. However, if the financial institutions that form the foundation of our economic system are cracking, what are the chances that everyone else will be if not well, then only mildly affected? Just how big a shoe - or boot - is waiting for its time to fall?

I actually just posted this on my blog about the writing business, but I realized that it was an interesting question of economic dynamics of e-books and the Kindle, so thought I'd post it here as well without using a link back.

Tim O'Reilly is a smart book publisher, and he took a look at some of the numbers that e-book enthusiasts tossed around with the advent of Amazon's Kindle. His argument is that even if prices do tumble for e-books, it will likely be only temporary. It's worth the read.I'll add an additional angle. Let's assume that he's wrong and prices do drop and stay at $5 a title. What publisher and author combination can make money that way? Reading hasn't reduced in volume because the prices are too high - books just aren't that expensive.

If you have a current business model under which most titles don't even make back the pitiful advances that authors get, and where the cost of the actual paper is only about $1.50 a copy, then dropping the price by 60 to 80 percent is going to mean that publishers won't be able to afford to print anything that isn't going to be wildly successful.Current backlists may stay around (if the publishers have acquired the necessary rights), but forget the variety of titles coming out now. You'll be down to a handful of authors who can generate the necessary sales.

Some individual authors might be able to self publish, but if they're getting 35 percent of $5, that's $1.75. Take out costs of design and production, and maybe they're at $1 a book if they're lucky, which is the inadequate stream of money they made from publishers - too low to support self-publishing. So $5a copy, if really gutting the paper model, would actually leave book publishing virtually dead. Then supply and demand will kick back in, because there are those massive infrastructures to feed, and prices will head back up anyway.

Market Meltdowns and Oil Spills

When listing to the radio and more news about the San Francisco oil spill, I heard some official wonder how it could all be possible - how, with all the GPS systems and electronics and procedures put into place that a freighter with an experienced pilot at the helm could hit into a bridge, open a 90 foot rip, and pollute the bay. At that moment, I realized this is the equivalent thought that had been going through the mind of every CEO dismissed or pushed out from one of the large banks, of the head of every investment department, of everyone in every board room. How could this have gone wrong? We had all the best computers and software, most highly paid experts and geniuses.

They did, and the mistake was to trust that it's possible to mechanically cheat the law of averages. Technology is fine, when used, but it isn't an omniscient and tireless protector. It can't think and doesn't have the flexibility to react to situations that are beyond programming. Technology only does in an efficient manner what people understand how to perform. Experts and mathematicians and economists can make amazing calculations, but they are still only approximations of reality that work the way they were designed. As conditions move past assumptions, the results fall apart.

We're back to the same word: risk. If you're going to make money, there's a risk you could lose it. The more money you make off your capital, the bigger the chance of loss. That, my friends, is the way of life. According to Hollywood insider Alec Baldwin, we've even seen this attitude in the results of the studios.

People, including those in high positions in business, want something for nothing, and when they can't get it, they want a guarantee that their losses won't be too painful. If all the people who called for letting the market do what it knows best were sincere, they would watch as entire large companies melted down. That is how the market tries to deal with it - through brutal and overwhelming force as punishment, so people will hopefully learn that when you touch a hot stove, you'll be burnt if you're not careful. But businesspeople aren't sincere in what they want. That's why no one will learn anything from the current market turmoils, why things will continue to spin out of control, and why we're all going to pay a potentially huge price, as those who set things into motion refuse to.

Is Making Money Self-Defeating Strategy?

This is one of those times that I wonder if I'm slipping off the edge of reason. But in a number of articles I'm currently working on, I keep coming back to various people in a range of financial fields making the same point: there's too much capital. Money's supposed to be good for economies, you'd think, but when you have a surplus of cash, the results are interesting. Too much money is one of the big reasons, apparently, that the credit crunch came about. Because so many nations, corporations, and wealthy individuals are trying to invest at a time when companies are not necessarily expanding, or when adding value might be comeing up with new code (low capital investment) rather than building new plants (high capital investment), we have one of the oddest examples you might find of high supply and low demand.

Risky credit became cheap becuse so many entities wanted to put their money into something, and stays cheap because companies don't need to expand. To need to expand, there would have to be wealth spread among a greater number of people who could then generate sufficient demand. In short, by having money concentrate at an ever greater level among a small group of people, there is less demand for investing that money, because most people don't have the money to spend on the things that drive business investment, and there aren't enough of the super wealthy to make up for it. So the accumulation of capital seems to limit its own growth potential, which makes some sense. But, my, who would have ever thought that capitalism could be its own worst enemy?

Falling Dollar and Credit Crunch

I've mentioned the credit crisis a number of times in this blog, and now we have another consideration: the state of the dollar. According to the New York Times (and other outlets as well, I'm sure), the dollar fell to a new low point against the euro:

Currencies are influenced by many factors, chief among them expectations for interest rates and inflation. If rates were to fall in the United States and remain unchanged in Europe, as many investors are expecting, traders will probably bid up the exchange value of euros.

It makes sense. As interest rates drop in the US, you get less bang for your literal buck, and you want to hold currency that has greater strength, because there's greater demand.

But forget about interest rates going forward, for a moment, and consider what happens to existing debt. As the value of the dollar falls, people and institutions in other countries find that the notes they hold keep dropping in effective value in their home currencies. Instead of paying the equivalent of X euros or Y yen, suddenly you're getting some percentage less. US investors don't see that particular effect as much because they are still paying for things in dollars.

Unfortunately, much of what we consume in this country is imported. As the dollar drops, the imports become more expensive. Consumers need more money to do the same purchasing, and they're not getting it from credit, so they buy less. That slows the economy and, I'm guessing, weakens the dollar even more, because people internationally are less interested in being tied to our currency. That acts as a positive feedback loop, helping to increase the effect.

All in all, I have a funny feeling that the business climate over the next couple of years is going to be much rockier and difficult than I hear most people in business admitting. Maybe I'm wrong, or maybe they don't want to come out and say what is actually happening.

US Gambling Stance Endangers Copyright

The New York Times has a great story about how US attempts to stop its citizens from using online gambling in Antigua could result in that country getting permission from the World Trade Organization to infringe on US copyright and sell copies of American products. Essentially, Antigua took the US to the WTO court, complaining that we were selectively allowing online gambling. So far, the US has lost the original case and an appeal, but has been ignoring the ruling.

But not complying with the decision presents big problems of its own for Washington. That’s because Mr. Mendel, who is claiming $3.4 billion in damages on behalf of Antigua, has asked the trade organization to grant a rare form of compensation if the American government refuses to accept the ruling: permission for Antiguans to violate intellectual property laws by allowing them to distribute copies of American music, movie and software products, among others.

Wow. The WTO is stuck because it must follow its own rules. The US doesn't want to allow offshore gambling, but by protesting and ignoring the ruling, it opens doors for other countries, like China, to do the same. And if Antigua gets permission to go ahead, what can the US actually do to stop sales and the losses that businesses would feel? This is the hidden problem of talking about completely open markets - eventually you get caught by the law of unintended consequences. Most countries that talk about open markets are all for them - for others.

Business Using Sub-Prime as an Excuse

There have been many news accounts of how the meltdown in the sub-prime credit markets have become like a contagion, affecting a growing amount of all business. The reasoning, as I understand it, goes something like this:

1. Housing prices kept escalating, so people had burgeoning amounts of equity, at least on paper.



2. Sub-prime lenders kept taking on more risk because high demand for homes and rising housing prices made it seem relative safe.



3. Lenders bundled together derivative securities that held the mortgages.



4. By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.



5. Prices topped and dropped, and a growing number of people were defaulting - not just on first mortgages, but on secondary ones, including equity-backed lines of credit.



6. Someone had to start paying out money, which meant credit insurers and mortgage lenders alike had to start pouring out cash, which meant reducing liquidity.



7. Those with lots of cash didn't want to lose it, so they stopped underwriting so much of the business being done.



8. As a result, some groups are losing money on deals because they couldn't get the terms they needed, and some hedge funds started to close because they were effectively undertaking high stakes gambling and finding that the house eventually wins.



9. Private equity firms, which had been indirectly fueling the rise in stock prices (not some quick miracle of economic conditions), are backing away from deals because they can't get the terms and returns that drive their business models. (Friday's Wall Street Journal had an article called "Leveraged Buyout Remorse?" with the following first line: "Having spent years racing to put deals together, some private-equity firms are puzzling over whether they should take them apart.")



10. The stock market is likely to see an increasing pinch as people and institutions aren't rushing to make a killing on the next takeover prospect.

So it's all the fault of the sub-prime markets, we hear. But I don't buy it. Yes, that is a mechanism, but it's not the finger pulling the trigger. That honor belongs to greed unchecked by business sense.

In the face of economic history, expecting that prices relative to other demands of life could rise forever, and even planning on that happening, is idiotic. That has never happened and isn't about to start. What we are seeing is the same as the tulip market mania of the 16th century. It's multi-level marketing on a grand scale. It's a ponzi scheme. At each point, furthering of the business "model" depends on someone having the expectation that no matter what the inflated price, he or she will shortly see the same type of return. If a business or investor wants to take some risk for high returns, that's fine, but it's called risk for a reason. There is a measurable chance, sometimes large, that you will lose part or all of the money you've invested.

To put virtually all of your eggs into this one basket is insane. Yet that's what the markets have done. All manners of companies have been betting on consumer spending to continue. But the spending wasn't itself fueled by increases in wages. No, because that would lead to inflation and corporations having higher labor expenses, and smaller returns. Instead, everyone more or less turned their heads, opened the credit taps, and let the money flow because, well, those increased housing prices would make everything fine in the end. One could always refinance, pay off the one lender at risk by transferring the risk to another, and take a little extra money out at the same time.

It's over. People are increasingly stuck in houses they couldn't afford and that, with dropping prices, they can't afford to sell, because they would remain in debt as the sales price wouldn't cover the mortgage. The markets are experiencing (I'm not sure they realize quite what is actually happening) a cold turkey economic abuse program. Now governments are involved, making cash available to keep enough money in the system to leave it afloat. Although you won't see it called such, this is the world's largest economic bailout masked as maintaining market liquidity. The sums that are going in and will probably continue to pour in will dwarf the savings and load debacle this country experienced. I wouldn't be surprised if it ultimately overtook the real spending during the Great Depression. We are in a pile of doo-doo, and all the finger-pointing and rationalization won't change the fact that it is of our own making.