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.

Foreclosures Up, Income Increases Uneven

The problem with focusing on only the "big picture" issues of the economy is that you miss the little guys who, collectively, are the real driving force. According to the Financial Times, U.S. home foreclosures doubled last month:

The number of foreclosures jumped to 223,538 in September, 99 per cent higher than the number last year, though down 8 per cent from August, according to RealtyTrac, which compiles housing data. California had the largest number of foreclosures, with 51,259, and Florida was second, with 33,354.
Nevada, which has seen explosive housing growth around Las Vegas, had the highest rate of foreclosures, with one for every 185 households. The overall foreclosure rate was one for every 557 households.

Countrywide Financial, the nation's largest mortgage lender, said "The number of foreclosures jumped to 223,538 in September, 99 per cent higher than the number last year, though down 8 per cent from August, according to RealtyTrac, which compiles housing data. California had the largest number of foreclosures, with 51,259, and Florida was second, with 33,354. Nevada, which has seen explosive housing growth around Las Vegas, had the highest rate of foreclosures, with one for every 185 households. The overall foreclosure rate was one for every 557 households."

RealtyTrac said the foreclosure jump was due in part to sub-prime borrowers being unable to make payments after rates went up. Countrywide Financial, the nation's largest mortgage lender, has seen deliquencies as a percentage of unpaid loans go to 5.85 percent, versus 4.04 percent a year ago. Its issuance of ARMs has dropped by 76 percent. Daily mortgage loan applications are down by 39 percent. This is alarming news.
And now factor in what the New York Times reports:

"New data shows that after adjusting for inflation, 95 percent of Americans reported smaller incomes to the tax man in 2005 than in 2000."

People had a bit more in their pockets due to the tax cuts - from about $20 a month for those in the bottom half of income to $5,400 a month for those in the top 1 percent. And only those in the top 5 percent of income saw higher incomes both before and after taxes. More than three-quarters of all taxpayers make less then $5,400 per month. When the bulk of the little guys are getting hit hard, the entire economy will follow. And I think the signs of this are getting clearer than I'd like. This is one of those times that I sure hope I'm completely wrong.