Author: subir

Datacenters, stock exchanges and jobs.

Datacenters, stock exchanges and jobs.

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We’ve been thinking about the potential for job creation in the current crew of technology companies, spurred along by some despondent Op-Eds. Felix Salmon wrote earlier this week:

Dorian Taylor sent me a thought-provoking email this morning which said that one of the reasons we’re seeing fewer companies tap the equity capital markets is that we’re in a phase where all of the buzz and excitement is in what he characterizes as “networked information services.”

“Relatively speaking,” writes Taylor, “these companies don’t really need a huge amount of capital at any given time because they aren’t buying stuff with it; they aren’t making or building or physically shipping anything.” (Yes, I know that datacenters are expensive, but this is broadly true).

The last line struck a chord. Back in 1997, I worked at a technology startup and it took an immense amount of effort and expense to reliably maintain networked machines for our high-traffic website. Times have changed a lot since. The typical new startup can now lease compute time and disk space on Amazon’s datacenters, which have significant excess capacity built to cope with demand during the holiday season. There are many competing service providers that offer a similar set of hosting services. On these platforms, individual virtual machines which include all the well-known open-source tools required to run or build a feature-rich website or app service can be deployed within minutes.

In most cases, you pay as you go for these services, and a simple website/app might end up paying a few dollars a month for enough capacity to serve thousands of users a day. Add a few Google ads and they might be cash flow positive on day one. Better still, you can scale up on-demand by adding more virtual machines. All of this has made building, deploying and expanding web-based services far simpler than it used to be. It’s a far cry from the dedicated hosting agreements and thousands of dollars a year it used to take to set up a website. As a friend remarked during a recent conversation, most web-based software/service startups now only require “sweat equity”. The point is that most startups, and many mid-sized firms, will not be building their own datacenters, nor should they. Only the largest of web-based services and sites with tens of millions of users need to maintain dedicated datacenters.

Felix Salmon kicked off this thread with a NYTimes op-ed titled Wall Street’s Dead End, which is worth a read simply because it’s so provocative. The op-ed was a comment on the NYSE-Duetsche Bourse merger. Felix thinks the stock market is largely irrelevant, partly because

the companies in which people most want to invest, technology stars like Facebook and Twitter, are managing to avoid the public markets entirely.

While we think the article is thought-provoking, it suffers from a number of blind spots. First, many major businesses through the years have been privately held for extended periods. Cargill, Mars and Ikea are just a few of the many examples where founding entrepreneurs have succeeded in retaining equity control over their companies for extended periods of time. Many investors would have been ecstatic to have the opportunity to be part-owners of these businesses, just as many are salivating at the prospect of investing in Twitter. Arguably, certain types of businesses simply shouldn’t be public, investment banks and commodity traders are the obvious examples.

Second,  many ordinary people do have exposure to private companies, generally through a pension fund that has a private equity or venture capital investment. Some ordinary folks are employees at the web darlings of today, and they have even more direct exposure to these companies.

Lastly, the IPO market is a poor measure of quality capital creation by the public capital markets. Ever since the South Sea Bubble, IPO crazes have signaled an unhealthy, manic capital markets. It is only during times of public mania that public market investors will gorge themselves on equity investments in unproven business models. In ordinary times, these companies have to raise capital from friends, family and astute private investors willing to finance ventures. There’s a good reason, for every Facebook, there is a Friendster, often a MySpace, and countless others that fail. In non-manic times, investor capital in the public equity and bond markets is rightfully allocated to companies with viable, sustainable business models. These companies are actively raising debt and equity capital today.

Which brings me to another NYTimes  op-ed, this one written by David Brooks titled The Experience Economy in which he writes:

As Cowen notes in his book, the automobile industry produced millions of jobs, but Facebook employs about 2,000, Twitter 300 and eBay about 17,000. It takes only 14,000 employees to make and sell iPods, but that device also eliminates jobs for those people who make and distribute CDs, potentially leading to net job losses.

In other words, as Cowen makes clear, many of this era’s technological breakthroughs produce enormous happiness gains, but surprisingly little additional economic activity.

The assertion Brooks’ is making will resonate with many, but is near-sighted. Technological progress has ever been about employing ideas to use resources more efficiently and open up possibilities. When the first farmer hitched up an ox to a plough he/she put more than a few people out of their regular jobs hoeing the fields. The successive rise of the steam, internal combustion and electric engines as the transport technologies of choice disrupted many, many existing businesses. Using fossil fuels, these new transport technologies spread and many buddy-whip makers, horse-handlers, stable-owners and carriage-drivers were undoubtedly put out of work. The specialized, advanced skills they had learned suddenly became less valuable. Yet few of us would clamor for a return to the days when city streets were over-run with horse manure, or when travel between New York and Philadelphia took a couple of days.

Just as the industrial revolution allowed us to make and move a far larger quantity of goods with less human effort, networks and computers are allowing us to move far greater and more varied bits of information around. Technological advances will always continue to disrupt many lives and livelihoods. For many these will be extremely painful experiences. Yet, in the end these advances will change the way we do things, and all of us will be led to them, as if by an invisible hand because the new ways are better, more convenient or more efficient.

Facebook’s existence and its 2,000 employees does not condemn the rest of us to lives of fruitless unemployment. Last week, a Search Engine Optimization company called me to ask whether we could use their services. This is a business that did not exist 15 years ago. What matters most is that Internet search is a lot better than trying to find a business or service in the yellow pages. The hoe has been replaced with the plough. And maybe, just maybe some of the folks who used to sell ad-space in the yellow pages will find work at SEO firms.

Webinar Invitation: Tax-free municipal bonds

Webinar Invitation: Tax-free municipal bonds

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Tax Free Municipal Bonds: Are They The Right Investment For You?

The past few months have been very eventful for the municipal bond market: the Bush era tax cuts have been extended, municipal governments are proposing massive budgets cuts, protests have broken out in states like Wisconsin and certain commentators have predicted widespread default. This uncertainty has provided an opportunity for those investors who know what to look for. In this webinar, we will provide an overview of municipal bonds, address many of the recent news events that have roiled these markets and share our approach to finding opportunities in this space.

This web-based presentation will run from 12:30-1:00 pm on Tuesday March 1st. It will include a 20 minute talk and 10 minutes for Q&A.

Please RSVP if you plan to attend as space is limited.

Presented by: Washington Square Capital Management

Speaker: Subir Grewal, CFA: Co-Founder and Principal

Date: Tuesday, March 1, 2011

Time: 12:30 pm, Eastern Standard Time (New York, GMT-05:00)

Discussion Topics:

  • Municipal bond market overview
  • The ramifications of recent legislative events
  • Our selection process and where we see opportunity

To register, please click here.

MA supreme court ruling on foreclosure only “apocalypse” for those who had a rosy outlook for residential real-estate.

MA supreme court ruling on foreclosure only “apocalypse” for those who had a rosy outlook for residential real-estate.

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Foreclosure signThe Massachusetts (MA) Supreme court upheld a ruling invalidating two foreclosures that were executed incorrectly.  The judgement is quite clear cut, and says banks need to ensure they are following the letter of the law when transferring, selling or assigning mortgage notes amongst themselves if they hope to have the court’s protection when they go to foreclose.  Nothing unusual here, and it is clear that documentation practices at many banking institutions and securitization firms were at best sloppy, and at worst fraudulent, heading into the real-estate crisis.  The plaintiffs (Wells Fargo and US Bank, attempting to foreclose on two delinquent mortgaged properties) argued that invalidating foreclosures where the borrower was clearly delinquent or had defaulted would create “widespread confusion” and impose “significant costs to innocent parties” (i.e. themselves).

We thought that what the MA attorney general had to say was interesting on this score:

Plaintiffs’ claims that the Land Court’s ruling will cause widespread confusion or significant cost to innocent parties are greatly exaggerated, and such reasoning does not warrant ignoring the plain requirements of the law designed to protect Massachusetts consumers.  Indeed, it is the foreclosing entities themselves who will bear the greatest cost of clearing title from their invalid foreclosures.  Having profited greatly from practices regarding the assignment and securitization of mortgages not grounded in the law, it is reasonable for them to bear the cost of failing to ensure that such practices conformed to Massachusetts law. (emphasis ours)

and further on:

Distressed homeowners often face challenges in the foreclosure process.  In certain cases, they may lack the technical knowledge and the financial resources to contest a wrongful foreclosure or otherwise ensure that the lender adheres to the obligation to serve the interests of the mortgagor in good faith.  Thus, plaintiffs’ implication that the borrowers have waived their right to challenge the legitimacy of the sale because they had “ample opportunity to challenge the foreclosure proceedings prior to the sales but failed to do so” is particularly troubling when the plaintiffs themselves have failed to comply with the statutory requirements to foreclose.

and further:

Thus, the plaintiffs profited from the risks they took, at the expense of each of the borrowers. Having reaped the benefits of their casual attitude toward ensuring they possessed valid assignments of the mortgages, it is not unjust that plaintiffs should now bear the costs of their errors.

The MA supreme court found that the plaintiffs who had foreclosed on the properties in question did not have valid assignments that gave them an interest in the mortgage at the time of foreclosure.  The documents they did have were either in incorrect form, or had been executed after the foreclosures. They also found that MA’s foreclosure notice requirement was not met because the mortgage holder was incorrectly identified in the notice (because the mortgages were never correctly assigned to the banks attempting to foreclose). In our view, there was really no other conceivable outcome for this case given the messy mortgage documentation.

Contrary to Felix Salmon’s view on the matter, we do not believe the court ruling is a housing-market catastrophe.  We do agree that it raises many questions about title to homes that may have been foreclosed on incorrectly (Judge Cordy in a concurring opinion made much the same note), and that many, many parties to real-estate transactions over the past few years may need to go back and confirm both their title-insurance and the documentation chain for mortgage assignment and transfer.  We also agree that banks who securitized mortgages will find that investors now have cause to question some of the representations made in the securities concerning transfer of mortgage documents.  However, the key fact preventing wholesale catastrophe in our our mind, is the court’s view on prospective remedies to any flaw in documentation.

In essence, the MA supreme court found that a party attempting to foreclose in Massachusetts had a strict responsibility to ensure their documentation was in order and that they had followed the letter of the law.  The court felt this was especially important since foreclosures in MA do not require judicial supervision, except for a couple of steps.  That said, the court writes concerning mortgage assignments:

We do not suggest that an assignment must be in recordable form at the time of the notice of sale or the subsequent foreclosure sale, although recording is likely the better practice. Where a pool of mortgages is assigned to a securitized trust, the executed agreement that assigns the pool of mortgages, with a schedule of the pooled mortgage loans that clearly and specifically identifies the mortgage at issue as among those assigned, may suffice to establish the trustee as the mortgage holder.  However, there must be proof that the assignment was made by a party that itself held the mortgage.

In one of the foreclosures, the bank failed to produce the schedule of loans and mortgages that comprised the trust.  In the other case, the bank provided a schedule, but that did not identify the mortgage with adequate specificity.  The court has, in our view, been very reasonable as to how this situation may be remedied:

A foreclosing entity may provide a complete chain of assignments linking it to the record holder of the mortgage, or a single assignment from the record holder of the mortgage.

and also:

where an assignment is confirmatory of an earlier, valid assignment made prior to the publication of notice and execution of the (foreclosure) sale, that confirmatory assignment may be executed and recorded after the foreclosure, and doing so will mot make the title defective.  A valid assignment of a mortgage gives the holder of that mortgage the statutory power to sell after a default regardless whether the assignment has been recorded.  Where the earlier assignment is not in recordable form or bears some defect, a written assignment executed after foreclosure that confirms the earlier assignment may be properly recorded.  A confirmatory assignment, however, cannot confirm an assignment that was not validly made earlier or backdate an assignment being made for the first time.

Creating new assignments with fresh dates, or  confirming a prior assignment so they are in correct form will be time-consuming, tedious and expensive.  As will restarting foreclosure proceedings once all documents required by state law are in correct form.  Ensuring staff who do this are competent and aware of the issues at stake will also be key, however, the problem is not insurmountable, nor is it prohibitively expensive. No doubt there will be cases where documents are in such poor shape that they cannot be remedied by banks or servicers alone.  But that is exactly the sort of situation the land transfer process is supposed to help fix.  In the two foreclosure cases covered by this ruling, the original mortgage was correctly executed and recorded, and the trustees may get an assignment from the holder of record (Option One, who was one of many mortgage originators supplying mortgages to banks for securitization).  No doubt there will be cases where the mortgage originators no longer exist, but with sufficient time and effort, successor entities can be identified.

The court’s ruling suggests it has no patience with mortgage-holders whose own sloppy practices got them into this mess:

The legal principles and requirements we set forth are well established in our case law and statutes.  All that has changed is the plaintiffs’ apparent failure to abide by those principles and requirements in the rush to sell mortgage-backed securities.

However, as we outlined above, it has left a route out for banks to cure problems with mortgage documentation, but is plainly unwilling to allow foreclosure proceedings when the process for real-property transfer has not been followed correctly.  We believe this is an important and correct ruling.  It clears the air for both consumers and mortgage-holders and should encourage banks to rectify errors in mortgage documentation.  We believe the banks and mortgage servicers will incur additional costs in rectifying these errors (of their own making), and that this will slow down the foreclosure process.

We do not believe this is an “apocalypse” scenario.  Rather, we believe the housing market will remain distressed for many years to come as these issues are sorted out and broader macroeconomic factors such as high unemployment fade.  For those who had been expecting a relatively quick rebound in housing, construction and real-estate price levels, this may well constitute an apocalypse.

10 themes for ’10 reviewed

10 themes for ’10 reviewed

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10 Economic Themes for 2010: Year-End Review

Since we’ve now closed the chapter on 2010, we’d like to review our “10 economic themes for 2010”  from last January, to see how well our ideas performed.

We’ve graded ourselves using these symbols:  Y Right  N Wrong  ? Not Exactly.

  1. ? We expect to see the US unemployment rate to peak at 11% in 2010: We were a bit aggressive with the numerical portion of this theme. While the US job market remains anemic, the headline unemployment rate stayed within the 9.5% to 9.9% range, ending the year at 9.8%[1]. Over 15.1 million American workers were unemployed and actively seeking work at the end of 2010, this is a larger number than at any time since WW-II (except for late 2009 when there were 15.6 million). Private sector job-creation continues to be very slow, and the broader measure of underemployment, U-6 has stayed between 16.5% and 17.1% all year, ending the year at 17.0%. U-6 counts those working part-time involuntarily and workers discouraged from looking for a job.
  2. Y Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010: This scenario played out almost entirely as we had outlined.  ICI[2] reports that investors withdrew a net $29.6 billion from stock mutual funds through Nov 2010.  Meanwhile, taxable and municipal bond funds saw net inflows of $266.4 billion.
  3. Y We expect a number of credit downgrades for developed nations as their persistent deficits come into focus.  The US Dollar will strengthen in any ensuing flight to safety: We were almost entirely right on this one. Throughout the year, we saw major credit downgrades affecting Greece, Portugal and Spain, as well as the creation of an unprecedented EU bailout plan for peripheral economies.  The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated.  It reached a level of 1.1875 per Euro on June 6th and ended the year at 1.3373.
  4. N Interest rates will remain effectively at 0% until the 4th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range: We were wrong on this one.  The Fed has continued to keep the fed funds rate at historically low levels and employed every form of monetary stimulus available to it.  We underestimated the dovish tone of the current Fed, and the Chairman’s commitment to maintain easy monetary policy while unemployment remains high.
  5. Y Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order: This was a major theme for consumers in 2010.  For Q2 2010, the personal savings rate was 10.5%, and it is likely that the full year personal savings rate will be above 5%, which is far higher than the 2006 full year rate of 0%.  Consumers continued to pay down credit card debt, the most recent data from the Fed[3] (for Oct 2008) shows revolving debt at $800 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
  6. N The US economy will see almost negligible growth for 2010: We will not have final estimates on 2010 GDP growth till the end of 2011, but it is likely that GDP grew between 2.5% and 3.0% (as compared to 0.0% and -2.6% in 2008 and 2009).  The caveat, of course, is that this has been accomplished with record government stimulus.
  7. Y Corporations will increasingly turn to mergers and acquisitions to grow market share: We’ll take half a victory lap on this one.  The New York Times[4] estimates global M&A activity grew 23.1% (to USD 2.4 trillion) by value over 2010, though we are still nowhere near the $4 trillion level achieved in 2006 and 2007.  This is partly due to lower stock market values and corporate treasurers who, after being shell-shocked by the turmoil in the commercial paper market in 2008-09, are now hoarding cash.
  8. Y Growth in emerging markets will continue to outpace developed economies.  But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery: This trend appears to have held up well.  Though we have our doubts about certain large economies (see below), emerging market economies and financial markets performed well in 2010.  The MSCI emerging markets index[5] ended the year up 16.36% in dollar terms, while the S&P 500 ended the year up 12.78% (neither number includes dividends).
  9. ? We believe there is continued risk for a massive correction in China: While we have not yet seen a “massive” correction in China, the Shanghai composite index ended the year down 10.61% (one of the few major market indices down in 2010).  Residential real-estate prices have moderated in many markets and concerns about overbuilding continue to exist.
  10. N In 2010, certain commodities are poised for a sharp sell-off.  Top of our lists for a correction are gold and oil: We were flat out wrong on this one.  ICE’s Brent index rose from 77.85 to 93.49 over the course of 2010 and gold was up from 1096 to 1421 over the course of the year.

So the final tally is 5 themes right, wrong on 3, and not exactly on 2.

[1] http://data.bls.gov/cgi-bin/surveymost?ce

[2] The Investment Company Institute, http://ici.org/research/stats/trends/trends_11_10

[3] http://www.federalreserve.gov/releases/z1/Current/

[4] http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/

[5] http://www.mscibarra.com/products/indices/global_equity_indices/gimi/stdindex/performance_em.html

2011 Themes: These Go To Eleven

2011 Themes: These Go To Eleven

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2011 Themes: These Go To Eleven

  1. Raise ’em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members.  We expect rates to end the year in the 1% to 2% range. We think it is likely that the Fed raises rates to the 2% range this year because moves during the 2012 presidential election year would be politically toxic.  A rise in the short-term rate will result in a flatter yield curve (compared to the extremely steep levels today) and reduce bank earnings.
  2. Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25[1], prices are at the upper end of historical range.  Governments across the world have provided immense demand support and a low rate environment over the past couple of years.  We also believe investor wariness and demographic changes (a large cohort of new retirees who will begin drawing down on savings) suggest much support for asset prices is weakening. We believe investors will continue to focus on fixed income investments, and rightfully should.
  3. United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe.  This will doubtless further strain the Euro and all European establishments.  We believe the stresses created by the currency union existing outside of a strong federal structure will be resolved with a more federal Europe.  The alternate solution where certain states opt to leave the currency union is less likely, but not outside the realm of possibility.  In general, we believe European sovereigns will begin to be treated more like US states (which do not have the power to issue currency either) by the markets. Over time, we expect a move towards additional bond issuance at the European Union level, with each state having access to a certain amount of borrowing against the EU federal credit in exchange for heightened oversight and restrictions.
  4. Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion.  We expect certain weaker revenue and real-estate project linked bonds to default, we also expect acrimonious budget debates on benefits for public sector employees and pensions in many states.  We think large scale defaults by major issuers (state GOs, water/sewer) are very unlikely, but investors will continue to discriminate between strong and weak credits and heavily discount informal support expectations and bond insurance.
  5. Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011.  Overbuilding and overinvestment in physical infrastructure during the past few years has left a glut of underutilized buildings and this could lead to a sharp downturn in Chinese property prices and construction activity.  Any such downturn would also impact Chinese banks, and potentially have a wider impact in the region, affecting commodity-driven economies like Australia and Canada.
  6. Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages.  This will make for a more difficult general retail environment and generally depress big-ticket discretionary spending.  The real-estate bubble has altered an entire generation’s perspective on housing, and we expect households and financial institutions both to be skeptical of high mortgage indebtedness and expectations of large capital gains in residential real-estate.  We expect similar deleveraging to occur in commodity-boom fueled economies like Australia and Canada. We do not believe US residential housing prices will rise in 2011, and may indeed fall further.
  7. Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year.  We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%.
  8. Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course.
  9. Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent.
  10. Feast and Famine: We expect 2011 to be a very volatile year for commodity prices.  We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well.  Such a correction would be far more likely if China has a hard landing from the withdrawal of extreme stimulative fiscal policy and over-building over the past few years. We expect food prices to become a focus of attention in many parts of the developing world (as they were in 2008), and that governments will be forced to respond in whatever manner they can.  In the developed world we expect a resurgence of interest in agricultural and timber land investment.
  11. Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform.  Corporate and higher-income tax-payer earnings will be the center of discussion and there is an off chance that the byzantine US tax code is simplified. In particular, trial balloons have been floated to withdraw the deductibility of mortgage interest, and tax life insurance benefits and municipal bond interest income.  Similarly, we have seen increasing discussion of doing away with the estate tax and replacing it with an income tax on proceeds received by heirs. Each of these deductions is supported by sizable vested interests and we think it is unlikely that they would all be swept aside and the tax code completely over-hauled.  Nevertheless, the possibility exists with a president and congress who are both eager to demonstrate their independence and fiscal sobriety to an irate electorate.
[1] http://www.econ.yale.edu/~shiller/data.htm

2010 Q4 letter

2010 Q4 letter

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Dear Client,

We hope you enjoyed a restful holiday season and have had a good start to the New Year.

We’ve attached two documents to this quarterly letter, one reviewing our economic themes for 2010, and another outlining our themes for 2011.

In the fourth quarter of 2010, risky assets (stocks, commodities) recovered sharply from mid-year lows, while safe-haven treasuries sold off dramatically in the last few weeks (the 10 Yr yield went from 2.81% to 3.30% in December).  The Federal Reserve continued to keep short-term interest rates at 0.00-0.25% and began a second round of extraordinary monetary easing (QE2). Unemployment continued to remain high and over 15 million Americans (9.7% of the labor force) were unemployed over the holiday season.  The mid-term election cycle was an expression of the electorate’s frustration with the lackluster recovery and increasing concerns about the national debt burden.

Our view remains that high levels of unemployment, household debt-reduction and relatively tight credit standards will continue to dampen growth in 2011. We believe stock market prices are higher than sustainable levels, and down-side risk has increased materially.  We continue to recommend holding substantial cash allocations while waiting for more attractive values to deploy cash.

We look forward to speaking with you during our quarterly review and wish you the best over the coming year.

Regards,

Subir Grewal                                                                           Louis Berger

2010 Q3 letter: Bonds and Bubbles, Breaking BRICs

2010 Q3 letter: Bonds and Bubbles, Breaking BRICs

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Bonds and Bubbles

Over the course of the summer, various market commentators have put forth the idea that we are in the midst of a “bond bubble”.  Since we advise substantial allocations to bond or fixed income investments, we thought it would be worthwhile to weigh in on this theory.  Since we are fully aware that bonds, like every investment, carry risk and have the potential to lose money for the investor, we think it’s important to review those risks and explain why we believe that in the current environment bonds continue to be a preferred investment option over stocks and other higher risk securities.

We believe talk of a “bond bubble” is over-stated because their limited return potential (maximum return is repayment of principal and interest) tempers speculative excess (unlike stocks, which are far more sensitive to cycles of euphoria and despair).  In general, we view bonds as less risky than stocks because bond-issuers have a contractual obligation to repay bond-holders, whereas holders of common stock are entitled to residual earnings.  Bond holders are creditors and thus rank higher in the capital structure than stockholders; this makes recoupment of bondholders’ principal more likely in the event of a bankruptcy or default.

Bonds drop in price due to three main factors, rising interest rates, credit or default risk, and inflation worries.  All these risks stem from the fact that a bondholder is essentially making a loan to an issuer who agrees to repay a fixed amount of principal, along with some interest.

In our view, the Federal Reserve cannot keep the fed funds rate at the extraordinarily low level of 0-0.25% for much longer.  Fed officials see the dangers in maintaining extremely low rates since we have just lived through a large scale credit crisis fueled in part by central-banks suppressing rates for far too long.  We expect spirited discussion after the mid-term elections on raising rates, and expect the Fed to raise short-term rates to 1.5-2% followed by a pause.  We believe interest rate risks for holders of medium and long-term bonds are substantial at this juncture.  That said, interest rate moves are typically measured and somewhat telegraphed by the Fed, and we expect any raise to be executed incrementally.

Bond prices also drop when investors are worried about default risk.  This has typically been a concern for investors in corporate or local government debt.  However, sovereign issues are not immune to default concerns, as demonstrated vividly by the collapse in Greek, Irish and Portuguese bonds this year.  This default risk exists for all issuers who do not control the repayment currency.  In the Euro-zone, monetary policy is controlled by the European Central Bank, not individual country’s governments or their central banks.  In this respect, individual Euro-zone countries are closer to individual US states than the United Kingdom, USA or Switzerland which control their own currencies.

US investors have begun to focus on default risk for municipal bonds after a rash of high profile defaults or near-defaults (Harrisburg PA, Vallejo CA, and Jefferson County AL).  Historically, municipal bond defaults have been lower and recovered amounts after default higher than those for corporate bonds.  However, numerous US states and localities are extremely stressed by the real-estate crisis and recession so historic comparisons may be unreliable.  Weak economic conditions, coupled with longer-range questions about pension obligations and eroding tax bases in certain regions have negatively impacted most US state and local finances.  We recognize these risks, but are reasonably confident that the political process in most states will tackle fiscal issues responsibly and issuers will honor pledges made to bondholders.  We do expect fundamental pension reform by states to control costs, and state workers will see retirement ages extended and rely on 401k-style retirement plans rather than defined pensions.  Both corporate and municipal bond markets have weak issuers and our role as investment advisors is to identify and avoid them.  Just as we analyze companies and industry conditions, when we invest in municipal bonds, we review regional economics, taxing ability, project viability and overall financials to gauge credit risk independent of ratings.  In 2009, we recommended purchases of corporate and municipal bonds as concerns about repayment were elevated and bonds were available at very attractive levels.  Over the past year and a half, these concerns have receded and prices for corporate and municipal bonds have risen to the point where we have considered taking gains by selling positions.

This brings us to the last risk to bonds: inflation. Inflation is the most difficult risk to manage because it’s unpredictably influenced by an array of macro-economic factors (commodity prices, money supply, interest rates, factory/labor under-utilization etc).  Its impact on the bond market is profound since it destroys confidence by undermining the real-value of future principal and interest payments.  Bond investors are justifiably fearful of inflation.

We recognize the risks in bonds, and our goal as investment advisors is to make intelligent decisions while balancing risks and potential rewards.  We know of no investment that carries zero risk.  The risk of any particular investment performing poorly rises if we pay too high a price to acquire it.  Even sound securities can be bad investments if we pay too much for them.  This is part of the reason we consider ourselves value investors – we like knowing what things are worth before we buy them, we like to buy when levels are cheap, and we generally intend to hold investments for the long term (for individual bonds, this usually means to maturity).  This applies equally to bonds and stocks, and it is undeniable that many bonds are currently above the price a prudent investor would pay.  As a result, we are looking for opportunities to sell bonds where we believe price appreciation has changed the risk-reward scenario.

If we do sell these bonds, we have to consider re-investment options.  We have discussed the possibility of purchasing stocks of high-quality, financially strong companies with cash on hand if the opportunity arises.  Since we will continue to hold some bonds for all clients, we have sought to limit interest rate and credit (repayment) risks by shifting investments towards financially stronger issuers and limiting bond maturities (i.e. focusing on shorter-term bonds or bond funds).  We believe inflation risk for US based investors are low, yet we have opted to limit inflation risk by keeping maturities short.  We are presently not recommending investments in long-dated bonds (over 7 year maturities).

Risk On, Risk Off

Over the past few months, we have seen an increase in the degree to which different markets move up and down together.  As various writers have noted, correlations between different stock markets have increased.  Surprisingly, this has been happening with equity market volumes at very low levels in developed countries.  Indiscriminate buying or selling can create opportunities for value investors and we are willing to take risk when rewarded well for it.  We are actively on the lookout for such opportunities.

Political Update

It’s a mid-term election year in the US and we have begun to see a lot of posturing and maneuvering by the political establishment to prepare for the November 2nd election.  The big story for this election will continue to be the state of the economy and persistent high unemployment levels.  The national mood is anti-incumbent, anti-Washington and we expect Democrats will lose House and Senate seats in this election cycle.

It is difficult for politicians to support free trade when unemployment is high, and these are certainly trying times for many workers in the US and Europe.  Every developed country would like to export its way out of this recession, but the entire world cannot do this at the same time.  High unemployment, low growth, large budget deficits and an impatient electorate can lead to irresistible pressures to enact protectionist policies in a short-sighted attempt to “keep jobs and industry at home”.  Rising trade barriers slows growth since it disrupts the global supply chains that virtually every industry relies on.  Only sustainable, balanced growth in both demand and supply can cure what ails developed economies, and we would be better served if elected representatives focused on encouraging sustainable global growth rather than protectionism.

Breaking BRICs

One of the great challenges confronting the world is how the rapidly developing economies of Brazil, China, Russia and India will be integrated into the broader global economy.  Thus far, they have been very successful as production centers of exportable goods and services.  However, as consuming and investing economies, their collective record is far more checkered.  China is a particular concern since many industries remain firmly under state control and consumption is a very small portion of GDP.  Capital and currency controls remain very rigid in China and most of the recent international tension has surrounded the floating peg maintained by Chinese authorities between the CNY and USD.  There are other fundamental institutional issues which affect China’s economic links to the world.  The Chinese legal system for one remains unpredictable and tightly under the administration’s control.  We have seen a number of instances where prosecution and arrest have been used to compel certain outcomes and actions from foreign businesses.  The recent wave of worker-led strikes and suicides at factories in China also betrays the fact that state-sponsored trade unions have not been representing workers’ interests.  Severe political repression of both workers and citizens leaves us concerned that discontent could quickly boil over into civil unrest provoking an unwelcome response from authoritarian regimes in both Russia and China.

In previous letters, we’ve written about the many imbalances and distortions we see in the Chinese economy.  We believe these concerns remain valid and we have begun to think about them and about the BRIC economies as a whole, in a slightly different way.  We now see a distinction between Brazil and India on one hand, and China and Russia on the other.  China and Russia remain heavily state-controlled, resource-intensive economies with repressive political environments, weak domestic consumption and a poor demographic outlook.  We believe future high growth in these two economies is not based on sustainable foundations.  In contrast, while growth in Brazil and India has been slower than in China and Russia, we believe it is more sustainable.  Political institutions in both countries are relatively democratic, state control of industry is limited and their legal systems, though notoriously slow and complex are not blatantly unfair.  Both Brazil and India have young populations with large numbers entering the workforce and this “demographic dividend” should lead to impressive growth over the next two decades.  This is not to say that Brazil and India do not face challenges; poor basic education and high inequality for instance are two issues that demand attention.  Still, it seems to us that these two countries are on a far more sustainable path than either China or Russia.  We will be taking a closer look at investments in India and Brazil, while our macro-view on China and Russia is more downbeat.  As always, we do not anticipate investing unless prices are attractive.

The Social Network

On the social media front, we wanted to let you know that you can now follow us through the following platforms online:

  • blog.wsqcapital.com – our blog.
  • facebook.com/wsqcapital – our page on Facebook
  • twitter.com/wsqcapital – our Twitter feed

We look forward to speaking with you during our quarterly review.

Innovation, jobs and national champions.

Innovation, jobs and national champions.

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We noticed an editorial by Andy Grove in Bloomberg a few weeks ago titled How to Make an American Job Before It’s Too Late.  Andy Grove, a founder of Intel, makes a number of very important points in the piece, chief amongst which is the link between production and future innovation.  Mr. Grove makes a powerful case for rethinking outsourcing (at both the corporate and national levels).

Meanwhile, in the Financial Times, Michael Spence wrote an equally strident piece titled America Needs a Growth Strategy.  Mr. Spence highlights the role capital formation (of all sorts) plays in spurring and sustaining future growth. Both authors make the argument that a steady decline in US manufacturing has removed important capital goods, including modern factories and assembly lines, from our economy with potentially dire consequences for innovation, business and eventually politics.  We find the argument that innovation and research cannot occur for long without a close link to production facilities very compelling.

The US case is in stark contrast to China, which, in the past 20 years, has managed to accumulate both capital goods and build the world’s largest manufacturing center.  Mure Dickie writes about how Chinese joint-venture partners emerged as strong competitors to Japanese high-speed rail firms in an article titled Japan Inc Shoots itself in foot on Bullet Train.  Mr. Dickie then followed up on this story with a full length analysis of the global high-speed rail industry, highlighting how Chinese state sponsored companies have “digested” technology from foreign partners and emerged as competitors at all levels, not simply for low value components.  The rapid rise of Chinese firms in industries that have taken decades to develop is neatly encapsulated in the Californian anecdote.  California, in many ways the cradle of modern high-technology, is considering a Chinese firm to build its high-speed corridor between San Francisco and LA. Similar trends have been visible in other clean technology industries, from photo-voltaic panels to high-efficiency batteries.

Which brings us to the curious case of Huawei, the world’s third-largest manufacturer of communications equipment, which has been shut out of the world’s largest market (the US) due to fears about the potential for espionage. Since US-based companies closely linked to the defense industry have been leaders in the communications industry for decades, we wonder whether we’re seeing frenzied jockeying for the prime eavesdropping territory in our newly networked world.  Paul Taylor and Stephanie Kirschgaessner  write about the company in the FT, Huawei in drive to land big US deal, and the Economist covered the company’s meteoric rise last year in Up, up and Huawei.

All this is occurring in the context of increasingly vocal complaints and criticism by senior executives at GE, Microsoft, Google, Siemens and BASF about the business climate in China for foreign firms.

We don’t believe governments are better resource allocators than free markets in general.  But it is difficult to be sanguine about an industrial policy intentionally developed to facilitate the transfer of technology from foreign participants with the goal of weakening them.  Technology is not a traditional resource, it is difficult and expensive to develop, but easy to copy and reuse.  We know that an industrial policy designed to accumulate a resource like iron ore or oil will drive up prices and be counter-productive.  But it seems to us that “digesting” technology while purchasing implementations has few ill-effects we can see.  That said, legal protections for intellectual property were developed with this in mind. Intellectual property rights are notoriously difficult to enforce within China’s opaque, arbitrary and unequal legal system, but we will be interested in following the intellectual property cases that arise when Chinese technology firms begin to compete for contracts in the global marketplace.

The long road ahead.

The long road ahead.

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For some time now, we have been concerned about the medium-term impact of persistent high unemployment in the US.  Not only does unemployment weaken consumer sentiment, it can cause workers’ skills to become obsolete.  That is of particular concern in this recession, as aggregate unemployment and the number of long-term unemployed (over six months), remains high.  We recently delved into the unemployment statistics to understand the extent of the damage done, get a better sense of how long recovery would take, how unemployment might affect the capital markets, and see how this recession compares to those prior.

The chart below illustrates what many Americans instinctively feel: that this recession is worse than other post-war recessions.  Unemployment is higher than at any point except the ’82-’83 recession.  What’s worse, in every other post-war recession, unemployment has fallen rapidly after reaching its peak. But that has not happened in this downturn.

Unemployment Rate (Seasonally Adjusted)

When we consider those who have been looking for work for over 27 weeks (chart below), the situation looks even more dire. Over 6 million Americans have been looking for work for 6 months or more.  Long-term unemployment is also at the highest levels it has been in the post-war era as a percentage of unemployed persons or as a percentage of the labor force.  In prior recessions, the culprit was largely the normal business cycle.  Too many goods were produced during the boom and production had to be cut quickly to bring inventories back in line with reduced demand in the bust.  What we are presently facing in the US is a business cycle amplified by a banking crisis and a real-estate bubble.  This is a different type of downturn, and it implies a protracted recovery with a lot of painful adjustment for both households and businesses.

Number of Unemployed (over 27 weeks)

This recession has also affected those without higher education much more severely than it has those with college degrees. In prior recessions, workers in manufacturing or construction were laid-off and then quickly re-hired once inventories were depleted and/or demand picked back up.  Not this time.  The average unemployed worker has been looking for a job far longer than in any other recession since the second world war (over 30 weeks as noted below).  Unemployment, particularly for those without a college education, remains stubbornly high. Workers are simply not being re-hired for their old jobs aftr a temporary layoff.  Before these workers can re-enter an increasingly service oriented, technology-heavy work environment, many of them will require re-training or additional education.

Average Weeks Unemployed (Seasonally Adjusted)

Long-term unemployment has enormous implications for the credit-worthiness of US households. Households with one member who has been unemployed for over 6 months are extremely stressed financially, and we expect further deterioration in consumer and residential mortgage credit unless unemployment falls dramatically.

Lets switch gears for a moment and talk about a few facets of the unemployment statistics which are not readily apparent from the headline unemployment number. Headline unemployment only includes those people who are actively looking for work. Those who are not actively seeking work are considered to have dropped out of the labor force or be marginally attached to it. As expected, during this recession, the labor force has contracted as the long-term unemployed are discouraged from looking for work due to repeated disappointment. This contraction is especially remarkable when we consider that the population of 25-65 year olds in the US continues to grow (i.e. this contraction in the labor force is not a result of baby boomers retiring). A labor force that had been increasing by about 100,000 each month now stands exactly where it was 32 months ago, in Jan 2008. Approximately 3 million people are no longer considered to be in the labor force and are not counted in the headline unemployment number.  In the graph of the civilian labor force level below, note the remarkable flattening of the curve over the past three years.  At some point, these people will start looking for work again.  When they do return, their numbers will swell the unemployment rolls and keep the headline unemployment rate high.

Civilian Labor Force Level (Seasonally Adjusted)

Looking at it in another way, the percentage of Americans participating in the labor force and the total percentage employed have fallen more than the unemployment rate has risen. These Americans are presumably being supported by working members of their families. But their involuntary idleness does matter, even if they don’t show up in the headline number. The longer they stay out of the labor force, the more outdated their skills become, and the tougher it becomes to re-integrate them into the work-force.  This will impact the nature and duration of any recovery and has structural implications for the US economy.

Employment - Population Ratio (Seasonally Adjusted)

This brings us to U-6, or “Broad Under-Employment” which is the BLS‘s measure of those unemployed, employed part-time (involuntarily) and discouraged workers. Broad unemployment remains stubbornly high at almost 17%.  This suggests probably one quarter of all US households are stressed in some way (many households have multiple workers).

Broad Unemployment and Under-Employment, U-6 (Seasonally Adjusted)

In our view, unemployment and labor under-utilization remains the big story three years into the real-estate and banking crisis. We have maintained that any recovery will be slow and require another 3 to 5 years.

There are two primary reasons we have held this view:

Households repairing balance sheets: After an extensive period of borrowing to consume, the average US household is saving and has cut consumption aggressively in an attempt to reduce debt. This is remarkably similar to what happened in Japan a few years after the Japanese real-estate/stock market bubble burst.  20 years later, Japanese households continue to save and skimp.  The US does not have the severe demographic contraction that Japan suffers from, nor was the US real-estate bubble as great as the Japanese bubble of the 80s, and the Japanese political environment creates even higher barriers to meaningful adjustment.   Keeping this in mind, we do not expect the impact of the recent crisis to be as severe as the lost decades of growth in Japan.  Nevertheless, we believe the depth and degree of this recession will affect American attitudes towards consumption and debt for a long time to come.  Not unlike the way the Great Depression did for a prior generation.

Structural Change in specific sectors: Over the past two decades, finance and construction employment in the US rose faster than expected, fueled by low interest rates. In our view, a fundamental shift in attitudes towards financial products and real-estate will lead to a permanent reduction in activity within these sectors. Unemployed workers from the Financial Services, Construction and Real-Estate sectors may need to transition to other industries. This will take time, and coupled with the re-entry of part-time and discouraged workers may conspire to keep headline unemployment high for a while.

A risk that we see developing is that political necessity drives government to intervene and support sectors that require painful structural changes before the broader economy is poised for sustainable growth. Emergency measures were taken to support the financial, real-estate and construction sectors, but these do need to be withdrawn. Further support to industries in dire need of restructuring would simply perpetuate the mis-allocation of resources and lead to future crises.

New solar thermal plant in Mojave

New solar thermal plant in Mojave

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The Mojave desert boasts some of the largest utility-scale solar power facilities in the world and it will soon get another one.  This week, the California Energy Commission approved the licenses required to begin construction on the Blythe solar power project.  When the facility’s four phases are online, it will generate 1,000 MW making it the 15th largest power plant in California.  The facility will produce roughly the same amount of power as a large-sized coal or gas facility and would be capable of powering 800,000 homes.

The size of the project is definitely attracting attention, and will go a long way towards California’s stated objective of meeting 33% of its power needs from renewable sources by 2020.  The Energy commission is currently reviewing a number of other solar thermal power projects which would add another 3,300 MW in total power generation capacity.

If built, the Blythe plant would be one of the largest solar power projects in the world, but still a drop in the bucket for US power consumption which averaged 420,000 MW per hour in 2009.

Lest we forget, solar projects do have an environmental impact, just as hydro-electric projects do.  This particular project would cover 7,000 acres of flat desert.   The New York Times Green Blog covered the story as well.

Finally, a grown-up discussion about US debt

Finally, a grown-up discussion about US debt

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In our view, the biggest financial market story of 2010 has been the unfolding sovereign debt crisis. The crisis started with Iceland and Greece, moved on to Ireland Spain and Portugal and is now approaching American shores.  It’s fitting that the debate should shift to the US, since in many ways a debt crisis in the US would have far graver implications than that in any other nation.

It is not simply that the numbers are bigger, and they are — our USD 1.4 Trillion deficit (the amount the government spends over the amount it collects in taxes) is larger than the GDP of all except a handful of nations. Part of the problem is that the US has been funding two wars without raising additional revenue.  In fact, tax rates were reduced in the early 2000s, and the cost of the wars was taken off the official budget and funded through emergency spending bills.  The US has also spent a great deal over the past two years to stabilize the financial system and broader economy.

But a larger problem looms in the years to come as record numbers of American workers (the baby-boom generation) retire and begin to draw on the Social Security and Medicare benefits they have been promised.  The cost of the benefits has never been fully funded, largely because it has always been in a politician’s self-interest to promise benefits and defer the costs.  In a similar way, special interest groups including health care providers, insurers and drug companies have  followed their own self-interest and grown a health-care system that delivers the most expensive care in the world, with mediocre results.

Earlier this week, the Congressional Budget Office published a report on the Federal Budget and The Risk of a Fiscal Crisis which contains a litany of alarming statistics.  The bare facts are that the US government spends more on programs for its citizens than it charges them in the form to taxes.  It has been doing this for decades, and financing the spending with debt, except for a brief period of surplus in the 90s.  This debt now totals USD 13 Trillion and it can only be repaid through tax revenues.  Either income and other tax rates go up, or spending comes down.

The problems seems so intractable, the political views so entrenched, and the distrust so pervasive, that it is difficult to know where to begin.  David Stockman’s Op-Ed in the NYTimes earlier this week makes an excellent start and is well worth the read.  He has also been making the rounds on TV, and there is an excellent interview on Bloomberg well worth watching:

We agree with Mr. Stockman that bringing the US deficit, and by extension the debt, under control will require increasing revenue and controlling spending.  We also agree that the problem has been nurtured and grown under both political parties, and in fact the Republicans may have more to answer for than the Democrats since they have presented a policy of revenue/tax reduction without bringing spending under control.

Mr. Stockman was partly responding to an Op-Ed in the Wall Street Journal by Arthur Laffer (another Reagan adviser).  In his piece, Mr. Laffer argues that lower taxes will spur investment and growth, raising revenues in the process, while raising taxes would do the inverse.  We find two aspects of Mr. Laffer’s  argument misleading.  Raising taxes from 33% to 36% is a very different proposition from raising them if they are already at 60% (as they were in the 1980s). Secondly, the top 1% of earners now pay a higher portion of GDP in taxes is because their share of GDP has grown while that of the rest of the population has stagnated. Extreme income inequality ultimately leads to a breakdown in the social contract. It is also important to remember that the Bush tax-cuts were implemented at a time when the US federal budget was running a surplus.  Sunset provisions were incorporated into the cuts because there was a concern that the

However, the political environment is extremely polarized and it is hard for us to imagine reasonable measures being undertaken prior to the mid-term election.  In our view, all legislative action between now and November 6th will be driven by its impact on congressional races.

The flip side of the debate on taxes revenue is the impact on spending and infrastructure.  Paul Krugman writes about this in the NY Times this weekend.

The immediate question is whether the temporary tax cuts enacted in 2000 are to be extended.  These cuts had a sunset provision embedded in them and were enacted at the height of the tech boom, when revenues were inflated and the US was running substantial fiscal surpluses.  Soon after they were passed, the tech-wreck of 2001-2002 and the events of 9/11 shrank US growth and we have seen deficits rise steadily.  The financial crisis and its aftermath have simply exacerbated a problem that was already quite severe.

In our view, the responsible course of action is to let the temporary Bush-era tax cuts expire.  They will result in small increases  to the federal income rates for most taxpayers, and they are a small step towards tackling the larger problem which is explaining to the American populace that the generous benefits they enjoy must be paid for and we may as well start now since we have been incurring the costs for a while.

As for the timing of any further tax increases, we believe they must be delayed. The US economy will experience the withdrawal of extraordinary fiscal stimulus and expansionary monetary policy over the next two years.  Raising taxes simultaneously could well stall or reverse any recovery.  However, there must be some commitment to simplifying the tax code and progress towards a balanced budget.  Ideally, we would like to see Congress debate and pass a tax reform and increase bill which would take effect in a phased manner over a number of years, with a clear goal of paying down the extraordinary debt the US has accumulated.  If the governing classes in the country don’t have the backbone to deliver this unpleasant medicine now, we may be forced to swallow an even worse pill down the road, much like Greece is today.

This week’s reading

This week’s reading

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Below are links to an article, pod cast and blog post we found interesting this week.

In his article Banking Needs More Robust Stress Tests Than These, John Kay writes in the Financial Times about the inadequacy of the European Bank stress tests.  He argues that while the language of “stress tests” is borrowed from engineering, the standards being applied are nowhere near as rigorous as those demanded in engineering.  As many banks learned first hand in 2008,  “industry-standard” stress assumptions can create complacency.  Wimpy standards blessed by primary regulators may be worse.

One of our favorite weekly radio programs/podcasts is This American Life.  The show does not generally cover finance, but does a remarkable job whenever it gets around to covering the topic.  For example, they present a very good explanation of the financial crisis in an episode titled The Giant Pool of Money.  In a recent episode, the team took a look at US state budget deficits through the unique mix of political dysfunction, profligacy and entrenched distrust that characterizes the politics of Albany.  The episode also contained a cautionary tale for states and countries with polarized political landscapes.  In what comes as close to a controlled experiment in economics as one gets, we have the tale of Barbados and Jamaica.  Both countries confronted a ruinous economic landscape in the late 70s.  The nature of their local politics and the level of social cohesion led to small difference in the way they tackled their crises, but these small differences appear to have had an out-sized impact on future growth.   The episode is titled Social Contract, and is worth listening to in its entirety.

and apropos of nothing in particular, we quote The Epicurean Dealmaker:

There are those who style themselves intellectuals—a notably large portion of whom, in my personal experience, happen to be economists—who are deeply suspicious of anecdotal data in general and anecdotes about finance, economics, and the behavior of market participants in particular. This has always struck me as revealing both a superficially shallow skepticism about the primary sense and experience data of others—which, after all, is the most reliable data each of us individually possesses—and a similarly unwarranted credulity about its opposite, broad and impersonal third party datasets.

…
Oh, and by the way, while quality has certainly improved since I started in investment banking 20 years ago, it remains true, for example, that the banker who wishes to remain employed will always check the accuracy of third party data against original sources before he incorporates it into his own work product. So much for the reliability of external datasets when real money—as opposed to, let’s say, a research grant—is on the line. Oh snap.

— TED, unpublished remarks

Banks and Real-Estate (yes, again).

Banks and Real-Estate (yes, again).

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A couple of news articles on the topic of China caught our attention last week.  In an article titled Cooling Property Market Tests Beijing’s Nerves, the Financial Times reported on the sudden, marked slowdown in apartment sales within mainland China and the potential government response to this phenomenon.  What stood out amongst all the anecdotal information is that apartment prices in Tongzhou (a suburb of Beijing) are currently hovering around USD $3,500 per sq. meter (or USD $325 per sq. ft.), perhaps more if you consider the CNY (Chinese Yuan or Renmindi) is undervalued to the USD.  We admit that we’ve never visited China, so we don’t have firsthand knowledge of real estate market trends in Tongzhou (it could be the Greenwich of Beijing for all we know, and in fact, it looks like a pretty nice place from space).  We also readily admit that we aren’t experts when it comes to navigating the complexities of the Hukou system of permits.  Perhaps Tongzhou is the recipient of pent-up demand from people who cannot buy apartments within Beijing proper.  Still, we think $325 per square foot is a bit high, especially when you consider the real estate market in suburban New York (the wealthiest city in the wealthiest nation in the world).   We conducted a quick (completely unscientific) analysis of the property market by looking for new developments in the NYC suburbs (accepting at face value sq. ft. area claims made by the developer).  We end up with asking prices in the range of $250-400 per sq. ft. (across the river in Jersey), $400-600 per sq. ft. (in Brooklyn and Queens) and $250-400 (Westchester).  Median household income in New York City (2008) was $56,000.  Beijing’s statistical bureau doesn’t publish median household income, but they do say that in 2009, disposable income per capita was CNY 26, 700 (USD $4,000).   By our estimate, that puts median household income around USD $12,000-15,000, or 20-25% of that in New York.  Yet prices are roughly comparable.   In our view, these levels are unsustainable and highlight the growing disparity between real estate prices and what Chinese citizens can reasonably be expected to pay for these properties.

Last week also saw the IPO of the Agricultural Bank of China (ABC), the last of China’s major state-owned banks to go public.  Like all the other state-owned banks, ABC spun-off a package of bad loans prior to going public.  What we’re wondering is whether they’ve also spun-off all the employees who made those bad loans (over 10% of ABC’s USD 828 Bn balance sheet at end 2007).  We’re also wondering it is possible to make USD $110 billion in bad loans in an economy that is growing at a 10% clip.  Fitch Ratings has some ideas.

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