Wednesday, November 28, 2007

where's the protest? Sub-Prime lending excesses as one more failure of capitalism

I don’t get it. Violations of honest business practices that produced the scandals at Enron, WorldCom, Health South brought about widespread rejection of short-termist thinking as a basic principle for capitalism. But the current crisis in American credit markets precipitated by rather similar violations of best practices has not provoked a similar degree of alarm and concern.

But the current failure of market-behavior to reach beneficial outcomes is more damaging perhaps to the American economy and society than the scandals of only a few years ago.

The consequences of Enron and related abuses of financial reporting obligations punctured a liquidity bubble in the stock market which led to a large fall in the prices of securities. Employees of Enron in particular, which was forced into bankruptcy suffered heavily and many who were buying stocks in the hopes of a continued rise in prices lost money. Within a few years, however, the markets recovered. Short term losses were made up with longer term gains.

New legislation was introduced mandating better financial reporting and oversight of the auditing function to prevent a re-occurrence of those particular scandals.

But this time, excessive extension of credit to sub-prime borrowers seeking to buy houses has boomeranged into a serious threat to the entire American economy. Investors are in a hurried, unreflective, general flight to quality and so many would-be borrowers are being left without cash and needed working capital to sustain their businesses and to expand the production of goods and services.

The system of finance and credit supports an economy; any dysfunction or retrenchment in this sector undermines the entire society’s well-being.

But in particular, the sub-prime crisis has led to more foreclosures on homes, lower housing sales, and falling house values. The poor and the middle class are most affected by this negative move in the activity volume in the housing industry and sectors that depend on consumer demand for housing and related fixtures, etc.

More wealthy Americans have a range of assets at their disposal; the poor and most of the middle class have their houses as their primary source of equity capital. Lower housing prices errode the wealth available to those who need it most, making them more financially vulnerable just as the economy becomes more difficult.

This is not the outcome we should want from modern capitalism.

A price will be paid by those who spawned the excess in risky lending. Both Merrill Lynch and Citibank have lost their CEO’s as a result and taken huge write-owns in their equity. And more bad news for the banking and financial sectors and for the owners of derivatives is still to come we hear.

One reassuring point, I suppose, about markets is that reality always sets in. There is no escaping karma; consequences cannot be avoided by wishful thinking. Raising the level of risk by making too many risky loans leads to some degree of risks actually coming true. And somebody must pay the price associated with those losses when they occur.

So it is with every speculative bubble: someday the bubble bursts.

The trouble, I think, with running transactions on a fee basis (some promoter takes some money and runs) is that fees shield the instigators of the transaction from having to live with long-term risk. Their market function is only to put the deal together. Others are left to bear the consequences.

So it was with the aiders and abettors of Enron special purpose entities, excessive investment in telecom and dot-com companies in the late 1990s and with the packagers of sub-prime mortgages and related derivatives.

Where fees are too high and too easily obtained, systemic risk management suffers. This is an iron law of human nature.

Monday, November 19, 2007

A Bucharest Glimpse into the Ethics of Hedge Funds

Romania now is part of the European Union, but traces of its past are more than evident in Bucharest. The massive, hubristic presidential edifice commissioned by the late despot Nicholas Caucescue hulks over the city on a site cleared of old houses and churches which had withstood centuries of pre-Communist turmoil.

And the Romanian economy, while growing and birthing a middle class, is more of a transitional economy than a developed one.

Bucharest needs infrastructure – better roads, underpasses, overpasses, ring roads, new streets, stop lights that work, parking ramps.

The new middle class is putting is disposable income into cars. There are too many for the streets of Bucharest, too much time wasted in traffic jams and no place to park them. The city needs parking facilities.

A business man has a plan. At least a small one. He owns a parcel of land in the central city and has estimated the cost and earnings of building and maintaining a modest parking ramp – 600 cars – on the site. It will pay off with interest in 5 years. But he can get no investors to finance the project.

Romanians are in a speculative mode; quick turnaround of capital at a good return – get your money back in 6 months at 30% interest.

Asset speculation – whether on financial exchanges, in wartime economies, or in real estate – always leads to trouble. It is built on the twin pillars of unrealistic valuations and “irrational exuberance” – the human propensity to gamble when facing the prospects of making easy money. It is a dysfunction that undermines the rationality of capitalism and pre-dated the emergence of capitalist production and systemic accumulation of invested wealth.

While in Bucharest to speak on corporate social responsibility recently, I met by chance a young investment broker from the UK seeking to earn commissions by channeling money into Romanian real estate projects. He is offering London hedge funds 400% returns on money they invest in Romania. They love the prospects he told me. Money is coming into Romania.

But not for parking ramps, needed infrastructure and other long-term payoff projects.

The effect of the hedge funds is to further distort Romanian economic priorities towards short term speculation.

Is this really very helpful?

Sunday, November 18, 2007

The UN Panel Report on Climate Change

My first response to the release of the report on Global Warming by the UN Inter-governmental Panel on Climate Change was, for me, a new thought – one no doubt well understood by others before me.

The general recommendation as to the continued human release of green-house gases is two fold: one, to switch our source of energy away from hydro-carbons and, second, to use less energy. The second alternative seems, at first, merely a prescription to increase the cost of energy in order, through the supply/demand mechanics of classical micro-economic theory, to reduce energy consumption.

This alternative is not welcomed by many who link increased cost of a basic input for global production to lower global output and reduced wealth creation.

However, the flip-side of less use could be higher productivity.

The wage rates for labor have risen steadily with industrialization and post-industrialization as rates of productivity rose and rose.

Less and less units of labor were needed for production of the same quantity of output, so per-unit labor costs could go up without triggering higher prices for consumers. Each unit of labor contributed to the production of more and more goods and services.

Productivity increases for labor inputs came with the introduction of capital improvements to the means and methods of production. With machines and other supplements to human handiwork the value generated for society by each working individual grew exponentially. Adam Smith understood that this increase in output through specialization was the origin of the wealth of nations.

Should we not apply this same thinking to our inputs of energy as well as of labor?

If we make energy more productive – getting more from each joule and kilowatt, each amp and BTU, then might we not enjoy growing prosperity with less energy consumption?

A higher cost for each unit of energy consumed would not necessarily lead to higher total costs for consumers and reduced growth for the world.

The action step that should flow from taking this point of view would be at a minimum better measurement and public disclosure of energy efficiency in all uses of energy.