Private Equity, my version of the neverending story

Nobody likes Private Equity, never have and never will. The hedge funds hate them because they make similar amounts but their structure prevents investor runs on the funds, unlike the ones that occur to a hedge fund. The i-bankers hate them because they have more freedom and make more money than they do. The regulators hate them because they operate outside their grasp. People hate them because the tippy-top make more money than Peru in a given year and almost everyone in the industry, at minimum, makes more than 3x what a median American household makes. For these reasons, and many, many more PE tries to keep a low profile. However, if you want to do the research you can find out about them their deal history, their portfolio companies, and anything else you might ponder. Dartmouth's Tuck School of Business has a dedicated unit writing up case studies and training talent for these firms. Of course, Harvard, Stanford and Chicago train plenty of MBAs who end up in PE, either by starting a firm or joining one. Still, the only thing that ends up in main stream media are the giant takeovers and the blow ups, which represent a very small and an even smaller proportion of the deals done.

The latest missive continues the trend of large takeovers and blow ups to again portray the industry in poor light. To help, I will refute some of the misunderstandings and bring about the industry in lay terms.

Imagine a house. Now imagine you want to buy that house. If you are unlike Bill Gates, you will more than likely require financing. Now the current owner's financing may be completely different from your idea of what an ideal capital structure may be. The mortgage may have already been paid off, or they may only own 25% equity if the had recently purchased it. This does not matter because you will pay them the agreed sales price and then can institute your own capital structure. For instance, once the sales agreement is negotiated stating you would pay 100,000 for the house. If it was the latter situation (25% equity), 75,000 would go to pay down the mortgage lender and 25,000 of equity would go to the former owners. Now your financing may be something like 50% cash and 50% mortgage from your local bank. The bank lends you money because it knows if you do not pay than it can reclaim the house from you, that is the mortgage is collateralized.

Most LBOs are like mortgages where the new owners put down 20% equity and borrow the last 80% from banks, or shadow banks (sophisticated debt investors) using the assets of the firm as collateral. After the mortgage is paid down, does not have to be all the way, you can sell it. The purchaser (PE firm) will make money in several ways: the equity appreciation (less debt in the capital structure), multiple expansion ( the next buyer will pay you more than you paid for the home.) That's basically all there is to private equity. Just like a 68% of Americans have done when purchasing their home, Private equity firms use collateralized loans.

Of course just like Americans found out, PE firms' portfolio companies can still end up underwater trying to live the American dream.

1st let me flesh out an idea about how the cycle of a portfolio company works. Ever see the movie Ronin. Well, Robert DeNiro's character never walked into a place he couldn't get out of. That's exactly how PE firms think. From day one they are thinking about the exit. (plenty of good work here.) Basically, there are a few ways PE firms will end their involvement with one of their portfolio companies.

• Merger with a public company, including a reverse merger where the public entity merges into the private entity
• Acquisition, this can be from a conglomerate, a competitor, or to another PE firm
• IPO, sell the shares to the public
• private placement, where a few large institutions purchase the company or a portion of it

So instead of this paragraph sounding ominous "... as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money." You can see that this is just one of the ways that a PE firm exits. It just so happens that each time it was to a financial buyer instead of a strategic purchase from a firm like Sealy or Tempurpedic.

The article then speaks about dividend recapitalization. Here I can agree with the article's thrust that this action is a very dangerous game to play. However, the General Partner of the PE firm, may be at a time where his investors are looking for a return. What this action does is bring money back immediately to the LPs (investors of the PE firm) but also gives them a call option should the firm continue to shed its debt with its operational cash flow. The new debt though has to be sold to someone and that entity or entities may require some agreements, or covenants, that restrict the flexibility of the firm. This is, as the article insinuates, akin to taking out a second mortgage. Plus, as in the case of Simmons, the company can become over-levered in an economic environment that is unfavorable thus tipping the portfolio company into bankruptcy. With no recourse to follow back up to the PE firm, this leaves a bad taste in the mouths of all the people mentioned in paragraph one.

As always, the financial intermediaries will make money as long as transactions are going on. So of course investment banks made money as underwriters of debt and of IPOs. Articles like these love to point this out when the company fails but the i-banks also make money when these firms succeed as well.

The rest of the article could be about any firm, any where in the current economic environment. The cheap debt era ended, consumers have cut back and employees who were looking for a lifetime commitment are in the best of cases receiving a severance on their way out the door.

From the article, "because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits."

This is in so many ways wrong. The PE firms do not hold cash, they hold commitments from their limited partners (LPs/investors.) When they find a firm to purchase they hold a capital call and the LPs are supposed to provide the cash necessary to support the capital structure the GP (general partner) thinks is best suited for the targeted firm given its micro- and macro-economic environment. So never will a PE firm pony up 100% of the cash to buy a firm, just to then lard it down with debt, given the new acquisition its best shot but just playing the coin flip of heads I win, tails you lose. Intense projections, which are corroborated by the retained management, are devised. The capital structure is tested for revenue drops and unexpected shocks. The management is encouraged by the PE firm because they will also have a stake in the new capital structure along with the PE firm. So everyone works together to make the most amount of money for the equity holders of the new firm.

As I stated above there are a few ways in which to make money in the PE process, the two already mentioned because they fell in with the house analogy are debt repayment and multiple expansion. The third however is the generation of cash flow. The PE firm's staff are highly trained management, process innovators, former industry titans and financiers who know how to change a business model from one that may putter along into a well oiled machine. The business model has to be that way to ensure enough leeway to make bond coupon payments from the debt the company has taken on.

Any cash taken out of the portfolio company is returned to the partners of the PE firm, either the General or the Limited Partners according to their agreement and how far along they are in the agreement. If this is the first cash generating investment it would more than likely all be going to the LPs. If it was the last 80% would go to the LPs and 20% to the GP. None of this money is used to make new investments.

The remaining piece of the article tends to hone on the two points, the dividend recapitalization and the fall of Simmons market & thus the company. I would point out one more thing, the dividend recap was oversubscribed. The investors buying this "home equity loan" knew what it was being used for and thought with all the cheap debt and the solid business model that Simmons could handle it and be able to pay them back. Unfortunately they were wrong. The human interest portion of the article while touching and sad as Schumpterian creative destruction takes hold, shows how the executives were trying to save the company. Whereas the employee remarks there were no more Christmas parties, I say, well that means that the factory can make payroll for the next week instead.

Did THL error, yes. Did employees suffer, yes. Is this what THL predicted or wanted as an outcome? No. That they may have gleaned their principal back is not what their LPs want. In fact when they raise their next fund the LPs will remember that in this investment they were returned their principal and not a return on the principal. The fact is at the end of the day the bondholders (including the ones who lent the "second mortgage,") will try to make a new go of it. The only thing changing will be the owners of the company. I predict that consumers will still be enjoying Simmons mattresses years from now.

“How Economists Are Missing Another One,” or Not

The worst thing I have ever read. It completely lacks an understanding of savings, investment and how the capital markets work. It does include enough facts that it seems plausible but I am still baffled as to how this was printed at The Big Picture at 10:18 AM 10/6/2009.

First, I would like to state that yes shares are traded on the secondary market and that people or corporations buying these shares are not really inserting new capital into a company unless they are buying an IPO or a seasoned offering. The reason this is done is to buy portions of current and future earnings that will be ultimately be returned to the shareholders through dividends, stock repurchases by the company or selling it to another entity who wishes to diversify their holdings and have a claim on the company’s earnings.

The “quelle horror” of total return versus dividends is because there is a tax benefit for shareholders in that dividends are taxed as ordinary income in the year received. However, when the corporation buys backs it shares and thus concentrates the earnings to the surviving shareholders; the shareholder can either choose to sell some of his holdings back to the company for income or hold on and be taxed later on. The taxation all depends on the shareholder’s preference. This is why total return is a better mark than dividends.

The argument that companies can create money is ridiculous. The Federal Reserve is the only entity that can create money using the banking system multiplier and open market purchases. There are newer tools but I won’t bore you with them now. This bold statement is made but then later on in the essay the author then decides that it isn’t really creating money it is shifting money from savers to investors, which is exactly the raison d’etre of the financial system. I would liken this to being angry with the sun because it basks us with sunlight every morning.

The paper fortune that you describe Bill Gates has is because each of those shares he has includes a claim of the near monopoly pricing and therefore earnings of Microsoft. If everyone traded in their laptop for an iPhone than guess what; those shares would drop in value not because they were worthless to begin with but because the future earnings of Microsoft would be in peril. Thus, the incendiary remark that it is a legal form of counterfeiting is placed in there only to excite the automatons. The whole piece reeks of this economic populism. For instance, “Despite Wall Street claims, retirement plans invest little in companies. Instead, the plans buy stock that insiders sell, thus transferring middle class savings to the richest people in the country and increasing the wealth gap.” While it may be true that entrepreneurs are benefiting by selling shares in their enterprises to the common man, they are not doing so without giving the common man a claim against any and all future income that the corporation may receive.

I cannot even fathom how the author comes up with the idea, let alone the evidence, that “These LBO outfits acquire a company with strong assets including cash but low stock prices; sell some of the assets; close down operations and eliminate jobs to cut costs; extract the cash with dividends; borrow large amounts to pay for the process; and sell the companies back on the market in a weakened condition.” If the “hulk” of the company was in such a “weakened” position than who would purchase it? This assumes that the i-bankers underwriting the IPOs are snake oil salesman and that this is done with the tacit agreement from the SEC. Both of these statements may still be true, however, at the end of the day the buyer of these IPO shares has to have done due diligence and expects to earn a return not a bankruptcy.

Here is a report by a Harvard and Chicago professor about the job loss at private equity firms. http://www.google.com/url?sa=t&source=web&ct=res&cd=3&url=http%3A%2F%2Fwww.scribd.com%2Fdoc%2F6310387%2FThe-Global-Economic-Impact-of-Private-Equity-Report-2008&ei=IMTLSvmnH4HJlAeJpZ3NBQ&usg=AFQjCNGSVZJhpNyCtj3hqJV7eh2-9aT8WA&sig2=pY8dkmJL8mhJ1Yb_gGLXEg

If no time read the article by Andrew Sorkin of the Times describing that paper and its results here. http://www.nytimes.com/2008/01/25/business/worldbusiness/25davos.html

Both find little evidence that private equity firms do more firings than is necessary to clear dead wood than any other firm. “[Portfolio companies] compared with those public companies with similar junk debt ratings, buyout [portfolio] companies defaulted at half the rate.” Tends to show that PE firms are more adept at managing a fiscal crisis than their public counter-parties. I will agree that the behemoth pe firms can have their incentive structured skewed to earn management fees and transaction advisory fees, ahem KKR, but the majority of funds and the GPs only make money once it has been all returned to the LPs. (indeed the carried interest doesn’t start until the principal and the management fees are returned.)

After that section though I have no quips with the analysis. The boomers turning from buyers to sellers is a valid argument, especially in the face of the liquidity crisis cum solvency crisis of the past few years. If on a whole investor’s risk appetites switch to shorter duration investments for income generation or just in cash or cash-like equivalents than yes the stock market could tank as there would be more supply than demand. But markets have a funny way of clearing. So if investors preferences do change to more income producing investments, I believe stock buybacks might be accelerated to decrease the supply of stock shares outstanding. Alternatively, the government may change its rules, as it is want do when a large portion of voters now need dividends, having capital gains and dividends receive the same tax treatment. This in turn would shift CFOs to go back to offering dividends with its excess cash instead of share buybacks, which would make the author happy?

Finally, I should think in concurrence with the author that baby boomers who planned on having twenty plus years of retirement may instead be more realistic and work later on into life, thus, decreasing the amount of time in which they have to live off of their investments.

I apologize for being so shrill to begin with, but there is some good analysis in this piece, it’s just that there is a ton of rhetoric contained in this piece that has been refuted.

I am re-posting this below because now I cannot find this anywhere on the internet. Here is a screen grab from my RSS feeder.

Thornton Parker is the author of “What If Boomers Can’t Retire? How to Build Real Security, Not Phantom Wealth” and has worked for the Department of Commerce and the Executive Office of the President. He focuses on retirement plans and investing in stocks to solve the ongoing Social Security problem. He defines phantom wealth as “the returns from corporate stocks that are based on market prices” as opposed to real wealth that is based on “work, earnings, and solid accomplishments, instead of just hopes.”

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Paul Krugman explained, in “How Did Economists Get It So Wrong” (The New York Times Magazine, September 6, 2009) how economists’ oversimplifying assumptions and models led to the present crisis by hiding important realities of the financial system and the real economy. He also described differences between the “salt water” economists at universities along the Atlantic and Pacific coasts and the “fresh water” economists of the Middle West, particularly the University of Chicago.

Today’s crisis grew out of problems on the credit and consumption sides of the economy. This essay builds on Krugman’s article and explains why problems on the equity and production sides, that few economists, political leaders, or corporate executives seem to understand or are willing to admit, are likely to cause another crisis.

Most salt water economists agree that creating jobs on Main Street is important. That will require extensive private sector investments, but the term “investment” has several meanings that can hide the different ways that stocks can affect jobs, wealth distribution, and the economy. The differences stem from three aspects of stock investments; types of investment, investors’ objectives, and stock flows.

Types of stock investments

Stock investments are productive or parasitic. The line between them can be fuzzy sometimes, but the differences are usually clear. Productive investments, which are called direct investments when made in other countries, provide capital to start and expand businesses in the real economy. They pay for the things, knowledge, and services that a company needs to operate. Young companies that are intended to become large need productive investments that usually come from the founders, their friends and families, and early stage investors such as angels and venture capitalists who take active interests. Because investments in these young companies involve many risks and are hard to liquidate, the companies depend on stock and rarely borrow very much. If they are successful, they may raise more productive capital from an initial public offering (IPO) and maybe from secondary offerings. If they continue to grow and establish a credit record, they may borrow money for productive investments, but equity capital is required for most early stage development.

In contrast, most stock purchases by individuals and institutional investors are parasitic investments because the buyers just want their money to grow. They are not interested in who gets their money or how it is used. They may buy stock of specific companies or they may buy shares of mutual and exchange traded funds that in turn buy companies’ stock. In any case, their money goes to the former stockholders, not to the companies. These are parasitic investments because they contribute little to the companies but piggy-back the productive investments that others have already made. And as will be discussed, they may be harmful and lead to eliminating rather than creating Main Street jobs.

Investors’ objectives

Five primary reasons for obtaining stock are for control of a company; to receive current income from its operations; for price gains; to store future purchasing power; and to create money. Company founders typically believe they know best how to manage their new enterprise, so they take large blocks of stock before the IPO in order to retain control. Similarly, outsiders who want to influence or take over a company may buy large amounts of its stock on secondary markets.

Income from dividends used to be a major reason to buy stock for the long term, but in the early 1980s, emphasis shifted to “total returns” which were dominated by price gains. S&P 500 Stock Index data show that 1981 was the last year after 1925 when the sum of all dividends paid was greater than the gains. The shift was profitable for Wall Street and coincided with the emergence of 401(k) retirement plans which emphasized growing portfolio values. Now, most stock purchases are for short term gains.

Retirement plans are the dominant stock buyers today, and their purpose is to build future purchasing power. But the plans have hurt Main Street and have fatal flaws which will be discussed below.

Finally, despite the general understanding that companies issue stock to raise money, their main reason is literally to create a form of money.

Stock flows

Individual and institutional investors buy most of their stock on the New York Stock Exchange, the NASDAQ and other secondary markets. Only small amounts of stock are bought directly from companies through public offerings. My analyses of Federal Reserve Flow of Funds Data indicate that after companies have their IPOs, most of their shares come to secondary markets when insiders sell them. This will be discussed below because it has major wealth distribution and other effects that few people understand, economists ignore, and those who benefit try to keep from being discussed.

Creating money with stocks

The reckless expansion of credit that led to over-consumption and the housing bubble has been widely discussed, but comparable mistakes with stock are being ignored. Creating money is the best place to start applying the three aspects of stock investments listed above (types of investment, investors’ objectives, and stock flows) to show how stocks can affect jobs, wealth distribution, and the economy.

It is natural for the founders of a company to want to keep control of their baby, so they can easily justify taking large blocks of stock before the IPO. Right after the IPO, however, all shares are treated as being worth the market price and if the founders took enough, their paper fortunes can make them rich in a day. Most recent fortunes have been made by (figuratively) printing stock certificates and passing them as money in what amounts to a legal form of counterfeiting. Few economists or public officials have recognized how this process expands the money supply while reducing the national savings rate, and almost no data are published to track it. Entrepreneurs need incentives to take risks, but there are serious questions about how large the incentives should be and how they should be taxed.

Insiders convert their paper fortunes into cash by selling the stock. Aggregate data for this are scarce, but it is how most stocks come into the market. The efficient-market hypothesis (EMH) does not consider how insiders drip feed stock into the market, pacing the sales to maximize their returns while not overly depressing the market.

Bill Gates, the richest person in the world, is the extreme example of this. He took 45% of the Microsoft stock before the company went public in 1986 and has been selling ever since. During the first eight months of 2009, he sold 60 million shares for a total of $1.2 billion. He more than recovered his investment from his first sale during the IPO, so all of his receipts are profit and are now taxed as capital gains at 15%. He still had 713 million shares as of August 18, 2009, which at the average price he received this year is a paper fortune of more than $14.7 billion. Like many other companies, a primary goal of Microsoft is to create personal fortunes using its stock, and at one time there were an estimated 10,000 “Microsoft millionaires.”

Retirement plans

Retirement plans exist to provide earnings streams to retirees. After 1982, Wall Street began promoting stocks as retirement investments by emphasizing their “total returns” which are driven by stock price growth more than dividend payments. Largely as a result of this change, stock prices were inflated in terms of their price-to-dividends and price-to-earnings ratios until the market peak in early 2000. Today, retirement plans of all types own nearly two thirds of the publicly-held stock traded on U.S. markets, but three important points are being overlooked.

First, as retirement plans bought stocks, almost no one asked where the stocks were coming from and where the retirement savings were going; or to put it another way, if stocks were such good long term investments, who was selling them and why? The answer, which few people including economists and political leaders seem to know, is that insiders like Bill Gates and his associates sold most of the stocks that the plans bought in order to convert their paper fortunes into cash. Despite Wall Street claims, retirement plans invest little in companies. Instead, the plans buy stock that insiders sell, thus transferring middle class savings to the richest people in the country and increasing the wealth gap.

The second point is that except for small amounts that some pension plans put into venture capital funds, nearly all stock investments by retirement plans are parasitic. As money flows in to plan managers who are expected to make it grow, they buy stocks and pass the pressure for growth on to companies. The companies respond by cutting costs, downsizing, outsourcing, laying off domestic employees, abandoning communities, promoting globalization, and going global themselves, all to inflate stock prices.

A recent example of these harmful effects grew out of the search for higher returns by pension systems. When stock prices stopped rising, they turned to “alternative investments,” including miss-named private equity funds which are actually leveraged buy-out operations. These LBO outfits acquire a company with strong assets including cash but low stock prices; sell some of the assets; close down operations and eliminate jobs to cut costs; extract the cash with dividends; borrow large amounts to pay for the process; and sell the companies back on the market in a weakened condition. The LBO outfits and pension plans are the winners, while companies, their employees, and their communities are the obvious losers. Less obvious are the companies that have learned not to look healthy enough to attract LBO attention.

The net effect of retirement plans’ buying insiders’ stock and parasitic investing has been to shrink both the production side of the economy and the middle class. The shrinkage was partly hidden while borrowing financed the housing bubble and excess consumption. Now, the country is trying to end the recession and create jobs, but the production side of the economy is crippled. Rebuilding it will require massive productive investments in companies and even new industries to create jobs that will be harder to export. People are being advised to save more for their retirements, but almost none of their savings that will be handled by retirement plans or Wall Street will become available for the productive, equity investments that will be needed to create jobs.

The third overlooked point about stock-based retirement plans that is until their stocks are sold, their portfolio values are just phantom wealth that can simply vanish, as it has done twice in the past ten years. Whether or not the plans can be successful will be determined by the demand for stocks and supply offered for sale when boomers want to retire. This leads to the fundamental flaws in stock-based retirement plans.

Retirement plan flaws can lead to another crisis

One of the worst things that could happen in the near future would be for stock prices to return to their former heights because that would restore confidence in stock-based retirement plans. These plans have eight fundamental flaws.

1. They are built on a stocks-for-retirement cycle. Most baby boomers are in the front, or buying half of the cycle, and to receive retirement incomes, they will have to shift to selling their stocks for substantial gains in the back half. This makes the cycle a national Ponzi scheme because returns to early investors (boomers) must come from money paid in by later investors (younger workers), not from companies as dividends.
2. When boomers gradually shift from buying stocks to selling them, the primary domestic buyers will have to be the younger workers that some believe will not be able to sustain Social Security in its present form. Stock-based plans and Social Security are joined at the hip by the same demographics—if stock based plans can work, there will be no Social Security problem, but if Social Security can’t work, neither can the stock-based plans. Despite urgings to boomers to save more and buy stock, their plans will be determined as much by the saving and stock-buying habits of younger workers as by the boomers’ own actions.
3. There has been a symbiosis between corporate insiders and boomers’ retirement plans. The plans wanted the insiders’ stocks and the insiders wanted the boomers’ money. As the boomers’ plans shift from buying to selling, the relationship will end and they will have to compete with insiders who will still be selling. This will add more downward pressure to stock prices in what may become a sustained bear market.
4. Boomers are told to plan to stretch their stock sales over many years, but if there is a serious bear market, some of them may decide to get out quickly and save what they can. This, of course, would feed the bear.
5. Boomers’ retirement plans that will have to sell stock suffer from the fallacy of composition; while some might be able to build and store future purchasing power individually, all of them can not do it collectively. Retirement income cannot be stored for a whole generation. It is a flow that can only come from other flows like employee and company earnings, which is why there appears to be a Social Security problem.
6. If there were an accepted due diligence analysis or feasibility study that explains how the boomers’ stocks-for-retirement cycle can be expected to work, Wall Street would quote it like a mantra. But there is no such document, so when asked, Wall Street changes the subject.
7. The plans are based on the same mistake of anticipating ever higher asset prices that led to the housing bubble. There is no accepted explanation of how stock prices can increase more than the economy grows for several generations, but this must happen for younger workers to pay adequate prices for the boomers’ stocks and then sell them at a profit to pay for their own retirements.
8. In a 2002 paper titled “Demography and the Long-Run Predictability of the Stock Market,” John Geanakoplos of Yale and two salt water associates from the West Coast explained that there has been a close relationship between stock prices as represented by price-earnings ratios and the ratio of young and old adults in the population. They predict a long bear market when boomers switch to selling.

The termination of thousands of company pension plans and the sorry shape of many state and local plans are evidence of these flaws. Any one of these flaws should be enough to make economists, corporate and government officials, and Wall Street question boomers’ plans before they all fail. But instead of asking questions, they avoid them.

What’s left?

Like fractals, the picture is similar at any level of detail. Few boomers have saved nearly enough to hope to retire for many years; despite Wall Street predictions, their stock-based retirement plans have done little for the past ten years; their savings in houses have declined; and ultimately the stock portion of their retirement plans are likely to fail as many pension plans are failing now. Many boomers will have to work more years than previous generations.

Governments typically approach employment problems with training programs, but unless jobs are created, training will be useless. Massive, productive investments must be made in new industries to create the middle class jobs with adequate pay and benefits that boomers, those who lost their jobs in the recession, and younger workers coming into the labor force will need. But these are just the kinds of investments and jobs that institutional investors, including retirement plans, have been forcing companies to avoid or eliminate. Further, Wall Street is devoted almost entirely to helping wealthy people speculate with parasitic investments and is not equipped to provide the equity capital needed to make the productive investments.

Today, attention is being paid to problems on the credit and consumption sides of the economy, but regardless of when the recession formally ends, America’s recovery and long range prosperity will be limited by problems on the equity and production sides. These problems will be harder to fix than the ones being considered now because they are more subtle; few people understand them; the fixes will require far more complex changes to the financial system; governments have reached their borrowing limits; and Wall Street will deny them and may delay action until it is too late to avoid a another crisis

But problems on Main Street, which Wall Street helped to create and many economists are missing, will not just go away and it is impossible to explain how the economy can regain its strength unless it is based on a strong Main Street.

tipparker@mac.com

Serial Drivel

I usually breeze through BusinessWeek in about 10 minutes, just trying to sense the flavor of what MSM is cooking. But this week I could not just bypass this article without adding a comment, or two, or three. So below is the article with my notes attached.

There's an old saying in economic forecasting: The consensus is always wrong. But which way? The average forecast of the 52 economists surveyed by Blue Chip Economic Indicators calls for growth in real gross domestic product of 2.7% over the next four quarters, with the annual rate in any single quarter no greater than 3%. This early in the recovery, it's tough to argue that the consensus is either too pessimistic or too optimistic, but one thing is clear. The herd does not think the past tendency of strong recoveries to follow deep recessions will hold true this time. For example, in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.

The herd. The author uses the word herd to generate an impression of herd behavior or herd thinking. Too caught up in being like everyone else to see what is really occurring. Fine.

The correlation between the depth of recessions and the strength of recoveries over the last nine business cycles is unmistakable. It relates to the extent of the cuts businesses make in output, payrolls, and inventories. It also reflects the amount of pent-up demand created as consumers and businesses postpone spending. Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.

As he does not posit which business cycles, I will just assume he is talking about NBER's marking of recessions. But why stop there, why not 10; why not the just the last few? Do the 9 really represent what has occurred in this cycle? How about we make a comparison of this cycle to what previously occurred to see if we can rely upon a snapback, v-shaped, pent-up demand recovery that he posits.

Look in the last chart you can see cash for clunkers. However, there is much more in the CFR's report. Suffice to say I am not completely convinced that we can rely on the data from the past 9 cycles to be representative of what has happened and what might happen next. But I will continue to read with open mind in hopes of being persuaded.

If the consensus is right, the economy's departure from past experience would be striking. Economist Robert J. Barbera at the research and trading firm ITG (ITG) notes that after each of the past nine recessions, deep or shallow, real GDP has never required more than three quarters to regain its peak level prior to the downturn. If GDP staged a full recovery over the next three quarters, the economy would grow at a 5.4% annual rate. Even stretched over four quarters, the pace would still be 4.1%.

Again you must accept the wisdom that this is a normal recession just like in 1990, 2001 1981, etc. to then follow the conclusion that growth will be even better than the forecasters median expectation.

The common argument is that the usual rebound effect will be limited by the aftershock of the financial crisis: Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit, limiting the business sector's response. However, that's no sure thing. Data on credit flows are not particularly useful for predicting the strength of a recovery, according to economists at Barclays Capital. They note that in the strong upturns of the 1970s and 1980s, consumer spending accelerated well before the upturn in consumer credit.

My counter-factuals would be: A)that in the 1970's and 1980s Baby Boomers were entering the workforce, and for each one who entered there were more behind him/her coming. Thus, staking your place was fine, you could "buy-the-dips." Now however, those same leaders will be leading the way into retirement. The first Boomers are 63 now and in their mind's eye have been targeting the good life once they hit the Social Security mark. Now however, they will have to either work longer or save more if they hope to maintain their lifestyle. B) Also while the analyst at Barclays argue that credit may not be the major concern, as businesses have hoarded cash to survive this liquidity and solvency crisis. What should be a concern is CapEx spending.

CapEx has been dropping sequentially and year on year. So where are these revenues to come from if no one is engaged in attempting to grow their top line? The companies have done well to keep their profits up by annihilating their variable costs (labor.) So still not quite convinced but there is still more to come.

Early in recoveries, the growth of household income is a more important impetus to spending than credit. As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months. Also, a lot of spending is done by households and businesses that either don't need to borrow or have good credit quality.

Aha! He has seen the light, it is hiring that will bring everyone back into spending! Let's look at the latest jobs report to see how great the job situation is going, the one that will bring us to above trend growth over the next 9 months.

Wait, what is this. The BLS stating that they have overestimated how many jobs have been lost over the past 20 months. It is actually 824,000 worse, which adds an additional .6% to the already abysmal 9.83% U-3 unemployment. Though it can be said that unemployment is not per se a bad thing when it is short term. It is only when it is long term unemployment that indicates a major problem with the economy.

That is structural unemployment is the highest it has been in 40 years! I am sure this is just a normal recession so the snap back should be starting any moment now. I wonder if I should mention that there is large proportion of part time employees who will have their hours increased before a firm begins to re-hire which can be seen in the hours worked survey from the BLS as well.

The recovery's oomph will also turn on how much income households feel they need to put away to eliminate debt and restore nest eggs. A rising saving rate weighs heavily on the growth of consumer spending. However, with savings in the second quarter already at 5% of aftertax income, up from 1.2% in early 2008, the saving rate may be about as high as it needs to go to give households the cushion they want.

So since we have established that all the rehiring because of all the revenue opportunities that companies are witnessing, we can then posit that consumers will go back to their prolific ways in spending our way to success. No mention of that as an open economy and the world's reserve currency that national savings will equal investment plus net capital outflows. Since the US dollar is in fact the world's dollar and that countries must use it as a store of wealth and a medium of exchange, which, of course, keeps the savings rate in the US artificially low since domestic investment is funded by foreigners allowing us to borrow freely from them. However, it does not state why consumers after being wounded with a 14 trillion dollar loss of wealth would want to continue to live paycheck to paycheck instead of saving for a rainy day. Please continue...

Historically, saving behavior loosely tracks the ratio of household income to wealth. As that ratio rises, in this case because of plunging stock prices and home values, so does the savings rate. By the second quarter the ratio had risen to the levels of the early 1990s, when the saving rate was about 6%, close to where it is now. Moreover, households in the second quarter recovered $2 trillion of the $14 trillion in net worth lost during the recession, and rising stock and home prices imply another gain of about $2 trillion this quarter.

The author now describes how savings is calculated and then undermines his argument by stating that the saving rate in a seemingly artificial manner dropped because of the rebound in the stock market. So we should actually look at the flow of funds report to see if savings increased not by its proportion but actually cash on cash over the preceding quarter. Here is the latest data 1219.9 followed by last quarter 1311.4 and the quarter a year back 1425.9. Since the economy has shrunk the savings rate shot up despite lower numbers. Although it must be said to save you have to pay off your creditors first.

So far, the raft of surprisingly positive data in recent weeks supports the more upbeat recovery scenario. In particular, the index of leading indicators, a composite of 10 gauges that tends to foreshadow recessions and recoveries, has turned up sharply. Since March the index has grown at an 11.7% annual rate, the fastest five-month pace since the 1981-82 recession.

The ten components of the Leading Economic Index include:

1. Average weekly hours worked by manufacturing workers - negative
   
2. Average number of initial applications for unemployment insurance - negative
   
3. Amount of manufacturers' new orders for consumer goods and materials - negative
   
4. Amount of manufacterers' new orders for capital goods unrelated to defense - negative
   
5. Speed of delivery of new merchandise to vendors from suppliers - positive
   
6. Amount of new building permits for residential buildings - positive
   
7. The S&P 500 stock index - positive
   
8. Inflation-adjusted money supply (M2) - negative
   
9. Spread between long and short interest rates (i.e. the yield curve) - positive
   
10. Consumer expectations - positive

So the positives from the reports are that monetary policy has effectively lifted the spread and the stock market. This has caused consumers to feel a bit better that the economic situation is not getting worse but is stabilizing. The new building permits has risen from a depressed level because of the cash for houses government initiative. However, on the whole no one is hiring, no one is adding more hours to the work week, no one is ordering more capital to build revenues. Seems a bit like a two sided report, everything that the government can touch is being held up by it and the rest is just wishful thinking.

For now, none of this will change the minds of the more pessimistic forecasters. However, the historical pattern is on the side of the optimists.

We finally agree. The analysis is sloppy. He does try to convey that he weighed both arguments for pessimism and optimism but it is not at all as thorough as it should be. I would have felt much better if he tried to dig further into his bullish arguments by explaining what portion of the LEI that he felt gave the economy the best bet. Was it the stock market? If so than his logic circles in this manner: the LEI is going up because the stock market has gone up therefore the stock market is going to continue to go up because the LEI presages it. Huh?

Economists do it with models! Part 2

This post involves a lot of pictures from PowerPoint. I will add notes to each image.


The above picture shows a "normal" supply and demand curve. National savings (the supply) will increase with an increase in the real interest rate. Thus it slopes upward. Investment and NCO acting as the demand component works in the opposite manner. As The real interest rate rises the amount of loanable funds is low, lower and the quantity rises, thus it slopes downwards. ( Loanable funds are usually used to invest in capital assets, either at home or abroad, thus its relation to I + NCO)


The demand curve (in blue) represents the demand for dollars which is 100% correlated to NX. We know that NX must equal NCO from earlier discussions. Imagine you buying that BMW again. You are giving BMW US dollars but they must pay their labor in Euros. So what do they do with their US dollars, probably buying a factory in South Carolina, otherwise known as purchasing a capital asset.

The real exchange rate will be where this market is in equilibrium. The supply curve is vertical because the Quantity of Dollars is not affected by the real exchange rate, it is affected by the real interest rate. The amount of NX will affect the demand for dollars which are necessary to make transactions between foreign countries. When the exchange rate is lower will stimulate a demand for dollars, thus the demand curve slopes downward.



The real rate of interest will affect NCO. If the rate is low in relation to the Euro then more funds will leave the country. When the rate is higher (relatively) in the US then funds will flow back into the country.


The NCO graph ties together the demand for dollars/real exchange rate graph and the loanable funds/real interest rate graphs so that analysis of policy decisions can be made.


This example shows China as the home country. It wishes to lessen its trade balance by removing its subsidy to Chinese export companies. By decreasing the amount of net exports no matter what the exchange causes the demand for Yuan to fall (move leftward.) The real exchange rate drops to R2, however, it does not affect the amount of capital leaving the country. (note this example assumes that the Yuan is a fully convertible currency) NCO is only affected by changes in the real rate of interest in relation to the rest of the world.


A second example where the US is the home country. How would it be affected by having the Chinese purchase less Treasury securities? First we would see NCO increase, which would cause the domestic real interest rate to rise. This would have a secondary affect of...

Increasing the supply of dollars in the foreign exchange market. The increase in dollars would lower the real exchange rate. All in all the US would export more, import less due to the change in exchange rate. It would also save more as the real rate of interest would rise.

I added that if this had been undertaken in an orderly fashion after the dot-bomb debacle, perhaps instead of invading Iraq, there might not have been such a huge financial crisis with its epicenter in the US housing market. Instead the Chinese have continued to purchase US treasury securities keeping the real rate of interest low. This allowed a borrowing binge and an asset price appreciation in the United States housing market. Instead of appropriating the funds in more productive sectors, citizens were buying and flipping houses back and forth to each other in a Ponzi-esque fashion.

You can also imagine this set of graphs analyzing government budgets, ( a deficit will draw down on the supply of loanable funds, crowding out private investment), trade policy (quotas help one industry at the expense of all exporting industries via a higher exchange rate) and Capital Crises (it is the same analysis of China pulling its investment example from above.)

Economists do it with models! Part 1

The last time we used a model we were looking at a hypothetical closed-economy. The model previously proposed was the market for loanable funds and now we can do the same analysis again with the new tools that we built in the preceding posts.

So now we go back to our Savings and Investment identity, S = I and add on NCO. Therefore,
S = I + NCO

Remember what S (national savings) consists of, which is public and private savings or

(Y - t - C) + (t - G) = S = I + NCO
Private Savings + Public Savings = National Savings = Investment and Net Capital Outflow

As we discussed last time NCO should be affected by real interest rates which behaves in the following fashion. As the real interest rate rises this encourages more people to save and less people to invest. The higher rates cost people & businesses more money to borrow to finance a project so instead they can just earn a rate of return by saving it. The higher borrowing costs create a hurdle rate that makes businesses take on the fewer projects that can meet this barrier.

Now though we have the added variable of real interest rates worldwide. So we should consider how those rates will affect financial flows. Note that this is a model and may not explain what currently happens in all places at all times. In fact what I am about to say next does not at all reflect the reality in America for the past 30 years.

So you have capital either located at home (I) or abroad (NCO). Savings will then purchase capital in either places. However, NCO can be positive or negative and will thus have an affect on the market for loanable funds in the following manner (usually): When NCO > 0, NX is greater than zero and we purchase capital abroad which increases the demand for loanable funds thus keeping real interest rates down. Conversely, when NCO <> 0, while NX < 0. How can this be so? Well as the nations that export to the US garner a bunch of dollars the countries then use their US Dollars to buy US debt.

Let's dig a little deeper into this and introduce a time differential. So in a closed economy the only way for a country to increase its investment is to increase savings. That is because S = I. In an open economy because S = I + NCO the domestic citizens do not have to raise their savings to fund investment. So if the US decides to build a nuclear plant it could import the parts from France and also borrow the funds in Euros. This will increase America's Investment (I) while increasing its NCO as well. We could also term NCO as the current account, as in the current account deficit. The reason this works is because the French have decided to save more so that the resources to build the plant are freed up for America. This is a time differential or in the jargon of economists it is an intertemporal trade, in that America imports present consumption (borrowing from the French) and exports future consumption (when it pays off the French.)

This is how the American consumer was able to spend so prolifically over the past 30 years because we kept buying present consumption and paying for it with IOUs (Treasury securities) that Asia snapped up. Because of the perceived weakness of the political and economic systems the Asians were willing to save more than their American counterpart and give up higher returns for two reasons: A) their economies relied upon the US consumer buying their goods, that is their own economies could not consume as much per capita as Americans because of the lack of a social safety net & B) the US dollar is a store of wealth and unit of exchange in the global economy.

I'll end here and begin again with the model.

Too small to bail has a nice ring to it - Breakingviews

I agree with the sentiment and the main thrust of the article but, there always is a but, it seems to make a small mistake. First the synopsis: the banking industry is seeing larger losses at the larger banks, the systematically important banks caused the financial crisis because of the interconnectedness, smaller banks have thus far outperformed their larger brethren, however larger banks lend out more of their deposits thus getting vital credit out to the financial system, one last caveat is that the larger banks employed more mark to market and thus we may see more & larger (relatively) losses on smaller banks financial statements later in the cycle.

From the article But there is a wrinkle. Small banks lent out a smaller percentage of their customers’ deposits — 83.11 percent in the second quarter, to be exact — than the big banks, which converted 94.24 percent of deposits into loans, according to SNL Financial.

That’s a meaningful difference. If all banks in the United States kept their loan-to-deposit ratios in line with smaller banks, some $830 billion less credit on total deposits of $7.54 trillion would reach American businesses and consumers than if all banks adopted the big banks’ lending ratio.

My bone is with the larger banks lending out more of their deposits. You see on the face this statement is correct, prima facie for you latin lovers. However, deposits are only one form of liability for a bank. (quick note: bank loans are assets for banks and bank deposits are liabilities for banks. Banks will also issue debt as a longer or shorter liability.) So that is where the bone is. Larger banks will have better access to the capital markets; thus, these banks can lend out more money because the liability side of their balance sheet will be larger than a bank who cannot issue debt as cheaply or as in abundance as its larger cousin. Here is the information directly from the horse's mouth, otherwise known as the FDIC.



In this case there is no story. Banks larger than 10B in assets lend out only 58.19% of their liabilities. Smaller banks lend out 70.13%. If you divide it by smaller banks being less than 1B than these banks lend out 75.26% of their assets and the banks larger than that lend out 60.32% of their assets. What is the story here?

Well the story is B.S. or as I say in front of my niece baloney, not to be confused with bologna a delicious treat for children.

The truth is that if all the banks lent out at the rate small banks are currently doing there would be more credit in the system. Don't know if that is necessarily a good thing, but the idea is on much more solid ground than the sloppy analysis from the article.

Open note to my congressman

Below in bold is a note I forwarded to my congressman. I also included a link to a more eloquent argument than my own, which is below in italics. I would urge you to send forward the italicized argument to your own congressman (especially if it is one of the following names who make up the financial service committee:
Rep. Barney Frank, MA
Rep. Paul E. Kanjorski, PA
Rep. Maxine Waters, CA
Rep. Carolyn B. Maloney, NY
Rep. Luis V. Gutierrez, IL
Rep. Nydia M. Velázquez, NY
Rep. Melvin L. Watt, NC
Rep. Gary L. Ackerman, NY
Rep. Brad Sherman, CA
Rep. Gregory W. Meeks, NY
Rep. Dennis Moore, KS
Rep. Michael E. Capuano, MA
Rep. Rubén Hinojosa, TX
Rep. William Lacy Clay, MO
Rep. Carolyn McCarthy, NY
Rep. Joe Baca, CA
Rep. Stephen F. Lynch, MA
Rep. Brad Miller, NC
Rep. David Scott, GA
Rep. Al Green, TX
Rep. Emanuel Cleaver, MO
Rep. Melissa L. Bean, IL
Rep. Gwen Moore, WI
Rep. Paul W. Hodes, NH
Rep. Keith Ellison, MN
Rep. Ron Klein, FL
Rep. Charles Wilson, OH
Rep. Ed Perlmutter, CO
Rep. Joe Donnelly, IN
Rep. Bill Foster, IL
Rep. Andre Carson, IN
Rep. Jackie Speier, CA
Rep. Travis Childers, MS
Rep. Walt Minnick, ID
Rep. John Adler, NJ
Rep. Mary Jo Kilroy, OH
Rep. Steve Driehaus, OH
Rep. Suzanne Kosmas, FL
Rep. Alan Grayson, FL
Rep. Jim Himes, CT
Rep. Gary Peters, MI
Rep. Dan Maffei, NY

Republican Members

Rep. Spencer Bachus, AL
Rep. Michael N. Castle, DE
Rep. Peter King, NY
Rep. Edward R. Royce, CA
Rep. Frank D. Lucas, OK
Rep. Ron Paul, TX
Rep. Donald A. Manzullo, IL
Rep. Walter B. Jones , NC
Rep. Judy Biggert, IL
Rep. Gary G. Miller, CA
Rep. Shelley Moore Capito, WV
Rep. Jeb Hensarling, TX
Rep. Scott Garrett, NJ
Rep. J. Gresham Barrett, SC
Rep. Jim Gerlach, PA
Rep. Randy Neugebauer, TX
Rep. Tom Price, GA
Rep. Patrick T. McHenry, NC
Rep. John Campbell, CA
Rep. Adam Putnam, FL
Rep. Michele Bachmann, MN
Rep. Kenny Marchant, TX
Rep. Thaddeus McCotter, MI
Rep. Kevin McCarthy, CA
Rep. Bill Posey, FL
Rep. Lynn Jenkins, KS
Rep. Christopher Lee, NY
Rep. Erik Paulsen, MN
Rep. Leonard Lance, NJ

Mr Frank, I am sure your aides have alerted you to this article as your name appears in it but I thought I might forward it along with a plea.

I have an undergraduate economics degree. I have a Masters of Business Administration in Finance. I have worked for financial services companies; negotiated contracts that were 20 pages deep, which were filled with hereafters and proper uses of semi-colons. So I can read a credit card disclosure or a savings account disclosure, but that is not the point. The point is that these products and their requisite disclosures are supposed to be easy and not required two degrees and 40 free minutes to wade through the nuances of how the contract will function when there are multiple variables at play. As Mr. Waldman eloquently argues below disclosure is not a transfer of information. Pages of dead trees layered upon each other in a type that is credibly said to be legible because font sizes are regulated does not mean that they are understandable to a lay person.

That is what I plead to you as a reasonable person, to instate a prudent person act that recognizes the information asymmetries exist that include benefits which are opaque and do not favor your constituents. One of the key arguments that I have studied over the length of this financial crisis that beset the global economy is that improved transparency and education could enhance outcomes.

However, it was Herbert Simon though who posited a long time ago "...in an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it..."

So per se, literacy in any subject is a good thing but the amount of information and the subjects are too consuming for any one person to master while maintaining their day job.

Thank you for your time and please reconsider your position,
Harry Coleman




Vanilla is a commodity

Do we have no fight left in us at all? Mike Konczal and Kevin Drum are excellent as always, but must we really write eulogies? Is one of the best regulatory proposals so far dead just because a single well-bought congressman says so?

Extracting the vanilla from the CFPA is not, as Felix Salmon put it "the beginning of the end of meaningful regulatory reform". It is the end of the end. Vanilla products were the only part of the CFPA proposal that was likely to stay effective for more than a brief period, that would be resistant to the games banks play. All the rest will be subject to off-news-cycle negotiation and evasion, the usual lion-and-mouse game where regulators are the rodents but it's the rest of us that get swallowed.

Wall Street's favorite comedian-politician, Barney Frank, was very savvy in framing the debate over the issue with his well-placed mischaracterization of vanilla products as "anti-market". That is bass-ackwards. The vanilla option is pro-market, because it is procompetitive. Of course, that is precisely why banks hate it: Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price.

Ezra Klein is suitably depressed, but he's wrong when he writes that "the 'plain vanilla' provision was never likely to do that much." Vanilla products would be very popular, which is why they are so threatening. Financial services are an area where markets not only fail due to informational problems, but where participants are very aware of that failure. Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic "lemons" problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don't take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will "voluntarily" participate in markets rigged against them for the privilege of being normal. And we do, every day.

But define a reliable vanilla option, and the dynamic flips on its head. Instead of tolerating rent-extraction as a cost of participation, consumers put up with one-size-fits-all products in exchange for peace of mind. Most consumers benefit very little from exotic product features, and I suspect that many are made deeply nervous by the complex contracts they can neither negotiate nor understand, but nevertheless must sign. Vanilla financial products would be extensively vetted and and their characteristics would soon become widely known. Inevitable malfunctions would be loudly discussed in the halls of Congress, rather than hushed-up in rigged private arbitrations. Vanilla products would face discipline both from private markets (no one is suggesting we forbid other flavors) and from a very public political process. Politics and markets are both deeply flawed, but they are flawed in different ways, and we should take advantage of that. In Arnold Kling's lexicon, a market in which vanilla and exotic financial products coexist and compete offers the benefits both of exit and of voice.

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

I'm sympathetic to the principled libertarian objection to having the government require that private parties offer a product they otherwise might not. No one should be forced to offer vanilla financial products. Small-enough-to-fail boutiques should be free to offer only the products they wish. However, if an institution wishes to avail itself of government-provided deposit insurance or to access Fed borrowing facilities, it is perfectly legitimate for the government to set requirements. The government can choose not to offer its safety net to institutions that don't offer vanilla products, just as banks currently choose not to offer me a credit card unless I sign up to binding arbitration and unilateral contract changes. I fail to see why one is coercive and the other not. (The government has no monopoly on deposit insurance. Private insurers are free to provide similar insurance, and do so for many financial service companies already.)

An Economist anonobloggeer has some peculiar non-compliments about the vanilla products proposal:

The vanilla offering seems to be intended to substitute for sophistication or research on the part of the customer, but I'm just not sure that's a good way to approach the issue. As best I can tell, the vanilla plan wouldn't mandate the price of the simple option; just because a bank would have to offer a vanilla mortgage loan doesn't mean it would have to offer a competitive vanilla mortgage loan. If that's the case, banks could easily use high rates on the simple products to steer individuals toward the complex offerings. Or, the vanilla rule could actually serve to direct bank collusion toward high-priced, high-margin products.

Just because a commodity exchange standardizes the quality of corn that must be delivered into a futures contract doesn't mean that any seller has to offer corn at a good price. So true! But sellers that offer commodities at above market prices don't usually find buyers. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price. Banks are very, very good at forming tacit cartels, but colluding on complicated terms and conditions is easier and less likely to attract the antitrust authorities than fixing a headline price.

More from the econoanonoblogger:

To me it seems like the more effective solution would be to require that financial institutions explain, in detail, each and every fee they are assessing (or might potentially assess) to customers. That would inform consumers of what's going on in the monthly bill, and it would create an incentive to reduce the number and complexity of fees, as lengthy explanations would be a hassle for all involved and would reduce business.

One of the great errors in modern policy is to confuse disclosure with information. It is not the case, currently, that banks secretly take your money without itemizing the charge on some statement. (Sometimes when they take your money they call it "service fee" or something equally nondescriptive, and it'd be nice if that practice went away.) Rather, banks intentionally define contracts in such a way that the cost to many customers of understanding and competitively shopping all the dimensions of the product seems higher than the cost of terminating the search and signing the dotted line. More detailed disclosure doesn't eliminate, and can sometimes exacerbate, the real information costs customers face, which derive from the complexity of the required analysis and lack of information about alternatives, not from an absence of product data. Of that we all have pages, with more arriving every month. You might think there'd be a market for ostentatious simplicity, and there might be. But no bank's lawyers would sign off on a single page, 12 point text, no-extratextual-incorporation-or-unilateral-modification contract. When routine contracts get more complex than that, it's just gibberish competing with gibberish for people who have lives. Some financial products are necessarily complex. But one way of managing complexity is standardization. It may be worth it for consumers to carefully study the one contract they will probably sign in a way that it would not be worth poring through 100 freeform contracts, 99 of which they will never sign.

The most serious objection I know to vanilla financial products is that they would be harmful precisely because they would catastrophically succeed. The theory is that nothing is more dangerous than a commodified bank, and the evidence is May Day, 1975, when the SEC ended fixed stock trading fees in the brokerage industry. Some commentators (e.g. Barry Eichengreen) claim that by eliminating a stable, cushy profit center, the May Day deregulation forced gentle investment banks to become hungry innovators, that the financial system has grown progressively less stable because under cut-throat competition risk-takers dominate (until they self-destruct and take the rest of us down with 'em). I don't buy the May Day story, but for the sake of argument, let's suppose it's true. Let's suppose that, in the name of stability, the best policy would be to ensure banks easy profits so that they needn't dabble in dangerous things. Then two conclusions follow:


1. If we are going to strike a policy bargain whereunder banks get a nice sinecure in exchange for a promise of stodgy mellowness, it seems reasonable that they should commit to the stodgy mellowness. Dull, subsidized banks should be heavily regulated banks, or, to use the term of art, "narrow banks".

2. If we are going to impose a regime that ensures bank profitability, we ought to do so in a reasonably equitable way. Business models that hide profit generators in complex contracts, or that extract fees especially from the disorganized and naive, are not reasonable instruments of public policy for keeping banks healthy. If we do go with the coddled but heavily regulated model of banking (not my preference!), and we're not willing to have the Treasury end the capitalist charade and just cut checks to its payment-systems subcontractors, then a decent approach would be to have narrow banks offer only vanilla products and provide monopoly rents by putting floors under fees and ceilings above deposit interest rates (as existed in the US until the 1980s). Under either a competitive or "regulated utility" model, the fairness and informational case for defining standardized vanilla products remains compelling.

I think people like Barney Frank, when they try to sleep at night, have been sold on the "we need healthy banks, so let's protect their profit centers" story, although they'd never admit to it while scoring points comparing powerless people with furniture. I wonder if it even occurs to Mr. Frank that maybe something serious should be demanded of banks in return for state protection of market power at the expense of the weak and disorganized. But then Mr. Frank has already gotten very much in return.

Not so much M&A but the trouble with financial disclosures and consent.