Monday, October 8, 2012
Small US investor an anachronism
Financial Review
PUBLISHED: 06 Oct 2012
While the Dow and the S&P indices were stealing all the headlines
over the last decade, a quiet revolution was occurring in the market
that’s gained little attention.
Call it the institutionalisation of the stockmarket. In the past decade the number of retail investors in the stockmarket has dropped steeply.
Company filings show the individual investor has been gradually replaced by ever larger index funds, pensions and quant funds. That has caused a fundamental shift in the balance of power in the stockmarket. And it’s something public companies are only beginning to grapple with.
For years, public companies thought they knew who their shareholders were.
Not any more. High-speed, computer-driven trading by quant funds in particular makes it harder than ever for companies to know who owns them. Often it’s merely a computer program, not a person, picking a stock to buy.
Moreover, the extensive use of derivatives blurs the boundaries of ownership. The owner listed in a share registry may have traded away any economic interest in a particular stock.
Retail investors used to be a pillar of the market, demanding and receiving attention from companies and their advisers. In recent years, though, retail investors have been disappearing from the stockmarket.
Partly that’s because there’s been a shift to mutual funds and index funds and away from individual stock ownership.
In the 1980s one-quarter of US households owned a mutual fund. By the end of the 1990s almost half of all households invested in mutual funds, according to the Investment Company Institute.
The reverse is true about direct stock ownership. In 1999, 25.5 per cent of households owned individual stocks directly. By 2011 that dropped to 20 per cent, according to ICI.
At the same time as more investors have shifted into mutual funds, there’s been a decline in the overall number of Americans who actually hold any stock at all.
Today about 46 per cent of US households have any exposure to stocks, either directly or indirectly, while in 2001 almost 60 per cent of households held stocks.
While individuals have been disappearing, institutions have emerged as the dominant owners of the stockmarket. Institutions include active investment managers, index funds, quant funds, public pension funds, hedge funds and exchange-traded funds.
According to one analysis by Goldman Sachs, in 1998 institutional investors owned 57.1 per cent of the stockmarket. By 2009 that had grown to almost three-quarters.
The composition of institutional investors has also been changing. More institutional shareholders are typically passive investors such as index or quant funds, rather than active fund managers.
There are a number of interesting implications. For starters, households these days have considerably less power to influence public companies than they did in the past.
Holding stock through a mutual fund means there’s an intermediary between the investor and the company. Will the index fund manager have the same concerns about executive compensation, for instance, or any other corporate governance issue as the investor?
As long as the stock meets the index manager’s performance requirement, mightn’t he or she be satisfied with that? But then who’s looking out to make company management better?
Then there are issues for public companies. How do companies talk to and communicate with shareholders when some of them might actually not even be human?
What’s more, the rise of derivatives and other complex securities means companies might not even know who their shareholders are. Two years ago the management of US retailer JC Penny was shocked to learn that two activist investors, Pershing Square Capital Management and Vornado Realty Trust, suddenly owned almost 27 per cent of the company after exercising derivatives positions.
The shift in the balance of power in the market puts more influence in the hands of traditionally passive shareholders. The big question is what they will do with that increased power. Could Vanguard, for instance, the pioneer of index funds, become a more active shareholder?
The CEO of Vanguard hinted earlier this year about a growing focus on corporate governance.
“We continue to be generally optimistic in our assessment of governance practices broadly,” F. William McNabb said. “Nonetheless, the tension among the roles of regulators, shareholders, company directors and executives in corporate governance matters remains a subject of much debate and we believe there is still substantial room for improvement on a number of fronts.”
How all this plays out remains to be seen as institutions adjust to their new, more powerful positions and companies adjust to their new shareholders.
One thing is clear, though. The US stockmarket is now a game of big players. The era of the little investor is long gone.
PUBLISHED: 06 Oct 2012
Anna Bernasek
Call it the institutionalisation of the stockmarket. In the past decade the number of retail investors in the stockmarket has dropped steeply.
Company filings show the individual investor has been gradually replaced by ever larger index funds, pensions and quant funds. That has caused a fundamental shift in the balance of power in the stockmarket. And it’s something public companies are only beginning to grapple with.
For years, public companies thought they knew who their shareholders were.
Not any more. High-speed, computer-driven trading by quant funds in particular makes it harder than ever for companies to know who owns them. Often it’s merely a computer program, not a person, picking a stock to buy.
Moreover, the extensive use of derivatives blurs the boundaries of ownership. The owner listed in a share registry may have traded away any economic interest in a particular stock.
Retail investors used to be a pillar of the market, demanding and receiving attention from companies and their advisers. In recent years, though, retail investors have been disappearing from the stockmarket.
Partly that’s because there’s been a shift to mutual funds and index funds and away from individual stock ownership.
In the 1980s one-quarter of US households owned a mutual fund. By the end of the 1990s almost half of all households invested in mutual funds, according to the Investment Company Institute.
The reverse is true about direct stock ownership. In 1999, 25.5 per cent of households owned individual stocks directly. By 2011 that dropped to 20 per cent, according to ICI.
At the same time as more investors have shifted into mutual funds, there’s been a decline in the overall number of Americans who actually hold any stock at all.
Today about 46 per cent of US households have any exposure to stocks, either directly or indirectly, while in 2001 almost 60 per cent of households held stocks.
While individuals have been disappearing, institutions have emerged as the dominant owners of the stockmarket. Institutions include active investment managers, index funds, quant funds, public pension funds, hedge funds and exchange-traded funds.
According to one analysis by Goldman Sachs, in 1998 institutional investors owned 57.1 per cent of the stockmarket. By 2009 that had grown to almost three-quarters.
The composition of institutional investors has also been changing. More institutional shareholders are typically passive investors such as index or quant funds, rather than active fund managers.
There are a number of interesting implications. For starters, households these days have considerably less power to influence public companies than they did in the past.
Holding stock through a mutual fund means there’s an intermediary between the investor and the company. Will the index fund manager have the same concerns about executive compensation, for instance, or any other corporate governance issue as the investor?
As long as the stock meets the index manager’s performance requirement, mightn’t he or she be satisfied with that? But then who’s looking out to make company management better?
Then there are issues for public companies. How do companies talk to and communicate with shareholders when some of them might actually not even be human?
What’s more, the rise of derivatives and other complex securities means companies might not even know who their shareholders are. Two years ago the management of US retailer JC Penny was shocked to learn that two activist investors, Pershing Square Capital Management and Vornado Realty Trust, suddenly owned almost 27 per cent of the company after exercising derivatives positions.
The shift in the balance of power in the market puts more influence in the hands of traditionally passive shareholders. The big question is what they will do with that increased power. Could Vanguard, for instance, the pioneer of index funds, become a more active shareholder?
The CEO of Vanguard hinted earlier this year about a growing focus on corporate governance.
“We continue to be generally optimistic in our assessment of governance practices broadly,” F. William McNabb said. “Nonetheless, the tension among the roles of regulators, shareholders, company directors and executives in corporate governance matters remains a subject of much debate and we believe there is still substantial room for improvement on a number of fronts.”
How all this plays out remains to be seen as institutions adjust to their new, more powerful positions and companies adjust to their new shareholders.
One thing is clear, though. The US stockmarket is now a game of big players. The era of the little investor is long gone.
A new type of tickle down economics
Around the world, economic policy in
recent years has been based on a simple belief. If you make sure that all the banks
are doing fine, the rest of the economy will eventually follow suit.
That’s what’s behind so called ‘quantative
easing’, the cornerstone of the Federal Reserve’s economic policy since the
financial crisis. And the Fed’s not alone. The Bank of England and the European
Central Bank pursued the same policy in the aftermath of the 2008 financial
panic. The Bank of Japan has done it since 2001.
The policy was born out of necessity.
With official interest rates set near zero, further interest rate cuts don’t do
anything. The theory of quantitative easing is that central banks can stimulate
the economy by printing money to buy longer maturing bonds. The holders, of
course, are primarily banks and other financial institutions.
That is supposed to help in three ways.
First, when banks themselves are in trouble it ensures that they don’t go bust.
Second, putting money in the hands of banks and institutions means they can lend
more to businesses and households.
Third, the central bank offers more
than the otherwise prevailing market rate to induce bondholders to sell. That
sends prices up and pushes down yields on those longer term bonds. If all goes
well, lower long term interest rates result and actors in the real economy see
a greater incentive to borrow and invest.
With employment in the US stalled, the
Fed has now turned to a third round of quantative easing, announcing it will
buy $40 billion a month of mortgage backed securities. Stated more clearly, the
Fed is printing money to buy real estate loans for a little more than they
would otherwise fetch.
It’s worth asking whether putting that money
into banks now is going to boost the economy.
Back in 2008, when the banks were the
source of the problem, quantative easing helped stabilize institutions on the
verge of collapse and averted what looked to be a real disaster.
The second time the Fed embarked on quantative
easing was in 2010 and 2011 when economic growth slowed to crawl speed. At that
time, the biggest effect of the Fed’s policy was on the stock market, sparking
a bull charge upwards from financial crisis lows.
But now the banks are doing very well.
The problem is a lack of hiring.
Economists think the rising stock
market may have had a slight wealth effect, helping to boost consumption at the
higher end. But the number of Americans owning stocks has been falling since
2001 when it reached a peak of nearly 60 percent. Today less than half of
households own any stocks at all, while the vast majority of stock wealth is
concentrated in a small sliver of the population. In contrast, a far greater
wealth effect could come from boosting the housing market where two-thirds of Americans
own their own home.
Whether quantative easing boosts the broad
economy or not hinges on the willingness of banks to lend. If banks get extra
funds from bond sales but don’t lend them out to companies and households, it
won’t help the economy. Companies and homebuyers may want to borrow at those
low, low rates but banks have to agree to take the risk. Big companies can
access stock markets and debt markets on their own, but small and medium firms
and individual homebuyers have few options.
So how willing are banks to lend right
now?
Since the financial crisis, banks have been
cutting their risk. They have lent readily to big companies and the most
creditworthy individuals, but not to anyone else. That leaves out the vast
majority of the population.
According to recent figures from the
Fed survey of senior loan officers, lending standards are easing but only in
the area where banks have already been lending—big companies and high quality
individuals. There’s just one problem. Those companies and individuals have
already borrowed as much as they want at historic low rates. They can’t use any
more money at the moment.
The Fed’s survey shows that there has
been no shift in lending to small and medium firms or consumers with less than
perfect credit. In fact, the Fed reported that standards have tightened on both
prime and nontraditional mortgages. It seems that a lot of people would like to
borrow but are being shut out.
Then where does that leave QE3? So far the Fed’s announcement of QE3 boosted the stock market. Major indicators like the Dow and S&P are trading near record highs. Bond traders may see a windfall as well. But unless banks change their lending standards, it won’t boost the economy.
Quantative easing is the latest in a long line of trickle down economic policies. Tax cuts for the already wealthy and for the corporate sector have not proven particularly powerful ways to stimulate the broader economy. Those policies have led to growing disparity between haves and have nots. Quantative easing looks like more of the same.
Monday, September 24, 2012
Even Republicans are losing faith
Financial Review
PUBLISHED: 22 Sept 2012
America has had no shortage of successful businessmen who think
national politics will be easy. Many people enjoyed watching the
presidential aspirations of Donald Trump. And then there’s Mitt Romney.
Business politicking isn’t for the meek. But that’s small potatoes compared with the real thing. Maybe that’s why Romney has been looking like a rank amateur.
While Americans are divided over who to vote for this November there’s one thing they can agree on: Romney has run a lacklustre campaign.
According to a USA Today/Gallup Poll, almost 60 per cent of Americans expect Obama to win the presidency. Intrade, the widely watched online betting site, tells a similar tale. Romney’s chances of becoming president have been steadily dropping. At present the odds are two to one against him.
The fact that Romney is struggling shouldn’t really come as a surprise. Not long ago we had an agonising series of Republican primaries. From the outset Romney was perceived as a lousy candidate by many within his own party.
The way Romney ultimately gained nomination was essentially brute force: applying more money and more personnel to the process than his rivals could match.
That’s been his current strategy, too. Romney seems to hold an unwavering belief that if he outspends Obama and the economy stays weak, he will win. That’s it, nothing more. He hasn’t offered many specifics, and the vague promises he has made haven’t gained any traction with the public. No matter what has come his way, he’s stuck to that simple strategy. Romney is no improviser.
But Romney’s approach hasn’t worked. In the long presidential campaign, candidates are scrutinised for their political skill, intellect and personal appeal. Time and time again, on those fronts, Romney showed he’s no match for the President. Obama lacks business experience and has a paltry fortune compared to Romney. But when it comes to politics he makes Romney look like a schoolboy.
Remember the last time Barack Obama made a mistake? Most people don’t. It was two years ago, when he was faulted for insulting conservative voters in Pennsylvania when he speculated that bitterness over the economy caused them to cling to their guns or their religion.
Since then Obama has run an absolutely flawless campaign. Romney’s campaign is a different matter, with gaffe after gaffe. It’s reached the point where even other Republicans and fellow conservatives are beginning to distance themselves from him.
The fun started when Romney maintained that “corporations are people”. Trying to elicit sympathy for companies at a time of booming profits and lousy wages didn’t endear him to voters. Then, when he went to London before the Olympic Games to preen over his success in organising the Winter Games in Salt Lake City, he wound up insulting his hosts. A tabloid headline said it all: “Mitt the Twit”. Prime Minister David Cameron helpfully pointed out that organising an Olympics in the “middle of nowhere” is a bit easier than doing it in one of the busiest cities there is.
Next came Romney’s comments relating to the death of Ambassador Christopher Stevens during a violent outbreak in Libya. Before he learnt what really happened, Romney attacked Obama for sympathising with anti-American protesters. There was just one problem. Romney’s assertions were blatantly false.
Polls show a large majority fault him for the unseemly attack while those in the know shuddered at the lack of temperament.
And finally a media storm erupted over a leaked video showing Romney telling a group of $US50,000 donors he doesn’t care about 47 per cent of Americans. “Well there are 47 per cent of people who will vote for the President no matter what … so my job is not to worry about those people,” he assured them. Romney went on to explain that the 47 per cent believe they are victims who are dependent on the government and won’t take responsibility for their lives.
Romney’s claim that those 47 per cent don’t pay income taxes was clearly false since all workers pay payroll tax even if they don’t pay other income taxes. And Romney has paid shockingly low taxes himself, so low he’s too embarrassed to release the details. By putting income taxes front and centre with the public, he hasn’t done any favours for his wealthy constituents who enjoy very low taxes compared with many workers.
Read a lot of news accounts and they’ll say the presidential race is still close. But what becomes apparent when you look closer is that Romney is not only behind but losing. The US electoral college system is winner-take-all in most states. The nationwide popular vote is legally irrelevant.
That’s why candidates spend all their money, energy and time on states that are up for grabs. And lately Romney is having trouble in states he must win to have a chance at the presidency. A key trouble spot is Ohio, where Romney is significantly behind Obama.
A Louisiana political candidate in 1983 famously quipped: “The only way I can lose this election is if I’m caught in bed with either a dead girl or a live boy.” Obama is too smart to make that kind of boast, but it seems to apply nonetheless.
PUBLISHED: 22 Sept 2012
Anna Bernasek
Business politicking isn’t for the meek. But that’s small potatoes compared with the real thing. Maybe that’s why Romney has been looking like a rank amateur.
While Americans are divided over who to vote for this November there’s one thing they can agree on: Romney has run a lacklustre campaign.
According to a USA Today/Gallup Poll, almost 60 per cent of Americans expect Obama to win the presidency. Intrade, the widely watched online betting site, tells a similar tale. Romney’s chances of becoming president have been steadily dropping. At present the odds are two to one against him.
The fact that Romney is struggling shouldn’t really come as a surprise. Not long ago we had an agonising series of Republican primaries. From the outset Romney was perceived as a lousy candidate by many within his own party.
The way Romney ultimately gained nomination was essentially brute force: applying more money and more personnel to the process than his rivals could match.
That’s been his current strategy, too. Romney seems to hold an unwavering belief that if he outspends Obama and the economy stays weak, he will win. That’s it, nothing more. He hasn’t offered many specifics, and the vague promises he has made haven’t gained any traction with the public. No matter what has come his way, he’s stuck to that simple strategy. Romney is no improviser.
But Romney’s approach hasn’t worked. In the long presidential campaign, candidates are scrutinised for their political skill, intellect and personal appeal. Time and time again, on those fronts, Romney showed he’s no match for the President. Obama lacks business experience and has a paltry fortune compared to Romney. But when it comes to politics he makes Romney look like a schoolboy.
Remember the last time Barack Obama made a mistake? Most people don’t. It was two years ago, when he was faulted for insulting conservative voters in Pennsylvania when he speculated that bitterness over the economy caused them to cling to their guns or their religion.
Since then Obama has run an absolutely flawless campaign. Romney’s campaign is a different matter, with gaffe after gaffe. It’s reached the point where even other Republicans and fellow conservatives are beginning to distance themselves from him.
The fun started when Romney maintained that “corporations are people”. Trying to elicit sympathy for companies at a time of booming profits and lousy wages didn’t endear him to voters. Then, when he went to London before the Olympic Games to preen over his success in organising the Winter Games in Salt Lake City, he wound up insulting his hosts. A tabloid headline said it all: “Mitt the Twit”. Prime Minister David Cameron helpfully pointed out that organising an Olympics in the “middle of nowhere” is a bit easier than doing it in one of the busiest cities there is.
Next came Romney’s comments relating to the death of Ambassador Christopher Stevens during a violent outbreak in Libya. Before he learnt what really happened, Romney attacked Obama for sympathising with anti-American protesters. There was just one problem. Romney’s assertions were blatantly false.
Polls show a large majority fault him for the unseemly attack while those in the know shuddered at the lack of temperament.
And finally a media storm erupted over a leaked video showing Romney telling a group of $US50,000 donors he doesn’t care about 47 per cent of Americans. “Well there are 47 per cent of people who will vote for the President no matter what … so my job is not to worry about those people,” he assured them. Romney went on to explain that the 47 per cent believe they are victims who are dependent on the government and won’t take responsibility for their lives.
Romney’s claim that those 47 per cent don’t pay income taxes was clearly false since all workers pay payroll tax even if they don’t pay other income taxes. And Romney has paid shockingly low taxes himself, so low he’s too embarrassed to release the details. By putting income taxes front and centre with the public, he hasn’t done any favours for his wealthy constituents who enjoy very low taxes compared with many workers.
Read a lot of news accounts and they’ll say the presidential race is still close. But what becomes apparent when you look closer is that Romney is not only behind but losing. The US electoral college system is winner-take-all in most states. The nationwide popular vote is legally irrelevant.
That’s why candidates spend all their money, energy and time on states that are up for grabs. And lately Romney is having trouble in states he must win to have a chance at the presidency. A key trouble spot is Ohio, where Romney is significantly behind Obama.
A Louisiana political candidate in 1983 famously quipped: “The only way I can lose this election is if I’m caught in bed with either a dead girl or a live boy.” Obama is too smart to make that kind of boast, but it seems to apply nonetheless.
Monday, September 17, 2012
Labor stats needn’t be such hard work
Financial Review
PUBLISHED: 15 Sept 2012
Since peaking at 10 per cent less than three years ago, unemployment has fallen by almost 2 full percentage points. Yet instead of good cheer, Americans seem more pessimistic.
It didn’t help that the main news story from August’s job numbers was that the drop in joblessness was due to a sharp decline in the workforce. The labour force participation rate – percentage of the adult population employed or actively seeking work – dropped to 63.5 per cent, its lowest level in more than three decades.
Commentators automatically assumed it was due to discouraged workers leaving en masse. Perhaps that’s correct. But official figures don’t break it down in a meaningful way. The drop could be due to any number of reasons; there’s no official way to be sure.
Most accounts of the job figures focused on the bad news – a paltry 96,000 new jobs created last month – and more or less ignored the lower jobless rate. That says a lot about the official “headline” unemployment number: it’s not particularly useful.
The jobless figure comes from a government survey of households. The method dates from 1940. The survey has been updated over the years but relies on a crude binary paradigm. Those who answer the survey are either employed or not; there’s no in-between.
The Bureau of Labour Statistics, which compiles the report, says the basic concepts “are quite simple”. People with jobs are employed. People who are not working for pay and who are looking for a job and available to work are unemployed.
The BLS says being employed means getting paid for anything or earning profit on work done. It also includes pitching in on a family farm or helping out at a family restaurant even if you don’t get paid. People who are not employed and either not looking for work or not available to work are not in the workforce.
Simple, maybe. But way out of date. Those concepts arose in a world long gone where men worked at a job for life, women kept house and kids went to school. Looking back at the 1940 cohort, nearly anyone looking for work in the US that year would find it before long.
The labour market has only become more complex. These days there’s a whole spectrum of work from traditional full-time work, various part-time occupations, moonlighting, freelancing, volunteering, and entrepreneurial roles. A person in a job may not be earning to her potential, and a person out of a job may be very productive.
If the official job numbers tend to include everyone who gets a pay cheque, they’re not an effective measure for what we want to use them for: a guide to national economic wellbeing. The BLS does publish an alternative measure. But they are just additions to the base unemployment number and, therefore, not fundamentally different.
Of most concern is that we’ve come to rely on an official statistic that doesn’t tell us very much. We still have little idea how much unused labour capacity is being wasted and how financial hardship arising from that unused capacity is distributed among the population.
It’s not just the jobless figure though. For instance, the poverty line that we use to set critical policy has been long criticised by economists as needing a complete overhaul to keep up with changes since it was introduced in 1963. The measure assumes an average family spends one third of income on food, yet today that’s more like 12 per cent.
While economists remain stuck in the typewriter age, the rest of mankind is in the middle of the biggest revolution in data and information in history. The cost of acquiring and analysing data has fallen so far, so fast, that it has become possible to measure the economy on a granular level. Many government agencies would like to modernise the major economic measures but often the talent and funding just aren’t there.
Meanwhile, outside government, thousands of economists pore over the same dubious numbers month after month. Private sector economists could devote more time and energy to making innovative measurements of the economy.
A few enterprising economists have done just that. Bob Shiller, Karl Case and Allan Weiss devised a national housing price index. Introduced just in time to capture the housing bubble, the Case-Shiller index provided invaluable help in understanding the extent and impact of the housing crash.
Today’s digital economy needs and deserves better economic data. Developing better ways to measure economic performance may be the single biggest opportunity in economics today.
PUBLISHED: 15 Sept 2012
Anna Bernasek
It should have been good news that the US jobless rate fell last
month from 8.3 per cent to 8.1 per cent. Surprisingly, that message
landed with a thud.Since peaking at 10 per cent less than three years ago, unemployment has fallen by almost 2 full percentage points. Yet instead of good cheer, Americans seem more pessimistic.
It didn’t help that the main news story from August’s job numbers was that the drop in joblessness was due to a sharp decline in the workforce. The labour force participation rate – percentage of the adult population employed or actively seeking work – dropped to 63.5 per cent, its lowest level in more than three decades.
Commentators automatically assumed it was due to discouraged workers leaving en masse. Perhaps that’s correct. But official figures don’t break it down in a meaningful way. The drop could be due to any number of reasons; there’s no official way to be sure.
Most accounts of the job figures focused on the bad news – a paltry 96,000 new jobs created last month – and more or less ignored the lower jobless rate. That says a lot about the official “headline” unemployment number: it’s not particularly useful.
The jobless figure comes from a government survey of households. The method dates from 1940. The survey has been updated over the years but relies on a crude binary paradigm. Those who answer the survey are either employed or not; there’s no in-between.
The Bureau of Labour Statistics, which compiles the report, says the basic concepts “are quite simple”. People with jobs are employed. People who are not working for pay and who are looking for a job and available to work are unemployed.
The BLS says being employed means getting paid for anything or earning profit on work done. It also includes pitching in on a family farm or helping out at a family restaurant even if you don’t get paid. People who are not employed and either not looking for work or not available to work are not in the workforce.
Simple, maybe. But way out of date. Those concepts arose in a world long gone where men worked at a job for life, women kept house and kids went to school. Looking back at the 1940 cohort, nearly anyone looking for work in the US that year would find it before long.
The labour market has only become more complex. These days there’s a whole spectrum of work from traditional full-time work, various part-time occupations, moonlighting, freelancing, volunteering, and entrepreneurial roles. A person in a job may not be earning to her potential, and a person out of a job may be very productive.
If the official job numbers tend to include everyone who gets a pay cheque, they’re not an effective measure for what we want to use them for: a guide to national economic wellbeing. The BLS does publish an alternative measure. But they are just additions to the base unemployment number and, therefore, not fundamentally different.
Of most concern is that we’ve come to rely on an official statistic that doesn’t tell us very much. We still have little idea how much unused labour capacity is being wasted and how financial hardship arising from that unused capacity is distributed among the population.
It’s not just the jobless figure though. For instance, the poverty line that we use to set critical policy has been long criticised by economists as needing a complete overhaul to keep up with changes since it was introduced in 1963. The measure assumes an average family spends one third of income on food, yet today that’s more like 12 per cent.
While economists remain stuck in the typewriter age, the rest of mankind is in the middle of the biggest revolution in data and information in history. The cost of acquiring and analysing data has fallen so far, so fast, that it has become possible to measure the economy on a granular level. Many government agencies would like to modernise the major economic measures but often the talent and funding just aren’t there.
Meanwhile, outside government, thousands of economists pore over the same dubious numbers month after month. Private sector economists could devote more time and energy to making innovative measurements of the economy.
A few enterprising economists have done just that. Bob Shiller, Karl Case and Allan Weiss devised a national housing price index. Introduced just in time to capture the housing bubble, the Case-Shiller index provided invaluable help in understanding the extent and impact of the housing crash.
Today’s digital economy needs and deserves better economic data. Developing better ways to measure economic performance may be the single biggest opportunity in economics today.
Tuesday, September 11, 2012
Words may be action enough for ‘invisible man’ Fed
Financial Review
PUBLISHED: 08 Sept 2012
A week ago, America’s economic glitterati gathered at a resort in Wyoming with the spectacular backdrop of the rugged Grand Teton mountain range.
The Jackson Hole conference, hosted each year by the Federal Reserve Bank of Kansas City, brings together an elite group of central bankers, policymakers, academics and Wall Street economists. It’s America’s answer to Davos, and those who get invited feel very much on the inside of the power elite.
The Federal Reserve chairman is the star, and his address is eagerly anticipated, sometimes revealing a new insight, idea or even policy move. Papers presented by other guest speakers fuel discussions, and new ideas can at times percolate out of the two-day symposium. This year’s meeting was named “The Changing Policy Landscape”.
So what exactly came out of Jackson Hole, 2012? Zilch. At least as far as the Fed is concerned, the policy landscape may change but policy remains the same.
Fed chairman Ben Bernanke spoke about monetary policy since the financial crisis. He extolled the virtues of non-traditional monetary policy tools, namely quantitative easing, whereby the Fed bought up stacks of bonds from institutions and investors. But he stuck to an almost wooden script, announcing no actions but promising that the Fed was ready to do something if needed.
It’s been the same story since the last major round of quantitative easing ended a year and a half ago.
Yet, even as Bernanke spoke, the signs of a weakening economy were evident. Just before his speech, the Commerce Department said second-quarter growth figures for the US economy were revised down to an annual 1.6 per cent from the previously estimated 2.4 per cent. Since then the August data has been weak. New home sales slowed sharply and manufacturing, the lone bright spot post-crisis, contracted for the third month in a row.
The problem is the more Bernanke says the Fed is standing by, the less reassuring he gets. Could somebody remind him of the old adage that actions speak louder than words? With Europe collapsing and the US in stagnation, the Fed is the invisible man of the global economy.
Bernanke knows that by law he has a dual mandate: to promote price stability and full employment. Price stability isn’t a problem, but employment is far from where it should be. Setting aside economics entirely, there’s a legal requirement for Bernanke to act that he’s been simply ignoring.
And when you consider the economics, continued Fed inaction borders on the reprehensible.
Labour economists recognise that an extended period of high unemployment results not only in a short-term, dead-weight loss of economic output, but a long-term destruction of skills and earning potential that will haunt the economy for years. The US needs action now.
Some observers call for a third round of quantitative easing, a so-called QE3. But with $US2 trillion in bonds already sitting on the government’s books, others are concerned about the costs. That’s because when the Fed bought those bonds it printed the money to pay for them out of thin air. As a result the Fed isn’t lifting another finger.
It doesn’t have to be this way. There are other potentially far less expensive tools. To take one example, a paper presented at Jackson Hole by Columbia University economist Michael Woodford argues the Fed could nudge the economy without spending any money at all.
Woodford analysed the options central banks have for boosting the economy when interest rates sit about as low as they can go, near the so-called “zero bound”. He focuses on two areas.
The first he calls forward guidance. By that he means explicit statements by the Fed about the outlook for future monetary policy. The second he calls balance sheet actions. That’s when the central bank changes the size or composition of its balance sheet, for example through quantitative easing.
Woodford suggests that the more effective approach is to change future inflationary expectations. The Fed could help the economy by making an explicit promise to hold off on interest rate increases even after a stronger recovery takes hold.
That would signal that while inflation remains low now, the Fed will tolerate a bit more once the economy gets going. Woodford reasons that this would actually be more effective than further quantitative easing.
The beauty of Woodford’s argument is it doesn’t cost anything. If the Fed embarks on a publicity campaign to change inflationary expectations and it doesn’t work, the Fed can change its tune. Isn’t that exactly the role of the Fed chairman, to communicate with the public?
Whether you buy Woodford’s argument or not there are surely things the central bank can be doing instead of sitting on its hands. With so much destruction caused by high unemployment, it’s past time for the Fed to take the lead.
PUBLISHED: 08 Sept 2012
Anna Bernasek
A week ago, America’s economic glitterati gathered at a resort in Wyoming with the spectacular backdrop of the rugged Grand Teton mountain range.
The Jackson Hole conference, hosted each year by the Federal Reserve Bank of Kansas City, brings together an elite group of central bankers, policymakers, academics and Wall Street economists. It’s America’s answer to Davos, and those who get invited feel very much on the inside of the power elite.
The Federal Reserve chairman is the star, and his address is eagerly anticipated, sometimes revealing a new insight, idea or even policy move. Papers presented by other guest speakers fuel discussions, and new ideas can at times percolate out of the two-day symposium. This year’s meeting was named “The Changing Policy Landscape”.
So what exactly came out of Jackson Hole, 2012? Zilch. At least as far as the Fed is concerned, the policy landscape may change but policy remains the same.
Fed chairman Ben Bernanke spoke about monetary policy since the financial crisis. He extolled the virtues of non-traditional monetary policy tools, namely quantitative easing, whereby the Fed bought up stacks of bonds from institutions and investors. But he stuck to an almost wooden script, announcing no actions but promising that the Fed was ready to do something if needed.
It’s been the same story since the last major round of quantitative easing ended a year and a half ago.
Yet, even as Bernanke spoke, the signs of a weakening economy were evident. Just before his speech, the Commerce Department said second-quarter growth figures for the US economy were revised down to an annual 1.6 per cent from the previously estimated 2.4 per cent. Since then the August data has been weak. New home sales slowed sharply and manufacturing, the lone bright spot post-crisis, contracted for the third month in a row.
The problem is the more Bernanke says the Fed is standing by, the less reassuring he gets. Could somebody remind him of the old adage that actions speak louder than words? With Europe collapsing and the US in stagnation, the Fed is the invisible man of the global economy.
Bernanke knows that by law he has a dual mandate: to promote price stability and full employment. Price stability isn’t a problem, but employment is far from where it should be. Setting aside economics entirely, there’s a legal requirement for Bernanke to act that he’s been simply ignoring.
And when you consider the economics, continued Fed inaction borders on the reprehensible.
Labour economists recognise that an extended period of high unemployment results not only in a short-term, dead-weight loss of economic output, but a long-term destruction of skills and earning potential that will haunt the economy for years. The US needs action now.
Some observers call for a third round of quantitative easing, a so-called QE3. But with $US2 trillion in bonds already sitting on the government’s books, others are concerned about the costs. That’s because when the Fed bought those bonds it printed the money to pay for them out of thin air. As a result the Fed isn’t lifting another finger.
It doesn’t have to be this way. There are other potentially far less expensive tools. To take one example, a paper presented at Jackson Hole by Columbia University economist Michael Woodford argues the Fed could nudge the economy without spending any money at all.
Woodford analysed the options central banks have for boosting the economy when interest rates sit about as low as they can go, near the so-called “zero bound”. He focuses on two areas.
The first he calls forward guidance. By that he means explicit statements by the Fed about the outlook for future monetary policy. The second he calls balance sheet actions. That’s when the central bank changes the size or composition of its balance sheet, for example through quantitative easing.
Woodford suggests that the more effective approach is to change future inflationary expectations. The Fed could help the economy by making an explicit promise to hold off on interest rate increases even after a stronger recovery takes hold.
That would signal that while inflation remains low now, the Fed will tolerate a bit more once the economy gets going. Woodford reasons that this would actually be more effective than further quantitative easing.
The beauty of Woodford’s argument is it doesn’t cost anything. If the Fed embarks on a publicity campaign to change inflationary expectations and it doesn’t work, the Fed can change its tune. Isn’t that exactly the role of the Fed chairman, to communicate with the public?
Whether you buy Woodford’s argument or not there are surely things the central bank can be doing instead of sitting on its hands. With so much destruction caused by high unemployment, it’s past time for the Fed to take the lead.
Wednesday, September 5, 2012
Standardised results fail to pass the good education test
Financial Review
PUBLISHED: 01 Sept 2012
As September dawns, the “back to school” season begins in America.
Millions of families prepare their offspring for new schools and new
classes in the coming academic year.
So how is the American school system doing? The answer isn’t particularly reassuring. Formerly the most admired education system in the world, US education seems costly, inefficient and increasingly ineffectual compared with other systems.
Education is a big business. Americans spend more than $US600 billion a year on public elementary and secondary education. Meanwhile, survey after survey shows American students on average are slipping in educational attainment compared with the rest of the world, at least as far as standardised tests can measure.
The centrepiece of American education reform to date has been to link teacher evaluations to student test scores. In 2009, $US4.35 billion worth of federal grants went to states with teacher evaluation systems based on student test performance.
So popular is the idea of measuring teachers based on student test scores that the Obama administration is hoping to spread the use of standardised tests to the university level.
The idea is to use the standardised tests as a way to compare results to costs at colleges. Over the past 30 years the cost of college education has soared in the US. College remains a major financial challenge for many families, leaving many wondering if it’s really worth the expense.
Standardised testing has broad support. In addition to President Barack Obama, even fierce opponents such as conservative Republican governor of New Jersey Chris Christie believe it’s a great idea.
Christie just signed a teacher tenure reform bill tied to student test scores. Now when teachers are evaluated for tenure after four years, student test scores will be taken into account. Although the actual weight of test scores is still to be determined, Christie wants test scores to count for half of a teacher’s tenure evaluation.
In neighbouring New York, after a two-year fight, the state passed a new teacher evaluation system in February. School districts can link up to 40 per cent of a teacher’s pay to student test scores.
The appeal is that test scores are simple. They can be easily ranked and applied to teachers and schools as well as students. They seem objective. But while measurement is crucial in business and economics, you have to measure the right things, the right way.
Consider how reliable standardised tests actually are as an indicator of future performance. On that score standardised tests have plenty of flaws. Often they don’t accurately represent what students know or understand. They certainly can’t measure a student’s interest or engagement in a subject. And standardised tests tend to promote narrow, literal interpretations over nuance and creativity.
As standardised tests gain currency with students, teachers and schools, the school curriculum becomes dominated by test preparation. Unfortunately teaching to the test rather than teaching other intellectual skills students need to grow and develop can actually limit or hinder academic achievement.
There are some unintended consequences. For one, cheating seems to have become more widespread. With so much now riding on the results, Americans have experienced cheating scandals involving not only students at our best schools but even teachers and administrators as well.
And then there’s the business of test marking and scoring. In the US that’s a $US700 million market dominated by a handful of big companies: Harcourt Educational Measurement, CTB/McGraw-Hill, Riverside Publishing (a Houghton Mifflin company), and NCS Pearson. Recently Rupert Murdoch’s News Corp announced plans to enter the market. These companies not only supply tests but also test-preparation materials, curriculum content and teacher evaluation. It’s a self-reinforcing market where sales of one service lead to sales of the others.
There’s no doubt teachers need to be evaluated in the job. High-performing teachers need challenge and reinforcement, and low-performing teachers need to improve or move on.
But standardised test scores are a poor substitute for thorough supervision. They are far too narrow a measure to form a true picture of teacher performance.
There are other ways to do it. In fields where education is crucial, for example law or medicine, standardised test results are used to weed out the most unprepared or ill-equipped students. But individual evaluations by knowledgeable professionals are the gold standard for determining who are the top law and medical students, as well as the top schools and teachers. Beyond a threshold, test scores aren’t particularly important in these professions.
So while Americans struggle to reform their education sector, they haven’t spent enough time answering a basic question: what does a good education consist of? Without that answer, all the testing in the world won’t do much good.
PUBLISHED: 01 Sept 2012
Anna Bernasek
So how is the American school system doing? The answer isn’t particularly reassuring. Formerly the most admired education system in the world, US education seems costly, inefficient and increasingly ineffectual compared with other systems.
Education is a big business. Americans spend more than $US600 billion a year on public elementary and secondary education. Meanwhile, survey after survey shows American students on average are slipping in educational attainment compared with the rest of the world, at least as far as standardised tests can measure.
The centrepiece of American education reform to date has been to link teacher evaluations to student test scores. In 2009, $US4.35 billion worth of federal grants went to states with teacher evaluation systems based on student test performance.
So popular is the idea of measuring teachers based on student test scores that the Obama administration is hoping to spread the use of standardised tests to the university level.
The idea is to use the standardised tests as a way to compare results to costs at colleges. Over the past 30 years the cost of college education has soared in the US. College remains a major financial challenge for many families, leaving many wondering if it’s really worth the expense.
Standardised testing has broad support. In addition to President Barack Obama, even fierce opponents such as conservative Republican governor of New Jersey Chris Christie believe it’s a great idea.
Christie just signed a teacher tenure reform bill tied to student test scores. Now when teachers are evaluated for tenure after four years, student test scores will be taken into account. Although the actual weight of test scores is still to be determined, Christie wants test scores to count for half of a teacher’s tenure evaluation.
In neighbouring New York, after a two-year fight, the state passed a new teacher evaluation system in February. School districts can link up to 40 per cent of a teacher’s pay to student test scores.
The appeal is that test scores are simple. They can be easily ranked and applied to teachers and schools as well as students. They seem objective. But while measurement is crucial in business and economics, you have to measure the right things, the right way.
Consider how reliable standardised tests actually are as an indicator of future performance. On that score standardised tests have plenty of flaws. Often they don’t accurately represent what students know or understand. They certainly can’t measure a student’s interest or engagement in a subject. And standardised tests tend to promote narrow, literal interpretations over nuance and creativity.
As standardised tests gain currency with students, teachers and schools, the school curriculum becomes dominated by test preparation. Unfortunately teaching to the test rather than teaching other intellectual skills students need to grow and develop can actually limit or hinder academic achievement.
There are some unintended consequences. For one, cheating seems to have become more widespread. With so much now riding on the results, Americans have experienced cheating scandals involving not only students at our best schools but even teachers and administrators as well.
And then there’s the business of test marking and scoring. In the US that’s a $US700 million market dominated by a handful of big companies: Harcourt Educational Measurement, CTB/McGraw-Hill, Riverside Publishing (a Houghton Mifflin company), and NCS Pearson. Recently Rupert Murdoch’s News Corp announced plans to enter the market. These companies not only supply tests but also test-preparation materials, curriculum content and teacher evaluation. It’s a self-reinforcing market where sales of one service lead to sales of the others.
There’s no doubt teachers need to be evaluated in the job. High-performing teachers need challenge and reinforcement, and low-performing teachers need to improve or move on.
But standardised test scores are a poor substitute for thorough supervision. They are far too narrow a measure to form a true picture of teacher performance.
There are other ways to do it. In fields where education is crucial, for example law or medicine, standardised test results are used to weed out the most unprepared or ill-equipped students. But individual evaluations by knowledgeable professionals are the gold standard for determining who are the top law and medical students, as well as the top schools and teachers. Beyond a threshold, test scores aren’t particularly important in these professions.
So while Americans struggle to reform their education sector, they haven’t spent enough time answering a basic question: what does a good education consist of? Without that answer, all the testing in the world won’t do much good.
Romney tax returns a nightmare for Republicans
Financial Review
PUBLISHED: 25 Aug 2012
What’s keeping the Republican Party up at night? Surprisingly, it’s
not the fear of losing the next presidential election. In fact, it’s
Mitt Romney’s tax returns.
Romney has drawn a line in the sand, refusing to release his tax details before 2010. He has been mighty vague about his reasons.
For decades the convention has been for presidential candidates to release their tax returns as a test of their integrity. Democrats were quick to remind Romney of his own father’s decision to release more than 12 years of tax returns when he ran for president in the 1960s.
The issue just won’t go away, and Republicans are beginning to hate it. Coverage of this keeps a harsh spotlight on something very dear to the party – the surprisingly low tax rates for the already wealthy. The issue has been hidden in plain sight for a while. For the better part of a century “capital preservation” lay at the core of the Republican coalition. Social issues such as racial integration, abortion and gay marriage can come and go, but low taxes on accumulated wealth have been a consistent Republican aim.
The contretemps about Romney’s tax returns comes at a time when pressure has mounted to raise taxes on the wealthy to help control America’s enormous budget deficit. Just last month the French government touched a nerve by proposing 75 per cent tax rates on higher incomes. In the US that was front page news.
So if Romney won’t disclose his taxes, what can he be hiding?
So far, Romney has revealed that in 2010 he paid an effective tax rate of 13.9 per cent on income of $27 million. That tax rate matches households earning about $80,000 a year rather than millions. But it ignores something crucial. While America’s income taxes are moderately progressive, its wage taxes, which are also income taxes but apply only to wage earners, are harshly regressive. An $80,000 household would have borne the burden of an additional 16 per cent in wage taxes over and above the 13.9 per cent income tax that Romney paid. Romney probably didn’t pay any of that.
An undisclosed portion of Romney’s wealth is kept in offshore tax shelters. The information he has released provides little clarity about precisely how much money he holds overseas and where. It has revealed that millions of dollars sit in a Swiss bank account and in the Cayman Islands. But Romney also apparently has investments in Germany, Luxembourg, Australia and Ireland, which were not detailed in his 2010 tax release.
Democrats plan to make much of Romney’s low effective tax rate and refusal to detail more about his finances. Earlier this month, the highest ranking Democrat in the Senate, Harry Reid, made an explosive allegation. According to information Reid says came from a Bain investor, Romney hadn’t paid any taxes over 10 years.
Romney denied the claim and confirmed that he wouldn’t release any more financial information. But when asked if he ever paid an effective tax rate less than 13.9 per cent, he said he couldn’t remember.
Senator John McCain could have come to Romney’s rescue. When McCain was running for president in 2008 and considering running mates he vetted Romney for the vice-president role. McCain examined 23 years of Romney’s tax returns up to 2008. It would have been easy to say Romney paid taxes every year but that wasn’t the message from McCain.
He sidestepped when asked whether Romney might not have paid any taxes in the last 10 years. “I can personally vouch for the fact that there was nothing in his tax returns that would in any way be disqualifying for him to be a candidate,” McCain said. That doesn’t rule out the possibility that Romney paid zero or near zero taxes in one or more years.
The problem for Republicans is the more Romney refuses to release details on his finances, the more he looks like he’s got something to hide. At the same time, if Romney does release more information and it shows he paid zero taxes in a year when wage earners paid plenty, it will amplify the huge inequities in the US tax system. That’s an issue Republicans just want to go away.
Capital gains and dividends in the US are taxed at a maximum rate of 15 per cent. The maximum rate on earned income is 35 per cent.
The American public may be waking up to the many glaring inequalities in the tax code. If Romney becomes the poster child for raising taxes on the rich, the Republicans could lose everything they have worked so long to gain. In that case, perhaps Republicans would rather have Barack Obama win and let the tax issue die, along with Romney’s presidential chances.
PUBLISHED: 25 Aug 2012
Anna Bernasek
Romney has drawn a line in the sand, refusing to release his tax details before 2010. He has been mighty vague about his reasons.
For decades the convention has been for presidential candidates to release their tax returns as a test of their integrity. Democrats were quick to remind Romney of his own father’s decision to release more than 12 years of tax returns when he ran for president in the 1960s.
The issue just won’t go away, and Republicans are beginning to hate it. Coverage of this keeps a harsh spotlight on something very dear to the party – the surprisingly low tax rates for the already wealthy. The issue has been hidden in plain sight for a while. For the better part of a century “capital preservation” lay at the core of the Republican coalition. Social issues such as racial integration, abortion and gay marriage can come and go, but low taxes on accumulated wealth have been a consistent Republican aim.
The contretemps about Romney’s tax returns comes at a time when pressure has mounted to raise taxes on the wealthy to help control America’s enormous budget deficit. Just last month the French government touched a nerve by proposing 75 per cent tax rates on higher incomes. In the US that was front page news.
So if Romney won’t disclose his taxes, what can he be hiding?
So far, Romney has revealed that in 2010 he paid an effective tax rate of 13.9 per cent on income of $27 million. That tax rate matches households earning about $80,000 a year rather than millions. But it ignores something crucial. While America’s income taxes are moderately progressive, its wage taxes, which are also income taxes but apply only to wage earners, are harshly regressive. An $80,000 household would have borne the burden of an additional 16 per cent in wage taxes over and above the 13.9 per cent income tax that Romney paid. Romney probably didn’t pay any of that.
An undisclosed portion of Romney’s wealth is kept in offshore tax shelters. The information he has released provides little clarity about precisely how much money he holds overseas and where. It has revealed that millions of dollars sit in a Swiss bank account and in the Cayman Islands. But Romney also apparently has investments in Germany, Luxembourg, Australia and Ireland, which were not detailed in his 2010 tax release.
Democrats plan to make much of Romney’s low effective tax rate and refusal to detail more about his finances. Earlier this month, the highest ranking Democrat in the Senate, Harry Reid, made an explosive allegation. According to information Reid says came from a Bain investor, Romney hadn’t paid any taxes over 10 years.
Romney denied the claim and confirmed that he wouldn’t release any more financial information. But when asked if he ever paid an effective tax rate less than 13.9 per cent, he said he couldn’t remember.
Senator John McCain could have come to Romney’s rescue. When McCain was running for president in 2008 and considering running mates he vetted Romney for the vice-president role. McCain examined 23 years of Romney’s tax returns up to 2008. It would have been easy to say Romney paid taxes every year but that wasn’t the message from McCain.
He sidestepped when asked whether Romney might not have paid any taxes in the last 10 years. “I can personally vouch for the fact that there was nothing in his tax returns that would in any way be disqualifying for him to be a candidate,” McCain said. That doesn’t rule out the possibility that Romney paid zero or near zero taxes in one or more years.
The problem for Republicans is the more Romney refuses to release details on his finances, the more he looks like he’s got something to hide. At the same time, if Romney does release more information and it shows he paid zero taxes in a year when wage earners paid plenty, it will amplify the huge inequities in the US tax system. That’s an issue Republicans just want to go away.
Capital gains and dividends in the US are taxed at a maximum rate of 15 per cent. The maximum rate on earned income is 35 per cent.
The American public may be waking up to the many glaring inequalities in the tax code. If Romney becomes the poster child for raising taxes on the rich, the Republicans could lose everything they have worked so long to gain. In that case, perhaps Republicans would rather have Barack Obama win and let the tax issue die, along with Romney’s presidential chances.
Imperial CEOs rule supreme in corporate realm
Financial Review
PUBLISHED: 18 Aug 2012
Anna Bernasek
One of the great puzzles of American economics is a phenomenon known as the “imperial CEO”.
In our free-market system there should be mechanisms to hold executive power in check. But jaw-dropping salaries and seemingly guaranteed tenure are familiar features in the corporate landscape.
The mechanism for controlling executives is simple. Shareholders elect a board of directors. Then directors decide who gets the chief executive’s job and set the pay.
Simple and elegant, perhaps. But in practice the system doesn’t seem to work well.
Take the case of Forest Laboratories, a publicly listed pharmaceutical company with $US4.5 billion in annual revenue, based in New York City.
Forest Labs built the bulk of its value on the antidepressant called Celexa, introduced in the late 1990s. A few years later Forest developed a closely related compound, the blockbuster drug Lexapro.
Despite plenty of cash to spend, Forest hasn’t been able to come up with a compelling second act. This year, it lost patent protection on Lexapro and generic versions flooded the market. Forest Labs’ first-quarter profit sank 79 per cent.
The company also pleaded guilty to obstructing justice and to fraud relating to the illegal marketing of antidepressants to children and adolescents, and distribution of an unapproved drug. Forest Labs paid a $US313 million fine in 2010 to settle the case with the United States government.
Just one year later, regulators threatened to exclude Forest’s CEO from doing any further business with the US government. That’s not an everyday threat against a corporate chieftain, and it wasn’t made lightly.
Fortunately for the company, the government backed down.
But the brouhaha attracted the unwelcome attention of activist shareholder Carl Icahn, who invests in companies he believes are mismanaged to force them to change. Icahn hasn’t always been right but along the way he’s made $US14 billion in personal winnings.
He now owns nearly 10 per cent of Forest Labs’ shares, making him one of its biggest shareholders. And for the past two years, Icahn has demanded the head of Howard Solomon, the company’s CEO.
Icahn claims Solomon puts his own interest ahead of the company. “Corporate governance failures at Forest are among the chief factors leading to its dismal results,” Icahn says. “Forest Lab’s enterprise value has declined by $US7.9 billion, or 55 per cent, during the last 10 years.”
“Moreover, we believe that Forest was inadequately prepared for the Lexapro patent cliff, resulting in an estimated 80 per cent decline in earnings.”
Icahn slams the board for generous payouts to Solomon while profits fell and the company battled charges of wrongdoing. He claims Solomon is grooming his son to take over in a dynastic succession.
And Icahn has uncovered change-of-control clauses in Forest Lab’s licensing deals that seem intended to keep management in place.
Howard Solomon, 84, has been in the top job since the 1970s. Unlike Icahn, Solomon holds under 1 per cent of the company’s shares.
Despite the many issues, the board has backed Solomon. Icahn took his case to shareholders last year but failed. And last week, shareholders re-elected Solomon and his nominees to Forest’s board, with an Icahn crony winning a single seat.
In a show of modesty, Solomon asked for his base pay not to be increased in 2012. It is expected to be a mere $US8.5 million, down from $US8.8 million.
According to Icahn, Solomon received $US60 million in cash, equity and other compensation over the past eight years while the stock price fell 50 per cent. Meanwhile, Solomon apparently sold around $US500 million worth of stock while publicly promoting the company’s prospects.
Icahn isn’t alone in his criticisms. Institutional Shareholder Services, a respected independent service, has agreed with many of Icahn’s charges.
There may be a good reason why the board backed a CEO who has been around for so long – three of the 10 directors were current or former executives of Forest, and two others were on the board for 10 years.
Solomon’s response has been consistent. The company says that Icahn is “distorting the facts” and the board claims shareholders are better off with them than with Icahn.
It seems like a good case for change. But the US shareholder process marches to its own pace.
PUBLISHED: 18 Aug 2012
Anna Bernasek
One of the great puzzles of American economics is a phenomenon known as the “imperial CEO”.
In our free-market system there should be mechanisms to hold executive power in check. But jaw-dropping salaries and seemingly guaranteed tenure are familiar features in the corporate landscape.
The mechanism for controlling executives is simple. Shareholders elect a board of directors. Then directors decide who gets the chief executive’s job and set the pay.
Simple and elegant, perhaps. But in practice the system doesn’t seem to work well.
Take the case of Forest Laboratories, a publicly listed pharmaceutical company with $US4.5 billion in annual revenue, based in New York City.
Forest Labs built the bulk of its value on the antidepressant called Celexa, introduced in the late 1990s. A few years later Forest developed a closely related compound, the blockbuster drug Lexapro.
Despite plenty of cash to spend, Forest hasn’t been able to come up with a compelling second act. This year, it lost patent protection on Lexapro and generic versions flooded the market. Forest Labs’ first-quarter profit sank 79 per cent.
The company also pleaded guilty to obstructing justice and to fraud relating to the illegal marketing of antidepressants to children and adolescents, and distribution of an unapproved drug. Forest Labs paid a $US313 million fine in 2010 to settle the case with the United States government.
Just one year later, regulators threatened to exclude Forest’s CEO from doing any further business with the US government. That’s not an everyday threat against a corporate chieftain, and it wasn’t made lightly.
Fortunately for the company, the government backed down.
But the brouhaha attracted the unwelcome attention of activist shareholder Carl Icahn, who invests in companies he believes are mismanaged to force them to change. Icahn hasn’t always been right but along the way he’s made $US14 billion in personal winnings.
He now owns nearly 10 per cent of Forest Labs’ shares, making him one of its biggest shareholders. And for the past two years, Icahn has demanded the head of Howard Solomon, the company’s CEO.
Icahn claims Solomon puts his own interest ahead of the company. “Corporate governance failures at Forest are among the chief factors leading to its dismal results,” Icahn says. “Forest Lab’s enterprise value has declined by $US7.9 billion, or 55 per cent, during the last 10 years.”
“Moreover, we believe that Forest was inadequately prepared for the Lexapro patent cliff, resulting in an estimated 80 per cent decline in earnings.”
Icahn slams the board for generous payouts to Solomon while profits fell and the company battled charges of wrongdoing. He claims Solomon is grooming his son to take over in a dynastic succession.
And Icahn has uncovered change-of-control clauses in Forest Lab’s licensing deals that seem intended to keep management in place.
Howard Solomon, 84, has been in the top job since the 1970s. Unlike Icahn, Solomon holds under 1 per cent of the company’s shares.
Despite the many issues, the board has backed Solomon. Icahn took his case to shareholders last year but failed. And last week, shareholders re-elected Solomon and his nominees to Forest’s board, with an Icahn crony winning a single seat.
In a show of modesty, Solomon asked for his base pay not to be increased in 2012. It is expected to be a mere $US8.5 million, down from $US8.8 million.
According to Icahn, Solomon received $US60 million in cash, equity and other compensation over the past eight years while the stock price fell 50 per cent. Meanwhile, Solomon apparently sold around $US500 million worth of stock while publicly promoting the company’s prospects.
Icahn isn’t alone in his criticisms. Institutional Shareholder Services, a respected independent service, has agreed with many of Icahn’s charges.
There may be a good reason why the board backed a CEO who has been around for so long – three of the 10 directors were current or former executives of Forest, and two others were on the board for 10 years.
Solomon’s response has been consistent. The company says that Icahn is “distorting the facts” and the board claims shareholders are better off with them than with Icahn.
It seems like a good case for change. But the US shareholder process marches to its own pace.
Monday, August 13, 2012
Gross spells out doomsday scenario for investors
Financial Review
Anna Bernasek
Bill Gross, billionaire king of the
bond market, could be the biggest party pooper of all time. Especially as far
as the stock market is concerned. This month Gross, who runs the world’s
largest mutual fund, boldly asserted that automatic asset appreciation was a
thing of the past and equities were “dead”.
In his monthly letter to investors,
Gross said both bonds and stocks would not generate the kind of historic
returns Americans are accustomed to. According to Gross we need to work much
more or accept a lot less.
For the past few decades the
conventional wisdom has been that stocks generate substantial returns over the
long run. Experts told individual investors to invest in stocks for their
retirement. That view was backed up by analysis from Wharton economist Jeremy
Siegel who showed stocks had delivered real annual returns of 6.6 per cent
since 1912. That expectation became conventional wisdom which Gross called into
question.
“The Siegel constant of
6.6% real appreciation, therefore, is an historical freak, a mutation likely
never to be seen again as far as we mortals are concerned,” wrote Gross. “The simple point
though whether approached in real or nominal space is that U.S. and global
economies will undergo substantial change if they mistakenly expect asset price
appreciation to do the heavy lifting over the next few decades.”
If Gross is right, then the
implications are far reaching. The American investment mentality has been underpinned
by ‘stocks for the long run’ for a generation. Major pieces of the economy--taxes,
investment, retirement, and lots of jobs—depend on that foundation. But does it
have to be a gloomy forecast?
What Gross says is that the
fundamentals for stocks and bonds are lousy and won’t get better any time soon.
On one hand interest rates are already so low that bonds have nowhere to go. And
on the other, slow growth gripping the world economy means equities can’t
perform.
“If
labor and indeed government must demand some recompense for the four decades
long downward tilting teeter-totter of wealth creation, and if GDP growth
itself is slowing significantly due to deleveraging in a New Normal economy,
then how can stocks appreciate at 6.6% real?” Gross asks and answers: “They
cannot, absent a productivity miracle that resembles Apple’s wizardry.”
Let’s
decode that for a minute. The downward teeter totter refers to a historic shift
of wealth and assets from the working middle class to a highly concentrated
group of stockholders over the last thirty years. And when Gross talks about
labor and government “recompense”, he means higher wages and higher taxes are
on their way.
Simple
demographics are also at work. As the baby boom generation ages and retires,
they shift out of equities and into cash and fixed income assets. Generations x
and y have become disenchanted with stocks. And the youngest Americans, known
as generation z, have nothing to invest.
We can already see the shift away from
equities. In the $11.6 trillion US mutual fund market, last year investors
withdrew money from equity funds at a faster pace than in 2010. Meanwhile US
stocks returned a total of just 1 per cent after including dividends.
According to the Investment Company
Institute: “Domestic
equity funds have had six consecutive years of withdrawals totaling $471
billion, more than expected based on the historical relationship between
returns on U.S. stocks and demand for domestic equity funds.”
For three decades, indeed a whole
generation, exceptional returns accrued to the owners of American businesses. If
that’s no longer the case, we’re at the beginning of a big structural shift.
For some high fliers the fastest way to
create wealth was to own companies, cut a few costs and then re-sell them to an
eager public. Think of presidential candidate Mitt Romney. When he was at Bain
Capital that’s a pretty good summary of what he did. But if owning a company is
no longer a golden ticket, many short term strategies will no longer pay off.
A few years of quick profits can amount
to nothing over the longer term. Americans may need to start playing a longer game,
putting emphasis on incremental, durable value creation. That doesn’t mean
phenomenal wealth can’t be created. But it will take lots of time and effort.
Many aspects of our current investment
system offer short term rewards. Compensation is still mainly tied to yearly
marks. Quarterly reporting cycles and 24-hour news reward gamesmanship while
punishing anyone intent on longer plans.
The implication of Gross’s view is that
instead of boldness and speed Americans ought to practice patience and
determination to build their wealth.
The big picture is typically cloudy. So
long as unemployment remains high wages will remain under pressure. But
companies building durable, high functioning teams that will work effectively
for decades might nudge pay upwards. Many mature businesses could well see
diminishing returns. But the irrepressible spirits of innovation and progress
may spawn unforeseen growth. So despite the apparent gloom of Gross’s wake up
call it might set the stage for long overdue changes. And that just might turn
out to be the silver lining.
Monday, August 6, 2012
China's solar blaze of glory dims
Financial Review
Anna Bernasek
Like Ye, Chinese industries have powered past global competitors. Whole industries have started from scratch and not just prospered but decimated former leaders. Take the solar industry. Invented in the US in 1882 with the first working solar cell, Americans dominated until recently.
That reality hit home last August when three big US solar power companies filed for bankruptcy, unable to produce solar panels in the face of plunging world prices.
China has three-fifths of the world’s production capacity and supplies more than half of the US market for solar panels.
Like other industries dependent on R&D, US companies developed technology and techniques for mass production, then disseminated their know-how. With its low cost base and cheap funding, Chinese solar companies have driven down prices and crushed competition. Industry insiders watched in amazement as solar panel prices fell 50 per cent in the past year alone – how can China keep doing what nobody else can?
Lately we’ve got a few clues to China’s amazing success. Earlier this year, the US Commerce Department determined that Chinese companies benefited from government subsidies allowing them to sell their product below cost. In response, new tariffs were imposed.
For years, Chinese manufacturers benefited from indirect subsidies as well. Solar companies could get cheap bank loans and extremely cheap land for production facilities. Consequently, many manufacturers are saddled with significant debt.
There may also have been wrongdoing. Reports this week suggested the largest Chinese solar manufacturer, Suntech Power Holdings, was involved in a complex fraud scheme. This week Suntech announced that certain bonds used as security for loans it arranged for its customers might not exist.
Any time a company lends money to customers so they can buy product, it’s a matter of concern. Unless the company has a high degree of integrity, it may succumb to the temptation to artificially inflate its business.
Suntech, through an affiliated company, arranged financing for customers to buy solar panels. The loans didn’t come from the company but a Chinese state-owned bank. The bank asked Suntech for collateral, which it arranged by having a European affiliate pledge almost $US700 million in German government for security. Lo and behold, those bonds might not actually exist.
Borrowing at low rates to build facilities gave Suntech a nice boost. And giving customers loans to buy product was pretty clever too. But the underlying economics of its business have caught up with Suntech. Despite low interest rates, high debt levels have put pressure on its business. Worse, as Chinese capacity grew, demand in the US and Europe fell.
Other Chinese manufacturers have also come under pressure due to the collapse in demand. In order to keep market share, the companies cut prices, damaging their ability to service debt.
The consequences are becoming clear. US-listed Chinese solar firms have had a terrible year. On average, the solar index is down about 75 per cent, with shares in Suntech down about 79 per cent.
So when Americans wonder how the Chinese can keep doing it, maybe we’re beginning to find out. In some cases, they just can’t.
Monday, July 30, 2012
Tiny Jamaica’s factory of speed
Financial Review
Anna Bernasek
The race ends in the blink of an eye. With millions watching around the world, a pistol shatters the silence and in a little over nine seconds, a mere 40 strides, the 100-metre sprint is history. The 100-metre event, among the oldest and greatest athletic competitions ever devised, is the ultimate test of nerve, skill and explosive athleticism. That sprint in the London Olympics will probably decide the fastest person in human history.
Favoured to win is the metaphorically named Jamaican sprinter, Usain St Leo Bolt. At 26, Bolt has been the runner to beat since winning three gold medals in Beijing in 2008 for the 100 metres, 200 metres and 4x100-metre relay. Bolt also holds the record for the fastest 100-metre sprint ever, an incredible 9.58 seconds.
He is an extraordinary physical specimen. At 6ft 5in (195cm) and weighing 200 pounds (90kg), Bolt has the physique of an Olympic swimmer, rather than the more compact frame typical of a sprinter.
There are two crucial factors in sprinting ability. One is stride frequency: how fast you can step. The other is stride length: how long each of those steps is. World-class sprinters tend to have very fast stride frequency but ordinary stature, lengthening their strides by applying extraordinary force. Bolt turns his size into an advantage and uses not only remarkable strength but his long bone structure to dominate opponents.
His biggest threat is his teammate and training partner Yohan Blake. The only sprinters close to their ability are Americans Tyson Gay and Justin Gatlin. But London bookmakers are offering overwhelming odds that one of the Jamaicans will win.
Which raises a fascinating question. In a nation of just 2.8 million people, it’s incredible that Jamaica has produced not just one contender for the fastest person in the world, but two. You’d expect the US – the richest nation in the world, with a long sporting tradition and a population 100 times greater – to produce champions. Is it pure luck that Jamaica is sending not one but two of the fastest men in the world to London?
It turns out Bolt and Blake are not unique in Jamaica. The country also has some of the top women sprinters in the world, including Veronica Campbell-Brown and Shelly-Ann Fraser-Pryce.
In the past 75 years, Jamaica has won 42 Commonwealth gold medals, 14 world championship gold medals and 13 Olympic gold medals in athletics. Looking at the 100-metre event alone, Jamaica has been the leader. Its sprinters have beaten 9.85 seconds in the event 46 times, while sprinters from its closest rival, the US, beat that mark only 19 times.
How does a tiny island nation in the Caribbean produce the best sprinters in the world? It doesn’t happen in a vacuum. When you take a look, you find Jamaica has created an exceptional athletic culture. It’s built a factory of speed.
The story starts in 1948, when two little-known Jamaicans, Arthur Wint and Herbert McKenley, won Olympic gold and two silver medals in sprinting. Then, in 1976, Jamaican sprinter Donald Quarrie, one of the sport’s all-time greats, inspired the nation by winning Olympic gold in the 200 metres and silver in the 100 metres.
Bolt wasn’t groomed to sprint from birth. But when a cricket coach recognised his ability and encouraged him to run, he entered a well-organised system of training, competition and coaching that brought forth his remarkable abilities. There’s no one thing behind it. It’s as important to have tough competitors as good coaches. And it’s as important to have peer approval as financial backing.
Cultures of excellence – of winning – are among the most fascinating and prized economic phenomena. Such things come to exist in an individual company, or in a city or region. They don’t last forever, nothing does. But when they thrive, they produce breathtaking results.
It’s perhaps the most important question in business and economics. How do you create a culture of success? That question gets a lot of attention but it hasn’t been satisfactorily answered, at least not yet. After all, a lot of places have billed themselves as “the next Silicon Valley”, but none of them has succeeded. And let’s not even discuss all the companies that bill themselves as “the next Google”.
While the subject remains shrouded in mystery, there are tantalising clues to creating a winning culture. For one, you need pathbreakers. There would be no Bolt without Wint, McKenley and Quarrie. And money matters. The Jamaican Amateur Athletic Association is a key player, as is the system of sponsorship of pro track athletes. Then there are the coaches and gurus. Pablo McNeil, an Olympic sprinter himself, was among Bolt’s first coaches.
Finally, politics and culture come into play. Bolt attracted personal attention all the way up to the Prime Minister, and there was no shortage of peer approval for an exceptional sprinter in Jamaica.
Business people and economists often use the language of competitive sport to describe the world of commerce. As the Olympics unfold, perhaps we’ll learn a few lessons about how communities can intelligently compete and create lasting success.
Monday, July 23, 2012
Front-running just more secrets and lies
Financial Review
Anna Bernasek
The latest exposé of how some financial players make their money centres on gaining advance knowledge of analyst recommendations. A few well-connected hedge funds appear to have come up with a clever way of front-running the market by finding out when analysts are about to change their opinions on stocks, before they become public.
According to a report in The New York Times, hedge funds controlled by BlackRock, Two Sigma Investments and Marshall Wace created comprehensive surveys for stock analysts to enable those funds to predict upcoming shifts in stock recommendations. The funds were positioned to make quick profits ahead of public disclosure.
It seems to have been something of a shared secret. Analysts across the industry are reported to have participated in these surveys including those at Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch and UBS while the practice grew over recent years. And not without reason. When a well-regarded analyst changes her view on a stock it tends to affect the price. Any hedge fund that knows ahead of time is almost guaranteed a profit.
Front-running is a practice as old as the markets. As much as organised markets offer attractive liquidity and transparency, they also afford unique opportunities for parasitic operators to take advantage of unsuspecting customers and the general public.
According to an internal memo by Barclays, which owned a money management company conducting analyst surveys, the practice was understood: “The results support prior evidence that our signal enables front-running individual analyst recommendations.”
It’s further evidence that what’s behind many a successful Wall Street career is secret information. Fortunes can be made by knowing things others don’t – at least not yet – and exploiting that for gain.
There are growing indications that the basic services of finance, the bread and butter of our economy, aren’t profitable enough to satisfy the lords of finance. After all, who makes money on plain vanilla brokerage or banking any more? When Wall Street pays lip service to transparency and efficiency, be sceptical. A level playing field isn’t what insiders are after. It’s not good for profits.
Hedge funds in particular have spent millions of dollars lobbying to ensure disclosure rules aren’t strengthened. Banks have been no better fighting disclosure on the grounds it will expose crucial information to competitors.
What’s really going on is a process of creating and protecting deep pockets of knowledge not available to the public in order to make windfall profits. Banks know it, hedge funds know it, and regulators ought to know it.
The free market is almost an icon of the developed world. Yet the very notion of a free market open to all depends on maintaining a level playing field. Secret information is antithetical to free markets, undermining confidence and raising costs for broad swaths of society.
You can trace a solid line through the illiquid junk bonds of the 1980s, the over-promoted stocks of the late 1990s and the faulty real estate bonds of the 2000s to the Libor and front-running scandals unfolding today. In each case a highly profitable sector of Wall Street looks less like the free market than a low grade Coney Island scam.
It makes one wonder who’s in charge. Regulators, banks and funds all share a vital long-term interest in the markets. They need to speak up. Wrongdoing should be systematically exposed and rooted out, not allowed to fester and grow in the dark recesses of the markets. Regulated disclosure has to be priority number one.
Which brings us back to Libor. A little disclosure would have done a lot in avoiding the Libor mess. The Libor rate is one of the most important rates in finance. It’s treated as the actual rate at which a typical bank can borrow. You’d think such a benchmark would be calculated based on hard evidence. In fact it is based on an opinion survey. Effectively, regulators ask a few large banks what they guess it would cost to borrow. Some answers are thrown out and the rest are averaged.
What an invitation to mislead! Barclays apparently did this during the financial crisis to make itself seem healthier. Is it too much to ask for banks to disclose their actual borrowing rates? The truth tends to be relatively useful for markets.
If you’re like me and sometimes wonder why financiers have big houses compared with journalists, here’s your answer. Financial players find things out and keep it to themselves. Journalists trot the secrets out for all to see. That’s the difference between a public service and something that’s neither public, nor a service.
Monday, July 16, 2012
Disconcerting choice in US election
Financial Review
Anna Bernasek
US unemployment is stuck at 8.2 per cent, so it’s time to look at a true story of two candidates vying for the same job. Each has impressive academic and experiential credentials. By most objective measures either one would be well qualified for the job. But this isn’t any job. It’s a very senior executive position. The folks deciding who to hire need to look deeper.
The first guy has experience in an analogous position in the same organisation. His performance was spotty – some impressive achievements but lacklustre, bordering on unacceptable, in dollars and cents results. The other talks a big game and freely criticises his rival. When asked for his ideas though, he avoids the question.
The job, incidentally, is President of the United States.
The first candidate, of course, is the incumbent Barack Obama. He’s personally stunning – brilliant, articulate and at times decisive. His signal achievement, healthcare reform legislation, hasn’t taken full effect but even passing it was a huge win. The economy is another matter. His presidency has been marred by sluggish growth and persistent high unemployment.
The other is Mitt Romney, a high-powered and successful financier who was governor of Massachusetts. Incidentally Romney did healthcare reform first, in Massachusetts, although he denies that now. His few ideas for returning the nation to prosperity amount to giving more tax breaks and benefits to the extremely wealthy in the hope it will somehow rub off on everyone else – a tried and failed Republican strategy for promoting widespread prosperity.
Elections, like hiring, sometimes turn on trivial issues of personality or likeability. But the real focus should be on how the next US president will tackle the biggest problem facing the nation – unemployment and its accompanying dead weight loss.
Jobs are the key to widespread prosperity. Unless the US economy starts creating jobs at a strong and sustainable pace, most Americans will remain under financial pressure and a sense the system is failing them will prevail. Sufficient job creation, on the other hand,ends the housing crisis and renders America’s debts manageable.
The latest jobs figures for June showed job growth has stalled, well behind population growth. In June a mere 80,000 new jobs were created, the third straight month of jobs growth under the 100,000 or so needed just to tread water. The jobless rate is stuck at 8.2 per cent, the same as Britain’s; it’s 11 per cent in the rest of the euro zone.
But those numbers are misleading. The real problem is twofold: high long-term unemployment and high youth unemployment.
It seems that a vast section of the population may never recover from the financial crisis unless policy action is taken. And a whole new generation may be left vulnerable to future shocks. A third of those out of work have been out of work for more than a year.
Among younger workers, the rate is 17.3 per cent, more than double the headline rate of 8.2 per cent. Although youth unemployment in the US is nowhere near the levels of Spain or Greece at 45 per cent, it is double Germany’s 8.5 per cent.
More troubling is that youth jobless rates for minorities is higher. For Latinos the rate is 20.5 per cent; for African Americans, 30.2 per cent.
There are reasons to expect job growth to remain weak or even falter. Corporate profits fell in the first quarter of 2012, the first decline in four years, due to a slowdown in growth globally. And the slowdown in China, India and Europe doesn’t look like it will reverse soon.
So how do the candidates rate on solving the jobs problem?
Obama has had a chance to tackle the jobs problem. Since he became president, he stopped the destruction of jobs that occurred in the immediate aftermath of the financial crisis but failed to make sustained headway on job creation. An analysis by Andrew Tanenbaum, who writes the political blog Electoral Vote, says Obama is to blame for the slow jobs growth.
While Romney’s policies are not fully fleshed out, there’s little doubt his basic philosophy is one of laissez faire. He has expressed his view that government should get out of managing the economy and he has not proposed widespread economic stimulus or mass hiring to promote jobs growth.
So Americans face a disconcerting choice in November: a guy who did about half of what he should have done on the most pressing issue and a guy who won’t do anything. Whoever wins, the real loser will be the American public.
Monday, July 9, 2012
Cheap money fuels asset bubbles
Financial Review
PUBLISHED: 07 Jul 2012
Anna Bernasek
So, today, with interest rates at historic lows, in some cases zero in effect, shouldn’t we expect to see some kinds of speculative behaviour?
Well, yes. Asset price bubbles have been the consistent companions of low interest rates. And they’re still going on.
Take a look at Toronto, the fifth largest city in North America with close to six million residents. It’s caught in the grip of a major housing boom.
In March alone, prices increased 10 per cent, according to official data. Average nominal home prices have steadily advanced more than 85 per cent over the past decade. Bidding wars have broken out and talk of a housing bubble is on everyone’s lips.
David Townsend, a professor of Medieval Studies and English at the University of Toronto, just sold a small house in the centre of the city one week after listing the property.
In that week, 85 people came to take a look. Three made bids. The property went to a woman who had lost out to higher bids on at least three other properties. Determined not to lose again, she bid $70,000 over the asking price of $450,000.
The boom is especially prevalent in condos. Toronto has more high-rise building projects under way than any other city in North America, even New York City. According to a market researcher, 6070 new condo units sold in the first three months of the year, a record number of sales for a single quarter. Another 11,000 condo units are expected to be available for sale in the second quarter.
The Canadian housing boom caught the attention of the International Monetary Fund late last year. It warned that the Canadian housing market was vulnerable to a correction, especially in light of a slowdown in the commodities sector and a worldwide slowdown in growth.
“Adverse macro-economic shocks, such as a faltering global environment and declining commodity prices, could result in significant job losses, tighter lending standards, and declines in house prices, triggering a protracted period of weak private consumption as households reduce their debt,” the IMF wrote in an annual report about Canada.
Canadian officials have also weighed in, urging households not to take on too much debt. Yet all that seems to be having little effect while the Canadian central bank keeps official interest rates at 1 per cent. Some mortgage rates are as low as 3 per cent.
With interest rates so low, demand remains strong for housing in the centre of Toronto and that’s where many new buildings are going up. A compact city centre makes Toronto a pedestrian- and bicycle-friendly place to live.
The debate inside Canada about whether there’s a housing bubble or not seems eerily familiar. Those who argue against the bubble say that nothing like what happened in the US would happen in Canada.
Canadian banks were far more prudent than American banks, the argument goes, plus there has been no such thing as subprime lending.
Some commentators have argued there’s no evidence of a housing bubble in Toronto anyway. But that’s the disturbing thing about an asset price bubble. You only know with certainty that there’s a bubble once it pops.
If we’ve learned anything from the US housing bubble, it’s this: asset prices don’t go up forever. And when prices move the other way, debt exacerbates the problem.
Household debt levels in Canada are higher than the US at the peak of its housing boom. Official data shows that Canadian household debt rose to a record 153 per cent of disposable income in the third quarter of 2011 compared with 140 per cent in the US.
We’ve witnessed the apotheosis of Greenspanian monetarism, a tacit agreement that monetary policy will cure all ills.
Monetary policy has been remarkably effective in taming general inflation and moderating some types of recessions. But it hasn’t been effective against the inflation everybody loves: asset price inflation.
Designed to manage the real economy, monetary policy produces interesting side effects on the financial economy. Asset price bubbles are Exhibit A.
The trouble with asset bubbles is that they’re tremendously popular. Nobody in Toronto wants to stop the housing party right now. But when a debt-fuelled bubble eventually deflates, and it always does, the effects are noxious. Then everybody will be shocked – shocked! – that it was allowed to happen.
Monday, July 2, 2012
US recovery a decade away, at least
Financial Review
Anna Bernasek
The Federal Reserve dropped a bombshell recently. Two decades’ worth of wealth creation by the middle class had been erased in a mere three years as a result of the financial and economic crisis.
The Fed reported its findings in its June bulletin. What many American families had been feeling but couldn’t prove was in plain sight, an indisputable fact in black and white.
But what can we make of it? What does wealth destruction of that magnitude mean for the future?
First, look at the number that got everyone’s attention. Real median net worth fell almost 40 per cent to $US77,300 in 2010 from $US126,400 in 2007, according to the Fed’s 2010 Survey of Consumer Finances.
The 40 per cent drop is unprecedented. At least since the Fed began keeping track of consumer finances in 1989, a fall in median net worth had never occurred, let alone of 40 per cent.
The median figure gets to the real middle of the nation, where the story is very different from the top. What that median figure says is that out of 114 million households, 57 million have a net worth of less than $US77,300. On average, a household represents about three persons. For families facing retirement, serious illness or unemployment, $US77,000 will only carry them so far.
The Fed also reported that median family income fell 7.7 per cent to $US45,800 in 2010 from $US49,600 in 2007. Put the median income and wealth figures together and you get a picture of the middle class that’s dangerously stretched. Instead of net worth approaching three times income, middle-class families now have accumulated net worth less than two times income.
What’s behind the sharp fall in net worth? The main culprit is the housing crisis and the historic drop in home prices. Yet there’s something more at work. While nominal home prices fell on average 30 per cent, real net worth fell almost 40 per cent.
The difference is due to leverage. Look at a simple example. If a person buys a $200,000 home and finances it with a $100,000 mortgage, that buyer has a home equity of $100,000. If the price of the home declined 30 per cent, the house is now worth $140,000. That person’s net worth, though, has fallen much more. The mortgage is still $100,000, but equity has dropped 60 per cent to $40,000.
The bigger drop in net worth than in average home prices has taught Americans a costly lesson. Leverage is great on the way up but vicious on the way down.
The downturn has exacerbated America’s wealth inequality. While the middle class mainly have their net worth tied up in housing, the wealthy tend to have more of their net worth in financial assets. While housing prices fell 30 per cent, stocks quickly rebounded and settled at a 12 per cent loss.
So while the middle class has suffered an unprecedented destruction of wealth, the top earnings households haven’t suffered as much.
For generations, the US relied on a virtuous cycle of wage growth and consumption to power the economy. How long it takes to rebuild household net worth may be a good indication of when the economy will return to strength. And it might be a long way off.
There are two main ways to rebuild net worth. One is through savings and the other asset appreciation. The personal savings rate is calculated as personal saving as a percentage of disposable personal income. At the current 3 per cent rate, it would take about 17 years to get back to the 2007 level of household net worth.
As for asset appreciation, it doesn’t look like that will happen soon. Home prices in some parts of the country are still falling.
Just to get back to where household net worth was in 2007, home prices need to rise by more than the 30 per cent nominal fall in prices. Using the example again of a $200,000 home and a 30 per cent drop in prices, it would take a 42 per cent rise in price to get back to the original $200,000. There’s no chance of this in the near to medium term.
So if anyone tries to tell you that an economic recovery is just around the corner in the US, go ahead and agree. But be prepared to wait at least a decade, if we’re lucky!
Monday, June 25, 2012
New Fed bank rules will solve nothing
Financial Review
Anna Bernasek
Let’s turn the dial forward to 2009. The world didn’t end; not even the financial world ended, since it received infinite backing from the US Treasury. But still, nobody’s happy. The economy is in the tank. So is the stockmarket. There’s no lending to speak of. Reform of the global financial system is the talk of the day.
Another twist of the dial and we’re in November 2010. The G20 has just made a bold promise: in two years, sweeping changes to strengthen global bank capital requirements will be adopted by major countries.
Step out of the time machine with me, back to June 2012. The US Federal Reserve just unveiled its plan to meet the G20 timetable. The new bank regulations are here!
Fed chairman Ben Bernanke hailed it as a model for the rest of the world. “I think this may well be the standard against which other capital regimes around the world may be measured going forward, and I hope that other countries, other jurisdictions, will meet this standard,” he bragged.
But after two weeks, banks and lawyers are still trying to figure out what those standards really mean.
Maybe that’s because the Fed’s proposal is 800 pages long. A once-through read took one bank’s team of experts three days. Bankers, lawyers, and lobbying groups continue to diligently comb through every page. So far they only agree on one thing: the complexity is awe-inspiring. Which should give one pause.
Every serious review of systemic failures leading up to the collapse cited excessive complexity as a major cause. Some view complexity as the whole problem. A month – even a day! – before Lehman Brothers collapsed, there was no way for investors or the public to assess if it was fully solvent or worthless. There were lots of rules and disclosures, but none was worth a damn.
Four years later, the vaunted fix for what was condemned as overly complex and therefore unsafe is more complexity. If the devil lurks in the details, in 800 pages he’s surely got plenty of places to hide.
“The irony is when this is done there will be less uniformity than before because of all the complexity”, says someone close to the process.
The level of complexity makes a mockery of public disclosure. The banks will say their capital is “x per cent”. But how in heaven’s name can anybody get a commonsense picture of what’s really going on? Only the bank (at least one hopes so) and perhaps the Fed have a prayer of gaining insight into bank risk.
So will these new rules change anything? They certainly include lots of new categories and definitions as the Fed plays catch-up to financial “innovators”. But if the new rules don’t curtail innovation, how long do you think it will take to devise something risky to shoehorn into an unforeseen (maybe intentional) linguistic gap?
Bankers and experts are trying to understand the differences globally. “The whole notion of whether we will have a level playing field is very high on people’s minds,” says Tom McGuire, head of Barclays Capital capital advisory group in New York.
After a historic financial crisis, US regulators have missed the mark.
Monday, June 18, 2012
Enter online sites at your own risk
Financial Review
Anna Bernasek
The custodians of our digital lives, the internet’s newly minted billionaires, are shockingly young. But while novel social media and purveyors of big data explode on the internet scene, age-old concerns about individual rights and liberties have not yet been addressed.
A glance at the sharemarket shows how large the impact has been on business. But longer-term effects on society and politics may be even more profound.
No one questions the cleverness of Facebook’s Mark Zuckerberg or Groupon’s Andrew Mason for instance. But as each new wave of twenty-somethings pushes technology into areas never before explored, who is thinking about the long term? Data security looks like an early warning sign.
Earlier this month LinkedIn, a respected professional networking site, reported the theft of more than 6 million user passwords. In itself that’s not too big a shock. Getting hacked is par for the course for many companies these days. The thing about stolen passwords, though, is that many people use the same password for lots of things. An errant message on LinkedIn is one thing, but a financial or medical intrusion would be quite another. And in LinkedIn’s case what surprised the experts was a minimal approach to data security.
Since the theft, LinkedIn says it has upgraded security. Many of the costs arising from the glitch won’t be borne by LinkedIn, though. LinkedIn’s users and the websites and businesses they frequent are poised to spend countless hours sorting out a potential mess.
LinkedIn isn’t alone. Other social networking sites, such as the online dating site eHarmony, have also reported bulk password theft. The internet is an ecosystem based on trust, so a problem in one area can affect many others.
Then there’s Facebook. A disastrous initial public offering left the company and its top managers looking greedy. The ensuing scrutiny put the company under a bigger spotlight and cracks are showing.
Facebook’s day-to-day business practices are raising eyebrows. Some users are getting an unwelcome surprise when they click the “like” button connected to a product. They find their name and photo appearing in an online ad promoting somebody else’s business. Had they read the Facebook user agreement, of course, this would have been no surprise. But show me someone who has the time to read the online user agreements they sign up for.
Even reading those agreements might not help. You’d probably need a lawyer to understand them. So, even if you read it, the user agreement would still be a farce, since it’s not as if you can change it.
In the long run, of course, these things tend to work out. Unreasonable user agreements will eventually give way to customer-friendly ones. But to be useful today, the agreements need to be clear and understandable, which they’re generally not.
With hundreds of networking, search and email sites, the problem is multiplied. The ever-expanding web of legal rights and relationships is too complex for an individual to cope with. Users simply don’t understand what they are getting into. Some have even found themselves in physical danger.
The latest case involves Skout, a social networking app designed for “flirting” between adults. When Skout figured out that children were using its site, they developed a separate service restricted to 13 to 17-year-olds. But adults managed to pose as teenagers, and now there are three cases of child rape associated with Skout.
The internet is nothing if not dynamic, with thousands of social experiments happening in real time. But the business model followed by many internet entrepreneurs raises red flags. It works something like this. First, figure out how to apply technology to something people want. Next, offer it for free with seemingly no strings attached. Then, after you build up millions of followers, spring the trap. Hold their data and relationships hostage as you exploit their trust for your commercial gain.
If you are lucky enough to get to critical mass, most users won’t leave because they don’t know how to get everyone else to go with them. Companies build up just enough trust to hook people in, but then they start consuming that asset. In many ways the internet looks like a get-rich-quick scheme where some prosper but leave much of the hard work to others.
So far internet companies have had a free pass on some big issues. Whether it’s sales tax, ownership of sensitive information, or data security, internet companies aren’t paying all their freight. Yet until the public and policymakers catch up, users are practically on their own. Maybe sites should be required to come with a warning: enter at your own risk.
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