Business Blog: Hoover’s Business Insight Zone

Since I’m not much of an economist, this is more a question for discussion than an expression of any clear verdict on my part. For now I’ll say that some very smart folks think we are headed for a recession; that list of folks includes economist Nouriel Roubini, zillionaire Warren Buffett, and the top executives of Caterpillar. As much as two-thirds of the general U.S. population agrees with them, but opinions vary.

U.S. companies disagree on prospects for a recession

…Almost two-thirds of Americans said a recession was likely in the next year, and a majority said the economy was already faltering, according to a Bloomberg/Los Angeles Times poll taken from Oct. 19 to 22. The survey showed the gloomiest view of the economy since February 2003.

A survey of chief executives released this month by the Business Council predicted that U.S. growth would slump to 2 percent or less next year but that the economy would avoid a recession, defined as two successive quarters of declining gross domestic product….

This puts me in mind of The Epicurean Dealmaker’s witty post from this weekend, in which TED discusses just how poorly mathematicians sometimes do when they try to predict the movement of markets.

Down the Rabbit Hole

…Write this down: Black-Scholes [a prevailing theory of option pricing] works not because it describes some external ontological fact about how pricing relationships between securities and their derivatives have to work; it works because everyone agrees, more or less, that that’s how prices should work. It is a convention, not a physical or financial law. This is the central epistemological trap that quants fall into when they conflate the tools, techniques, and ontological assumptions of physics, which attempts to describe that which is (more or less independent of us humans), with those of mathematical finance, which attempts to descibe how human beings trade and value financial instruments and their derivatives….

Myself, I tend toward caution, so if I were running a company, I would long ago have put back a supply of dry powder to counter the effects of the mortgage crisis and the shriveling of the credit markets. My own view is that the marketplace — not just the financial markets, but the broader sphere of business — has more corrections to make before it stabilizes again. Some of these corrections will be large and painful. Whether that amounts to a recession, I don’t know.

What do you think?

Confession time: after a summer of relentless headlines about the mortgage meltdown, credit crunch, and assorted alliterative anti-affluence ailments, my eyes have started to glaze over when I read stories about the latest on CDOs, SIVs, et al. So I glanced at a few things about the supposedly big deal announced on Monday, through which Citigroup, JPMorgan Chase, and Bank of America will help to create a Master Liquidity Enhancement Conduit (MLE-C).

If you’re confused by that title, you’re not alone, but you can get clarification from this Floyd Norris article:

3 Major Banks Offer Plan to Calm Debts in Housing*

The biggest banks in the United States, with active encouragement from the Treasury Department, unveiled a plan yesterday to keep the housing-related debt crisis from worsening.

The plan calls for the banks to create a new financing vehicle to try to restore confidence and reduce the risk of a market meltdown by propping up an important part of the debt markets. But the banks hope to take minimal risk and avoid actually investing any of their own money.

If Norris isn’t the dean of financial journalist in the US, I’m not sure who is, and his treatment here is sound. But the most interesting analysis I’ve come across is this one from Andrew Leonard in Salon, who thinks the MLE-C plan implicitly enables the continuation of what he calls “Enron economics redux.”

First he lays out Wall Street’s reaction to the announcement of the plan:

Way to spoil the party! The Dow Jones industrial average immediately dropped by 108 points on Monday and another 71 on Tuesday. Why? Because the announcement of a rescue plan is tantamount to shouting, in capital letters: WALL STREET, WE STILL HAVE A PROBLEM.

When combined with Treasury Secretary Hank Paulson’s somber speech Tuesday morning warning that the housing crisis is set to drag on indeterminately, one can only conclude that the stresses that have flowed from real estate into the financial markets are going to ramp up. The purpose of the super conduit may not be to clean up the mess that already exists, but prevent matters from getting considerably worse.

Leonard then digs into the underlying issues of “conduits,” which are financial vehicles designed to make money by arbitraging long-term and short-term debt yields. (Read his description; it’s better than mine.) And he points out the ways in which conduits are supposed to be opaque — designed, as they are to live outside the typical categories of investments expressed on a bank’s balance sheet.

He also raises larger questions about the efficiacy of the Treasury/megabank plan:

Will it work? Nobody knows, and analysts are all over the map on the question of whether to call the plan a bail-out, a shell game, or just a highly ironic attempt to solve a problem by engaging in the exact same behavior that caused it. The only thing we know for sure is that the Master Liquidity Enhancement Vehicle will be featured in the center ring of the Wall Street circus for a while to come.

That circus is increasingly complex. It stretches far beyond Wall Street — throughout the globalized financial world, in fact. It involves many convoluted relationships between public and private entities, between individual consumers and massive institutions, and between the industries and economies of various countries. (German and Japanese banks have suffered from exposure to the US mortgage lending market, to pick just one handy example.)

In this environment, where so much uncertainty has reigned as the unexpected impacts of “exotic” financial instruments have begun to be felt, Leonard’s call for greater transparency is apt. Maybe the MLE-C plan has merit, but in any event it’s hard to get down to the brass tacks of fixing the mess in the financial markets if we can’t figure out where those brass tacks are.

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* Probably I’ve mentioned my increasing frustration with the Times’ headline writers. This one offers a case in point: the first thing mentioned in the headline is three banks . . . but the names of the banks don’t show up until the seventh paragraph of the story. I’m not even going to entertain counter-arguments on this point: the mismatch between the headline and the story is simply wrong-headed. Memo to Times headline writers: Either cast the headline to say something like “Treasury-Backed Plan to Calm Housing Debts,” or else name the banks at the top of the story.

Catching up on some reading, I came across this Carol Hymowitz column from a week ago:

Chiefs Who Bucked Early Spending Spree Have the Upper Hand

It used to be that private-equity investors were using piles of debt to acquire companies, and executives who borrowed to expand businesses or repurchase their company shares were lauded for their business acumen. Now, those who were much more cautious about spending and borrowing are the ones who look savvy, as debt markets roil, large deals collapse or are renegotiated at lower prices, and fears of a recession mount.

I’ve talked before about my own esteem for those who keep their powder dry. As Hymowitz points out, having cash on hand gives them a lot of latitude for operations in good times and bad.

My thumbnail view: during the private equity boom of the past couple of years, the getting was so good for pursuing maximum returns in the short run that some companies forgot that success isn’t all about what you do this quarter, or even this year. Yes, go get your profits, but also be ready to operate well when times change. These days, it’s often those who kept “excess” cash on hand who are in the best position.

Back when currency ratios were fixed, it was landscape all the way. These days . . . good question. James Surowiecki of The New Yorker asks questions that remind me of what I wrote in my initial “landscape and weather” post:

How can Americans, with their love for foreign goods, remain indifferent to the dollar’s drop? Mainly because so far it has had surprisingly little impact on our standard of living. Inflation, for instance, has remained solidly under control—the economy’s core inflation rate was about two per cent over the past twelve months, and it hasn’t been much higher than that in recent years. Even more surprisingly, the prices of imported goods have gone up only slightly. If you travel abroad, you feel like a pauper. Yet if you stay at home you’d be hard-pressed to notice any difference from a decade ago, with the notable exception of the price of oil.

Link.

First, check out this detailed Aleph Blog post by David Merkel:

Eight Notes on Residential Real Estate

The post offers many links to other stories addressing specific aspects of the mortgage crisis, so you can pick which parts of the story most interest (or scare) you and go from there.

Second, this post from Knowledge@Wharton

How We Got into the Subprime Lending Mess

offers a thoughtful and thorough overview of how we got to where we are today, when the credit crunch from the mortgage industry threatens the broader economy. This one comes complete with historical perspective and comparisons between the US mortgage market and housing markets abroad.  With all the daily hyperventilation and speculation about what’s coming next in the mortgage / real-estate / credit meltdown, this sort of perspective is quite tonic.

The New York-based venture capitalist offers his thoughts in the context of the Internet-business downturn he sees as inevitable. (He’s smart enough to also note that he can’t predict the future, and that he might be wrong about a downturn.) But what he says applies across the board:

Do we have to go through a shakeout to get to the next big move? I don’t know. I only know that’s what it took last time.

So if you see the downturn coming as the entrepreneur I met with clearly does, what do you do? If you are a VC, I think you keep investing, but carefully. Its not a time to step on the gas. And focus on your existing portfolio, take gains where you can take them, and make sure you’ve got plenty of ‘dry powder’ for your portfolio.

This is the sensible view of someone who’s been around the block and seen how business works — not just at the macro scale, but up close and personal — through more than one major economic cycle. It’s also a viewpoint worth keeping in mind to leaven the woe-is-me exclamations coming from some parts of the financial world, the real estate market, and so on. Financial grown-ups keep dry powder (it’s also called “cash”) in ready supply for the down times. This applies equally to households and businesses, and it doesn’t matter if the entities in question are rich or not.

Give Fred’s post a read — it’s worth your time.

–Joel Makower offers extensive thoughts on Coca-Cola and plastic bottles, which we discussed here the other day.

–Ryan Paul of Ars Technica reports on the decision that SCO will face a judge rather than a jury in its Novell trial. We talked about SCO’s legal issues last month. SCO’s troubles look to be getting worse.

–Ville Heiskanen of Bloomberg reports that “Motorola May Fail to Lift Profits With New Razr Phone.” This reminds me — in the vein of this post from a couple of months back — of how poor an indicator business-magazine stories are for long-term success. When the Razr was at its peak, the stories came thick and fast about how Motorola had gotten its groove back. Now the prevailing line — which seems apt, given the company’s struggles to sustain financial and branding performance — is that Motorola had a one-hit wonder with the Razr, and that so far it’s not built to produce a string of hits a la Apple.

–The New York Times offers this extended business/exec profile on Dell the man and Dell the company: “Can Michael Dell Refocus His Namesake?” Writer Steve Lohr’s answer to that runs to several thousand well-informed words. My own take: Dell the company is nowhere near folding its tents, but Dell the man faces an uphill battle. Just because his company has been successful doesn’t mean it has the long-term answers. It’s hard to think of it this way, but in fact the PC market is still quite young in historical terms. I wouldn’t bet against Michael Dell, but what got them to where they are is not likely to get them where they want to go.

–Like the rest of the business world, we’ve talked plenty about Countrywide Financial as the huge mortgage company has navigated the troubles in the real estate and credit markets. Now they’re going to be navigating with fewer hands on deck: the company is laying off 12,000 employees. I’ll say again what I’ve said before: we’re a long way from working out all the hidden problems that built up during the real estate bubble of the early 2000s.

Just a few more to round out the week . . .

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House foreclosures go up — for borrowers with good and bad credit alike — as do layoffs in the mortgage industry. Film at 11.

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For more analysis of Jim Press’s surprising move from Toyota to Chrysler — discussed yesterday — see this NYT piece from Micheline Maynard.

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Given strapped gasoline inventories in the US, must prices at the pump go up? That’s the thrust of this Oil Drum item from Robert Rapier.

The next few weeks will be interesting. We are at the end of peak driving season, but we will soon be heading into fall turnaround season where gasoline production will drop. Winter gasoline is also right around the corner. This time of year typically sees gasoline prices fall (prompting conspiracy calls when it also happens to be an election year) but with inventories where they are we probably won’t see that typical price drop. In my opinion, we can’t afford to see it. Last fall prices fell, and demand picked up. We can’t afford for demand to pick up with inventories setting where they are.

Today’s Company of the Day is Berkshire Hathaway.

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Let’s play what-if: it’s 1965, you’re a young person looking to buy a good stock, and you have $19 burning a hole in your pocket. You take a flyer on Berkshire Hathaway, a little textile company that’s come under new management. Maybe you’ve heard something good about the smart new CEO, Warren Buffett, and his business partner Charles Munger. You tuck aside the stock certificate, join the Foreign Legion, and forget all about Berkshire Hathaway. You miss the intervening 42 years, in which the company outperforms the S&P 500 index by a compounded annual margin of 11%. You miss the myriad acquisitions of companies from General Re to Acme Brick. When you return from the Foreign Legion to take your well-deserved retirement, you find your old Berkshire stock certificate and decide to cash it in. When you sell it at the close of business on August 31, 2007, you reap $118,390. It’s fun to pretend, huh?

How have Buffett and Munger made so much money for their devoted shareholders and for themselves? (Buffett’s fortune is far larger, but Munger is easily a billionaire in his own right.) They have profited not just from unusual acumen in valuing assets, but from unusual discipline in maintaining their principles in all weather. If they don’t understand how to value an asset, or can’t get it at a discount to its value, they simply won’t buy it, regardless of how sexy it may seem to the markets at the time. Because of this approach, Berkshire sat out the tech-driven IPO boom of the 1990s, as well as the private equity boom of the past couple of years. Of course, they also avoided the dot-com bust, and now that the real estate and credit markets have soured, Berkshire is on the prowl for bargains again — with $50 billion of its own cash at its disposal.

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Catching up on some reading the other day, I came across this Wall Street Journal article (subscription required) about how Berkshire Hathaway chief Warren Buffett has been taking advantage of the current swoon in the credit markets. There’s a predictable flow of sentiments from the financial world toward Buffett: against a background of constant respect, Buffett is regarded as overly staid during market booms, but then he’s seen as even more of a financial wizard when the markets go to pot.

This happened during the Internet bubble of the late 1990s, when Buffett eschewed ownership of online or high-tech companies because he claimed he simply didn’t understand those lines of business. Buffett is disciplined enough that, if he doesn’t know how to assign an accurate value to an asset, he doesn’t buy it. In the case of the Internet bubble, this meant that he avoided fallout from the spectacular collapses of Pets.com and the rest; meanwhile, his old-line assets like Acme Brick and building-supplies maker Johns Manville just kept chugging along, boringly posting profits year after year. In the past couple of years there has been some noise for Berkshire to disperse its extra cash as dividends, but Buffett has resisted these payouts because he believes that Berkshire can make more money for its investors in the long run by having cash available to invest on their behalf when markets are favorable.

Which brings us to today. During this round of market suffering, Buffett is sitting on a pile of cash — nearly $50 billion — that he can use to buy discounted assets, whether that means stocks, bonds, or whole businesses. Bargains are available because the credit crunch now underway has tightened banks’ willingness to lend money to the usual buyers of the past few years, including hedge funds and private equity shops. That means that Buffett is now running one of the best games in town for asset owners looking to sell. All of this makes Buffett happy because he loves bargains.

As the WSJ article points out in passing, Buffett’s standing also provides a luxury for Berkshire that many other buyers don’t enjoy: the company “doesn’t participate in auctions.” This means that Buffett need never suffer the “winner’s curse” common to auctions — that is, he never ends up “winning” an auction by agreeing to pay more than an asset is worth.

The Journal article touches upon one more thing that has marked Buffett’s business approach for decades: when the time is right, the Wizard of Omaha is able to move billions of dollars at a moment’s notice. The fact that Berkshire doesn’t do a lot of rapid buying and selling is one more testament to the discipline of Buffett, his business partner Charles Munger, and their lieutenants. But it does not mean that the company can’t pull the trigger quickly when conditions dictate.

Expect much more trigger-pulling from Berkshire in the months to come. Warren Buffett is ready to do business at a reasonable price any time, but he absolutely loves a buyer’s market.