Crisis & Evolution
The Economic Path of Free-enterprise & the American Investor
Since the dawn of societies, economies have been shaped by trial and error. This evolutionary process has brought much of the world’s societies to a free-enterprise system that encourages and protects one’s rights to engage in risky activities. Today’s crisis in the credit and housing markets is part of our economic evolutionary process that can be understood by looking through the lens of incentives.
Incentives also offer a glimpse into the future of the U.S. government’s position on the global stage, changes in the financial services sector, and enhancements for investors. Specifically:
- With a mounting government debt-load, we will likely experience a good dose of controversy related to adjusting the government’s ability to pay for its debt and provide entitlements to our citizenry
- Weaknesses in the financial service sector, particularly among the largest members, have been played out. The winners who arise out of crises will likely be smaller financial firms who have broadly avoided excessive risk. Many non-financial businesses will find it easier to do business with the winners of the crisis – smaller investment firms, smaller banks and private equity investors.
- As many public companies have embraced a sprinter’s philosophy of short term success, long-term term risks have contributed to volatility in the stock market. With two market crashes in 10-years, a growing group of retiring and risk-averse investors will dictate change among corporate behavior. This will ultimately usher in a new era of more effective proxy-voting and better risk-management tools.
The Historic of role of Incentives
The fall of the Western Roman Empire in 476 A.D. ushered in a period of great distress collectively known as the Dark Ages. As populations declined and life expectancies shriveled, local land owners attempted to earn profit from their tenants. Meanwhile, non-Christian invaders, such as the Vikings and Magyars, had great economic incentive to plunder the porous territories making Western Europe very unsafe. Eventually, land owners, having incentives of their own, militarized, and by approximately 1000 A.D. ushered in a new system of order known as Feudalism.
In the feudal system, every man was a servant or vassal of his lord. Institutions like castle-building, knighthood, and mounted warfare provided a robust platform for the return of economic growth and a renewal of urban life. However, widespread crisis erupted from 1300 to 1350 in the form of famine, plague, inflation, and endemic warfare. As populations declined and peasants either left their lands or revolted, monarchies could no longer rely on feudal land owners for taxes and cavalries for military success. These challenges provided incentives for kingdoms to build up their own infantries.
As the feudal system faded, Royal powers grew. Further, with the rise of the Ottoman Empire, European royalty had further incentives to secure new trade routes. As a result, royal powers began granting power to merchants and others who, in effect, gained monopolistic rights to a variety of business activities. This new group of power players included the Fuggers of Germany, the Medici’s of Italy, and the De La Poles of England – among others. Many achieved great wealth and political influence, and established many of today’s modern day business practices such as insurance, double-book-entry accounting, partnerships, and the rudiments of a banking system. Eventually, Royal Powers peaked in the form of Mercantilism. As new lands were discovered, raw materials were repatriated and finished goods where exported with the universal goal of maximizing exports and minimizing imports.
The ever-neglected labor class grew tired of their coercive incentives related to intrusive monarchies, poor working conditions, and lack of property rights. This led to the English Civil War in 1642 and similar events across Europe. Eventually, royalty was forced to share powers with parliaments, and rules of law were established to support property rights. These factors opened the door to a variety of new opportunities for a broad populace.
English philosopher and now recognized economist, Adam Smith in 1750 put best by saying “Little else is requisite to carry a state to the highest degree of opulence…but peace, easy taxes, and a tolerable administration of justice - all the rest being brought about by the natural course of things.” In this phrase, Mr. Smith captures the essence of free-enterprise and incentives by suggesting a strong and vibrant economy results from a system that protects everyone’s right to pursue his own self-interest.
World GDP 1990 Dollars
Source: The World Economy: A Millennial Perspective, 2001
While economic growth grew modestly from the fall of the Roman Empire to the end of Mercantilism, the incentives of free-enterprise have yielded an exponential growth in economic production since the 1700s – adjusted for inflation. In fact, countries that have embraced free-enterprise principles have since led virtually every measure of economic productivity. Today, The Wall Street Journal and The Heritage Foundation compile an “Economic Freedom Score” for each country, and a strong correlation exists between Freedom and Gross Domestic Production per capita.
Freedom and GDP per Capita
Source: Heritage Foundation, Laureola Asset Management Company
Credit & Housing Crisis – Some Simple Math
Much of today’s credit and housing crisis is linked to the burgeoning debt loads of consumers. Today, total consumer debt, as a percentage of GDP, stands at 100%. This compares to a 50-year average of 55%. Consumer debt has grown along with homeownership and a culture that has arguably shifted to a higher tolerance for debt – at least until recently. Of the consumer debt outstanding, it is estimated that 15% is considered “sub-prime” – meaning the borrower has a higher chance of defaulting on their debt. Further, it is estimated that the default rate on consumer debt will exceed 20%, vs. 5% prior to 2008.
Financial companies that own consumer debt, directly or indirectly, list it as assets since the idea is that loans would be repaid - similar in concept to an investor owning a bond. As default rates climb on consumer debt, the value of balance sheet assets, fall. So what impact does falling asset values have on financial companies? Falling asset values along side stable liabilities ultimately lowers the equity value of a company (assets minus liabilities equals equity). This increases the financial leverage of a company. For example, a bank with $1 billion in assets and $900 million in liabilities would have an equity value of $100, and $1 billion divided by $100 million equals 10 times – or 10x leverage ratio. If this bank’s assets decline by $50 million, it would therefore have an equity value of $50 million ($950 million minus $900 million) and a new leverage ratio of 19 times. This is the concept that is challenging financial companies today, including banks, brokerages, hedge funds, and government sponsored entities like Fannie Mae.
Leverage ratios for financial service companies turn out to be fairly reliable indicators of their health. Specifically, studies have shown that leverage ratios of 10 times indicate that a bank has a very low likelihood of failure, whereas banks with leverage ratios of 20 times tend to fail at a rate of 14% within two years (Estrella, Park, and Peristiani). When bank failure rates rise, history has shown that bank runs occur as customers attempt to cash out their accounts. Today, with deposit insurance, bank failures pose less of a threat to the concept of a vanishing customer account. However the notion of a bank failure poses a larger challenge for other banks that pass money back and forth in the form of very-short-term lending – as these loans are not formally insured. When other financial service companies, such as brokerages, become over-leveraged, similar business-to-business challenges occur. These sorts of activities led to seizure in the financial markets, which seemed to peak in October 2008 as the spread between inter-bank lending rates and treasury bills reached record levels. Without intervention (i.e. bailout) this seizure would have dramatically spread, in our opinion, to consumers and businesses that rely on financial service companies in any capacity – which would have ultimately led to a collapse in economic activity. Banks have indeed tightened credit standards and lines-of-credit, and the economy is in the grips of a recession. However despite the common tag-line that banks are hording Troubled-Asset-Relief Program (TARP) funds, lending activity and the recession would likely grow far worse without the bailout.
TED Spread – Inter-Bank Lending Rates
Minus Treasury Bill Rates – Historic Peak
In October 2008
The Perilous Position of the U.S. Government
The U.S. Constitution laid the ideological framework for a legal and political system that fostered a new economic powerhouse. The government has demonstrated time-and-time again that it will protect the risky endeavors of its constituents, particularly by bailing out larger businesses (or groups of businesses) in times of crisis. Some examples include Roosevelt’s Reconstruction Finance Corporation in 1932, Penn Central Railroad bailout in 1970, and Chrysler’s bailout in 1980. Bailouts have largely been in the form of loans or temporary equity investments, and these investments have generally been repaid plus interest.
Bailout History
Source: ProPublica, Laureola Asset Management
Today’s economy is much bigger, and the challenges arguably tougher, but the basic economic benefit of bailout loans, guarantees, and equity injections is not dramatically different than prior times. By offering to standing behind approximately $3 trillion of financial commitments in less than a year, the government’s role as savior has been commensurate to a larger economy and crisis.
Bailout Commitment ($billions)
Source: Laureola Asset Management estimates, November 2008
One main bailout measure used to bring down leverage ratios for financial service firms is to increase the equity values of financial companies, and this is the main idea behind TARP funding. Given the size of the financial services industry, a 3% decrease in asset values would be approximately $600 billion. The original idea behind the TARP plan, which is still largely in tact, allows for the Treasury to allocate up to $700 billion towards equity investments in financial companies.
So, what puts the U.S. Government in a perilous position?
- The pre-existing government debt-load, plus
- The size of the bailout commitment, plus
- A weighty sleight of future entitlement liabilities
The TARP plan along with all of the other new government commitments in 2008 has increased both the Treasury’s debt load and the Federal Reserve’s balance sheet. Currently US Public debt to GDP ratio has grown to 80% versus 60% in 2000. This ratio peaked at 120% following World War II. Given the Federal Reserve’s larger balance sheet, further bailout actions, and the Obama-Economic-Stimulus plan, it is quite reasonable to assume Federal Debt will climb to 100% of GDP in the next year or two.
Another longer-term factor contributing to a rise in Public debt involves the growing liabilities of entitlement programs – such as social security, Medicare/Medicaid. In fact before the credit crisis, the Government Accountability Office (GAO) has projected that public debt to GDP would climb to over 100% around the year 2035 and then continue to rapidly grow beyond. The GAO further predicts that without significant reform, entitlement spending plus interest due on public debt would exceed government revenues. This implies that all other non-entitlement government spending could not be funded whatsoever through tax revenues.
Consequently, today’s government actions related to solving the credit crises significantly shortens this time frame of not being able to pay for government programs other than entitlement and interest expenses.
Debt-to-GDP (chart constructed before bailout)
Source: Government Accountability Office
U.S. Debt & Taxes
Source: Oregon St. Univ., Tax Policy Center, US Treasury, Laureola Asset Management
The result of these current and pending financial stresses on the US Government brings us back to the notion of incentives. What sort of economic incentives will dictate US Government policy for the next several years? Simply put – negative incentives. The conflicting factors of a growing populist sentiment clamoring for universal health care and the tight financial position of the government will force difficult decisions on a broad array of benefit-hungry constituents. With the government’s financial position growing weaker by the year, it will ultimately be forced to impose a variety of tax increases, program cuts, and benefit reforms on an increasingly unhappy citizenry. Otherwise without significant reform, the government will find itself deeper in debt and its position on the global stage slide rather quickly.
Evolution in the Financial Services Sector
At the end of 2007, financial services companies had a collective leverage ratio of 12 times (David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin). However, if 20% of sub-prime debt defaults, as is estimated, then this translates into an estimated 3% overall decline in balance-sheet assets for financial companies. Further this translates into a new leverage ratio of 19 times, which significantly would bring the health of financial companies, collectively, into question. As leverage ratios have spiked and problems emerged for a few financial behemoths, fear led many banks from lending, particularly to each other. This seizure peaked in October 2008, but with the help of the bailout inter-bank lending has begun to recover.
Financial Services Sector – Actual Leverage in 2007
Source: David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin
Estimated 2008 Financial Service Leverage Pre-Bailout
Source: Laureola Asset Management
Implied Equity Needed
Source: Laureola Asset Management
Implied Equity Needed via TARP Plan – Scenario Analysis
 
Source: Laureola Asset Management
Note: This notion of sub-prime defaults and its impact on asset values does not fully include the impact of “Fair Value Accounting,” which further necessitates a write-down in asset values, and therefore equity, of many financial service firms, such as banks.
“Ideology is good in times of crisis” and the financial services sector has been granted great assistance to help it out of its treacherous position. With the government and other large investors (i.e. Warren Buffet, Saudi Prince Alaweed) essentially injecting capital, such as the TARP Plan, and co-signing financial service company loans, this sector will recover quite nicely over the next several years. The recovery process involves de-leveraging and paying back these saviors. In fact, these two factors will likely dominate the priorities of many larger financial service companies. Further, a greater degree of regulation is on the horizon, and will impact the activities of most financial service companies especially as independent investment banks have largely disappeared, merged, or morphed into traditional banks.
The incentives related to de-leveraging, repaying saviors, and obeying tightened regulations will drive lower loan growth rates, less creativity related to new exotic financial instruments, and smaller salaries within this sector. Further, non-financial companies who have historically relied on investment banks to create capital – such as bonds and stocks – for their operations, will now have a harder time finding solutions in this traditional route.
On the other hand, smaller financial service companies and banks have, in general, maintained lower leverage ratios and have been less involved in activities that have proven now to be quite risky. Further, technological advances have greatly reduced the barriers to entry related to forming financial service businesses, and we have seen a blossoming of new small private banks and money management firms, for example.
In essence, the crisis highlights weaknesses of large financial service firms who have taken on excessive risk and have received the bulk of the bailout pie. Large firms will focus on de-leveraging, paying back capital injections, and abiding by stronger regulations. This will muffle loan growth, foster less financial innovation, and shrink salaries. The winners of the crisis will likely be smaller banks and firms who have broadly avoided excessive risk. We will likely see a decentralization of Wall Street as smaller firms offer much better incentives to new employees and now have great opportunity to win business from larger banks.
Closing the Growing Gap between Wealth and Influence
Collectively, the top 20% of wealthy Americans own 90% of the private financial assets in the US. From most any perspective, this is a very influential demographic. Given the nature of a free-enterprise system, owners traditionally have a strong impact on the direction, leadership, and governance of their businesses. Companies in the public stock market are the largest business members of our free-enterprise system – collectively representing 75% of the business tax base. Today, with about 40% of US households owning stocks, public stock value has a significant impact on Americans’ lives, particularly the wealthiest 20% who own the majority of public company shares – albeit indirectly.
Wealth and Financial Assets
Source: Univ. of CA., 2006
In fact, most Americans own stocks indirectly through investment intermediaries or “institutions” (i.e. mutual funds, pension plans, money managers). Direct ownership (of public companies by individuals) is currently 32% of the value of public company stock. In 1929, only 1% of American households owned stocks in public companies, and the overwhelming majority (95%+) of that ownership was direct. Consequently, today’s predominance of indirect ownership relative to several decades ago, represents a transfer of influence from individuals to investment institutions – based on the notion that proxy voting is the legal framework by which public companies are controlled by owners, and institutions who directly hold 68% of the value of public stock for their investors, vote most proxies.
Essentially, the traditional impact individual owners have had on corporate direction, leadership, and governance on public companies, which is provided through proxy voting, has altered dramatically. These factors are now in the hands of proxy-voting institutions, which generally operate under a different set of incentives than direct owners. Institutions are typically motivated by shorter-term factors since they have relatively short time horizons for company ownership. In fact mutual funds on average hold a company for less than 1-year. As a result, investment institutions tend to care more about short term company results – as may be the case when a company is focused on meeting-or-beating quarterly earnings estimates. Alternatively, other institutional investors seem to care less in general about company leadership and direction than direct owners – as may be the case for passive investment vehicles.
The Vanguard 500 Fund, the largest US stock fund and a passive investment vehicle, has a longer-investment horizon given its lower turnover ratio (typically less than 10%) and so may not push companies towards shorter-term decision-making. On the other hand it seems to represent the non-interested view towards company behavior. Specifically, in 2007, for the 500 companies it invests in, it voted in favor of company-proposed proxies approximately 99% of the time. Whereas when a shareholder made a proxy proposal, the fund either abstained or voted against it approximately 90% of the time. To be fair, Vanguard seems to have a rigorous proxy committee, but the track-record raises a brow.
How did the Largest US Mutual Fund Vote?
Source: Vanguard, 2007 Proxy Voting
With a lesser-involved or instant gratification “direct” ownership base, companies often find themselves ignoring the long-term risks associated with short-term decision-making. This is perhaps why Warren Buffett, representing a distinctly different view in favor of “interested” longer-term investing, tends to buy companies whose managers are often significant owners in the business, and further why he often prefers to have a seat on the board of directors. Businesses in these cases tend to operate through longer-term objectives.
Generally, the longer-term risks that arise with businesses having shorter-term operational goals often explode when problems arise related to: excessive leverage, excessive off-balance sheet items, excessive CEO compensation, ethic issues, poor decision-making, and minimal reporting/disclosures on a variety of subjects.
In essence, today’s predominance of indirect ownership (via investment institutions) represents a huge gap between wealth and influence, and it will likely be closed. Since the dawn of societies, rare is the example of wealth having so little influence on its use, and as today’s situation is a relatively new phenomena it is likely temporary.
As investors have experienced two stock market crashes in 10 years and baby boomers are retiring by the millions, incentives of the wealthy will drive risk reduction for everything in their path – including institutional investors and the companies they invest in. Short-term decision-making leads to excessive risk-taking, and companies will have to answer to a more risk-averse wealth culture – indirectly for now. However, there are no legal restrictions that block mutual funds from seeking input on how they vote proxies from their mutual fund shareholders. Yet, not one mutual fund offers anything of the sort.
Another consequence of great market volatility highlights the weaknesses in the current risk-management approach to individual investing. As investor portfolios have declined in value, it becomes more expensive to pay for lifestyle needs – especially for those who rely on their portfolios. On the other hand, many institutional entities like pension funds and insurance companies have effective risk-management tools, such as asset-liability management where future portfolio obligations are “immunized” by suitable investments. Essentially, this approach applies a cash-flow matching framework where, for example, expenses (portfolio outflows) in two years might be offset by a 2-year bond, expenses in 5-years are offset by similar maturity investments, and long-term expenses might be reserved for equities.
Today’s risk-management approach for individual investors is dominated by simpler techniques that effectively ignore an investor’s future liabilities. For example, an investor with a low tolerance for risk would broadly have more bonds, and an investor with a high tolerance for risk would get fewer bonds – all without sufficient consideration of future cash outflows (i.e. liabilities). There is often some fancy math involved such as “mean variance optimization” or “Monte Carlo Simulation” that tend to speak broadly to risk. However, these methods have not gone far enough especially for investors who thought they had a high tolerance for risk, but now find themselves forced to downsize or cut back dramatically on living expenses – since real outflows have not been offset by suitable investments. Hence, the same incentives that will likely drive changes in the proxy-voting process, will likely drive better risk management tools for individual investors.
Conclusion
Incentives offer a powerful explanatory framework in studying economic history and evolution. Today’s rather treacherous position related to the housing and credit crisis will largely be answered by our free-enterprise ideology. This ideology has already applied a great deal of medicine as measured by the size and swiftness of the government-led bailout. However, with a mounting government debt-load, we will likely experience a good dose of controversy related to adjusting the government’s ability to pay for its debt and provide entitlements to our citizenry.
The current crisis has also highlighted the weaknesses of the financial service sector, particularly among the largest members. The winners who arise out of crises will likely be smaller financial firms and banks who have broadly avoided excessive risk. As the financial service sector’s role as facilitator and creator of capital lives on, many non-financial businesses will find it easier to do business with the winners of the crisis – smaller firms and private equity investors.
Finally, the current crisis also highlights the growing gap between wealth and influence – as demonstrated in the proxy-voting process. As many public companies have embraced a sprinter’s philosophy of short term success, long-term term risks have contributed to volatility in the stock market. With two market crashes in 10-years, a growing group of retiring and risk-averse investors will dictate change among corporate behavior. This will ultimately usher in a new era of improved proxy-voting processes and a new set of risk-management tools.
Diligent Global Value Investing
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This article has been distributed for educational purposes only and should not be considered as investment advice. All performance-related discussions are for illustration purposes only and do not reflect the performance of any actual portfolio. The results for individual portfolios will vary depending on market conditions and the portfolio’s overall composition. All investments carry a certain degree of risk including the possible loss of principal and there is no assurance that an investment will provide positive performance over any period of time. This article contains opinions of the author, which are subject to change without notice. Past performance is no guarantee of future results. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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