Pundit Interviews

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Perishable Pundit
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Pundit’s Six-Point Proposal
To Fix Financial Failures

With the collapse of the Treasury Department’s proposed bailout plan, we have avoided, at least for the moment, a very unfair plan.

As we mentioned in our last piece on the subject, which you can read here, the bottom line of the Paulson plan is that either the Treasury was going to buy assets at the market price — in which case, there is no need for a government plan — or the Treasury would have paid more than the market price — in which case, the plan would unfairly bail out specific Wall Street interests because of supposedly “systemic risks.”

By paying more than the market price, the same people who engaged in the risky behavior — high leverage, trade with parties without confirming they had resources to honor the trade, etc. — would be allowed to extort money from hard-working Americans because the Wall Street institutions are “too big to be allowed to fail.”

Newt Gingrich said the Paulson plan, with its vesting of virtually unlimited power in the Secretary of Treasury, was “un-American” and that Paulson should resign.

Though we have dodged a bullet, it has also come out that one of the consequences of the government’s bailout of AIG may have been saving the skin of Paulson’s old cronies at Goldman Sachs. See article here. We have not solved the crisis. Robert Salomon, a really sharp professor at NYU’s Stern School of Business who has occasionally taken note of some of our work on Tesco, sent us an e-mail that pointed this out about our piece:

I must disagree though (in principle) with the main assertion that we should not go ahead with some version of the Paulson plan (although the version they’re set to vote on leaves much to be desired).

At this point, not doing anything will result in financial Armageddon. In your article, you assert that it’s not that there is not a market for the securities, just that the sellers don’t like the price. However, if the banks did sell at the “true” market price, they would all be effectively insolvent.

Imagine the consequences of having the entire banking system (many of the banks at first, not just a few, and the counterparty risk of each to the other would then bring all the financial institutions down — even the “technically” solvent ones). This would force the FDIC to take receivership for most of the system.

Their balance sheet is $42B. Do you think they have enough money to cover $10T in insured deposits, or even some fraction of that?? Then think about all the social ramifications — the mass layoffs, the decrease in government budgets, etc. It would be an absolute nightmare. And even though I agree that the $700B may not work (for reasons I plan to explain in a blog post), at this point we absolutely have to do something — even if it is only rearranging deck chairs on the Titanic. That’s how scary this event is to me. But again, that’s just my opinion. Doesn’t mean I’m right…

Professor Salomon is being admirably self-effacing; he is exactly correct. Now we would say three things in response:

  1. The financial institutions may all be insolvent, but they are insolvent to different degrees. We still need to sell the assets so we can know what the actual market value is, as that knowledge is the crucial information that will make going forward possible. As long as there is ambiguity as to what these assets are worth, credit will remain frozen.
  2. The cost of this situation has to be paid. But it does not have to be paid directly to those whose negligence and self-serving behavior got us into the mess.
  3. We can put $700 billion into the FDIC as well as into buying up assets.

We do not propose to do nothing. The situation is serious, but we think that allowing one person, without any real supervision, to allocate $700 billion is a recipe for corruption. We also think that it won’t solve the problem. We need to act quickly and any rational system for valuing and acquiring assets on this scale will take months to set up. So we would propose the following:

1) Avoid runs on the bank.

One way the Paulson plan fails is that it does not provide depositors with direct assurance that their deposits are safe. We would suggest that the first thing that must be done is full FDIC insurance coverage must be offered in unlimited amounts to all non-interest-bearing bank accounts. Because of the popular perception that money market accounts are 100% safe, we would provide a similar guarantee to all current money market fund deposits for one year — giving funds and individuals time to adjust their investment portfolios to match their risk tolerance. Many will choose to invest in money market funds that invest solely in instruments backed by the “Full Faith and Credit” of the United States once the risk of commercial paper is explained.

2) Change the incentives by individuals and local governments in relation to housing.

It is widely believed that there is a public interest served in encouraging home ownership. The rootedness to a community, a stake in society, etc… these are democratic interests that we can favor through a sound housing policy. If we do this correctly we can also get people buying homes again. There are three separate problems:

  1. The government now bizarrely encourages people to use their homes as an ATM machine. Under most circumstances, interest on a home equity loan, for example, is tax deductible, whereas the interest on the same loan taken without a lien on the house is not deductible. Many a person who has the cash to buy a house or to put a larger down payment on a house has been encouraged by their tax advisers to take out a larger mortgage in order to get the tax deduction. This is all insane. Whatever the public interest in encouraging home ownership, there is no public interest in encouraging borrowing against one’s home.
  2. Equally, one of the biggest obstacles to home ownership is high real estate taxes. Yet the federal government encourages this by allowing full deductibility of real estate taxes. The truth is that real estate taxes should only be used to cover housing-related expenses — perhaps the fire department or that portion of the police effort that goes to protect property. Some people decide to have a lot of their assets in a house, some people decide to have only a small percentage of their assets in a house. This is a personal preference and should not affect the amount they pay for, say, supporting a community hospital. Although this is a local decision, by changing what is deductible and what is not, the federal government creates a strong political constituency for changing local taxation.
  3. Though there is a public interest in encouraging the ownership of a primary residence, there is no public interest in encouraging larger homes or ownership of vacation homes. Allowing deductions on million-dollar mortgages and real estate taxes on multiple residences encourages things we have no reason to encourage.

    The solution is to First, protect all current homes owners under the current status quo, then Second, announce that for all new home buyers, neither mortgage interest nor line of credit interest nor real estate taxes on home ownership would be deductible. Instead, there will be a flat tax credit given to those who own their primary residence.

    We haven’t been able to quickly get the exact average cost to the federal government of our current policies, but the average price of a house in America is around $250,000. If the average person has an 80% mortgage, that would be $200,000. At 7% as an example, that would be a deduction of $14,000 a year. If the taxes are 1.5% of value, the taxes might give a deduction of another $3,750, so the total available deduction would be $17,750. If the average person paid a third of his or her income in taxes — most pay much less — the value of the deduction would be about $6,000 a year.

    In lieu of deductibility for mortgage interest and real estate taxes, if we offer every homeowner a tax credit of $6,000 a year, indexed automatically for inflation, we would encourage home ownership while discouraging people from carrying mortgage debt, discouraging states and municipalities from taxing residential real estate and no longer incentivizing people to buy larger houses and vacation homes.

    This would provide a permanent basis for a sound housing policy.

3) Offer short-term incentives to get the housing market going.

Rather than give money to financial institutions to overpay for housing related securities, better to give money to people to buy houses and thus increase the value of the same paper. Basically, it is understood that every time the government undertakes a project for the public good — say building a highway — some lucky people — say property owners adjacent to the highway — may benefit disproportionately. That is OK, but that doesn’t mean it would be OK to just give money to those same property owners.

Equally, in pursuing a policy of encouraging home ownership, some holders of mortgage-related paper will benefit — that is entirely different than Secretary Paulson deciding to write a check to particular companies.

If, for the rest of 2008 and 2009, we offer a one-time $10,000 tax credit to anyone who becomes a first-time home buyer, we would provide a big psychological boost to the housing market as people would feel an urgency to buy a home, now, before the tax credit expires. Family members would see a compelling reason to help their loved ones get into a house now, etc.

4) Re-definition of insurance.

Ben Stein — of Ferris Buehler fame — wrote a brilliant column on this crisis:

…the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.

These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E. Buffett.

One of the reasons we can’t just bail out Wall Street is that in a very real sense these institutions and the people who run them defrauded the public. If one has $100 billion in mortgage-related securities and one enters into a credit default swap to protect against the decline in value, one will present financial statements showing those mortgage securities as being worth par. But if the Wall Street firm was negligent — or chose not to look too hard — and, in fact, the counter-party to that credit default swap didn’t have the assets to guarantee performance on the deal — those financial statements that constituted the earnings part of the P/E ratio were really fraudulent.

So every person who bought stock in those Wall Street firms was really hoodwinked.

It is important to understand that AIG, for example, has hundreds of insurance subsidiaries and, to this day, all seem basically sound. Why? Because selling insurance, by law, requires insurers to meet capital requirements, post collateral, etc. But a small subsidiary of AIG working out of London sold hundreds of billions of dollars of “insurance” against the decline in value of mortgage assets. Because of the way the laws and regulations were written and interpreted, this did not count as insurance, so no reserves were required.

Obviously the buyers of such insurance should have caught this, the sellers should have been more responsible and not written it, and the credit rating agencies should have caught it. This all being said, it is clear we need a legal change here, whereby these types of derivatives are classified as insurance and standards are set for collateral and capital ratios.

5) Ensure stronger financial institutions.

Citibank’s acquisition of Wachovia’s banking operations in a deal brokered by the goverment was really a result of Citibank moving quickly to bolster its capital position when this crisis first broke, whereas Wachovia dithered as it tried to avoid the dilution to existing shareholders such capital raising involves. In the end, Wachovia’s shareholders lost almost everything.

We wrote a piece here in which we called for companies to be restricted from buying their own stock, as this practice was being used to distort the market.

Now it is clear that both dividends and stock buybacks by financial and insurance institutions need to be deeply restricted. If a company is not profitable, it should be restricted from paying dividends or doing stock buybacks until it reestablishes a long-term record of consistent profitability — say ten years of profitable operations.

Tougher capital requirements, tougher reserve requirements and, most important, an assurance that all financial instruments are backed in this way — not a netherworld of derivative schemes that are neither insurance, nor securities — must be instituted to rebuild confidence in our financial institutions.

6) Segregate proprietary trading.

The root of a lot of these problems is that there has been a lot of confusion between a business and investing. Getting a commission on trading stocks is a business; giving financial advice on mergers and acquisitions is a business; managing money for investors and getting a fee to do so is a business; using a firm’s capital to buy billions in mortgage debt in the hope one can sell it at a higher price is just not a business — it is an investment, a speculation.

There is nothing wrong with speculating — but it shouldn’t be done by businesses as it creates conflicts of interest, and the inevitable losses will provide unnecessary shocks to the financial system.

Let proprietary trading be done by separate investment trusts.

Basically, the current crisis requires better capitalized financial institutions. Yet the proposal of the Paulsen plan to make them better capitalized by buying their troubled paper is very problematic, because the process of determining a value for that paper is fraught with difficulty and the potential for abuse.

Bill Kristol, who edits The Weekly Standard, pointed out that professor Lucian A. Bebchuk of Harvard law has come up with a very interesting proposal that involves the use of rights offerings to enhance capital ratios:

…financial firms that are undercapitalized but clearly solvent, as many financial firms seem to be, should be able to raise significant additional capital from private sources. It should be emphasized that the government has thus far not exhausted its options in terms of inducing financial firms to raise additional capital from private sources.

Following the Bear Stearns collapse in March, the government urged and encouraged some financial firms to raise additional capital. However, the government has not thus far required financial firms to go out and raise additional capital, and it should do so.

As pointed out by Raghuram Rajan, for financial firms that have substantial but sub-optimal capitalization, the government could and should require raising capital through right offerings to existing shareholders. While such right offerings would not be effective for firms in relatively fragile situations, they could bring significant additional capital to firms that are clearly solvent; this would substantially increase the aggregate capital available to the financial sector and, in turn, expand the pool of credit available to Main Street.

There can be little doubt that if, say, Bank of America were required to make a right offering at a price significantly below its current market price, the offering would be fully subscribed, would bring in significant additional capital, and hence would expand the capacity of this bank to provide financing to the real economy.

Because the proposed legislation is partly motivated by a concern that the financial sector’s undercapitalization might undermine its ability to finance Main Street, mandating such right offerings would contribute substantially to addressing this concern. Furthermore, it would do so at no cost to taxpayers. Thus, mandating right offerings for an appropriate subset of the country’s financial firms should be a useful supplement to (and partial substitute for) the use of public funds for these purposes.

We would say that some combination of four things needs to happen:

  1. People and companies must be reassured that their money is safe so there is no run on the bank.

  2. Housing policies should be reformed to be rationally related to the long term public interest.

  3. Short-term incentives need to be instated to boost the housing market.

  4. Financial institutions need to be recapitalized.

The Paulson plan does none of these things. Let us hope that its rejection will lead to a new, stronger policy, focused on the four points we have defined.




McCain And Obama Make A Proposal — The Intellectual Bankruptcy Of Our Politics May Be A Bigger Problem Than The Financial Insolvency Of Wall Street.

It is a sign of the bankruptcy of our politics that both Senators McCain and Obama independently called for precisely the wrong change in FDIC insurance coverage. The Washington Post ran a piece entitled Obama and McCain Call for Increase in Deposit Insurance:

In a moment of unintentional unity, Sens. Barack Obama and John McCain today both proposed raising the cap on federally insured bank deposits to $250,000 from $100,000 in an effort to broaden support among Republicans for the financial rescue package that failed on a close vote in the House yesterday.

The insurance increase would particularly benefit small businesses, a core GOP constituency. “While that guarantee is more than adequate for most families, it is insufficient for many small businesses that maintain bank accounts to meet their payroll, buy their supplies, and invest in expanding and creating jobs. The current insurance limit of $100,000 was set 28 years ago and has not been adjusted for inflation,” Obama noted.

McCain also called for the Federal Deposit Insurance Corp. limit to be raised, saying at an economic roundtable in Des Moines, Iowa, that “we cannot allow a crisis in our financial system to become a crisis in confidence.”

This may be good politics — a way to get support from people with over $100,000 in the bank — but it is horrible policy.

On the one hand that is way too much insurance for the government to give to people who are chasing yield. It will result in an instantaneous boom in CD brokering as weak, undercapitalized banks offer high interest rates to woo deposits. Such a policy is setting us up for the next big financial crisis.

On the other hand, it is a wildly insufficient amount when it comes to stopping bank panics. Businesses can often have checking account balances well over the quarter-million proposed limit — and they would still be at risk. A citizen who sells a house on Tuesday and intends to use the money on Wednesday to buy another one — and so has a big bank balance for one night — will still be vulnerable under both the McCain and Obama proposals.

Here is the reform that makes a difference: 100% of all funds in non-interest bearing accounts, commonly known as checking accounts, should be covered by the FDIC.

In most cases, these funds are just float waiting for people to receive checks and cash them. Or the funds represent cash being held for a specific purpose, say to meet a payroll.

If people are looking for an investment, we have to make them run the risk of loss — otherwise they will always put their money in a high-yield/high-risk situation because we are collectivizing the risk but letting the investor keep the high yield.

As long as companies are just doing business and not speculating to get a higher yield, the public interest is in encouraging a sense of security regarding banking.

The McCain and Obama proposals provide too much incentive to speculate on getting the best yield — without providing businesses and citizens the assurance that their checking account balances are completely safe.

How can all the smart people surrounding both candidates come up with such obviously inadequate proposals? If we don’t solve that problem, this financial crisis will be the least of our worries.




Tesco Puts Positive Spin
On Fresh & Easy Numbers

Tesco came out with its first hard numbers on Fresh & Easy, and the numbers don’t illuminate much.

Tesco said it had 74 Fresh & Easy stores open as of August 23, 2008, and would have 200 stores open by February 28, 2009. However, there is no particular reason to believe the company will be able to keep this schedule.

It acknowledged that after losing £17m last year, its losses so far this fiscal year have been £60m, so total losses to date on Fresh & Easy have been £77m — in contrast to total sales of the division of £76m.

So the losses have been greater than total sales. At today’s exchange rate, Tesco lost around $137 million so far in its US adventure. Tesco portrays these as start-up costs:

These planned losses reflect the fact that the US business — which has been trading for nine months — has been built with the necessary infrastructure in place from the beginning to support hundreds of stores. At this stage, it is therefore operating with high overhead and other costs in relation to the scale of the business, whilst also trading from immature stores.

Although the degree to which the losses were “planned” is in dispute, the fact that Tesco has an infrastructure that can handle more business is clearly true, but it is difficult to know the degree to which this is the cause of the losses. After all many of the start-up costs, such as building the new distribution center, have been capitalized. Tesco did not elect to detail what the store level contribution to overhead is and so we just don’t know to what degree adding additional stores will reduce losses or establish profitability.

Tesco described Fresh & Easy sales in this manner:

Sales densities are building well, with the average running at $11 per square foot per week, which is already substantially higher than the US supermarket industry average. Our best stores are now running at more than $25 per square foot and the stores opened since the Spring are averaging sales densities close to $13 per square foot per week.

The paragraph is a little odd. First of all, the Food Marketing Institute, the supermarket industry trade group, says US Supermarket sales are $11.27 per square foot, so sales of $11 per square foot are not only not “substantially higher than the US supermarket industry,” they are basically average.

Some of it points to our previously expressed view that the future for Fresh & Easy involves a massive write-off when the company closes a big chunk of the poorly sited stores. After all, if the best stores are now selling over $25 per square foot per week, and Tesco mentions this because it is meaningful — in other words this is not just an aberration of one freak store but represents what the top 10 to 20% of stores are doing — yet the average sales are $11 per square foot per week, there must be a whole chunk of stores that are doing $5 or $6 per square foot, per store, per week, in order to come out with that average.

One thing that did come out from the report is that Tesco owes a lot of people, including the Pundit, an apology. Here is the graph Tesco distributed to show how Fresh & Easy is improving on its sales numbers:

The chart doesn’t reveal much, but since Tesco tells us elsewhere that the stores are averaging $11 per square foot, per week, and the chart shows that average sales per store have more than doubled back from their low point when we were doing our estimates — as were others such as Willard Bishop — then Willard Bishop, ourselves and others who were estimating about $5 per square foot, per store, per week were exactly correct and Tesco’s dismissive attitude was just a smokescreen.

Now surely the sales increases are something to be pleased with, but the circumstances of the sales increases make it difficult to know their meaning or importance. It is sort of an apple-to-oranges comparison.

Initially Fresh & Easy had an EDLP model and did very little in the way of promotion. Now it has switched to be very promotional. Just the other day, we quoted an important industry expert:

No doubt Fresh & Easy is getting more promotional and now has ad/in-store specials versus their old EDLP ads. Keep in mind, once you have exposed your model to more people and more people like it, they will support it. It is the right decision to spend on deep promotional specials as the cheapest thing you have is the product, which usually accounts for 25% of the total sales and the rest is rent, payroll, utilities, transportation, and the ad man.

So Tesco is certainly doing the smart thing — but — and it is a big BUT — when you discount product through promotions at 50% off, as Tesco has done throughout the summer with “Grilling Packs” and other items, then allow 50% off perishables when perfectly good product, such as apples, approach an arbitrary date, then give people $5 off $20 coupons, which you allow to be used in multiples, it is unclear the consumers will stick with you should you ever decide you want to make money. Some consumers just follow the deals.

One interesting thing the data released does reveal is how horribly Fresh & Easy’s own brand product is doing. Here is what Tesco says on the subject:

Fresh foods and Fresh & Easy[s] own brand products, which represent 60% and 72% of sales respectively, have been particularly well-received by customers.

In America, though, most perishables, such as produce, meat, in-store bakery, deli etc., are not considered branded at all. In a category such as produce, with product sold in bulk, there often is no identifying information on the item or, if it is there, it is a trade brand with no consumer recognition.

If 60% of Fresh & Easy sales are perishables — whether they put the Fresh & Easy name on some pear or not is meaningless to most consumers — we would not credit this as private label at all. But as we read the report, it says that 60% of the sales are perishables, and since we know that virtually all of this product is Fresh & Easy label, the report indicates that of the 40% of store sales that come from non-perishable categories, 12 percentage points of total store sales are in private label — 60% of store sales that are perishable (and virtually all private label), plus 12 percentage points out of grocery brings us to 72% private label.

This means that on grocery product, out of the 40 percentage points of store sales in this category, 12 are private label and 28 points are brand name products. Put another way, only 12/28ths, or 43%, of grocery sales are Fresh & Easy brand — and we wonder if they are including the exclusive wine offerings. Because these are pricey, it would take up a big chunk of the private label business.

In the meantime an experienced retailer recently went to visit Fresh & Easy stores for the first time and found that the experience should be considered in light of the fact that Fresh & Easy is owned by Tesco — a public company:

You will often hear people say that labor is the biggest expense in retail. Actually it is inventory that is the biggest expense in retail. When I went to visit two Fresh & Easy stores in two wildly different demographics on the same weekday morning and found them both out of stock throughout the store on identical items — I thought something was up.

Frozen food was 25% out of stock, milk was 80% out of stock — and these are big profit sources. Meat, produce, prepared foods, bakery — all 20, 25, 30% out of stock. Tesco is a very competent retailer. It is most likely out of stock, not because of vague problems with the ordering system, but it is out of stock because it has decided to dial down the inventory — even at a risk to the consumer experience.

This could be because sales are terrible and they keep dumping product. More likely it is a conscious decision to manipulate the financial results by holding down inventory levels and thus the amount of cash required to stock the stores.

It is a theory and from one who has experience working with publicly held retailers. So it could be true. It makes more sense than the theory that the uber-achieving Tesco can’t stop the out-of-stocks because the ordering system doesn’t work well.

In any case, with Wal-Mart about to open its Marketside, which we now know will have in-store food preparation and service delis — although not an in-store sandwich program — the competition is starting to heat up. Although small stores are everyone’s “project” right now, whether they can make money in suburban areas of the United States is very much an open question.




Perishable Thoughts —
Resolve To Succeed

With the economy on a tightrope and a recession in the offering, we are grateful to Scott Danner, Chief Operating Officer of Liberty Fruit Co., Kansas City, Kansas, for sending along this quote:

“Always bear in mind that your own resolution to succeed is more important than any other one thing. “

Letter to Isham Reavis
Abraham Lincoln
November 5, 1855

The letter can be viewed/purchased in:

Abraham Lincoln: His Speeches and Writings
By Roy Prentice Basler, Abraham Lincoln, Carl Sandburg
Photographs by Carl Sandburg
Contributor Carl Sandburg
Published by Da Capo Press, 2001
Pg. 337

Isham Reavis had written to Lincoln and applied for a student’s position in Lincoln’s office. In those days studying with a lawyer was the typical route to becoming an attorney. Lincoln wrote back explaining that he traveled too frequently to make studying with him advantageous. He advised young Reavis to get books and to study them on his own, pointing out that his own desire and capacity were more important than any other factor in his obtaining the goal of becoming a lawyer.

This point seems worth remembering when general economic trouble approaches. There are always opportunities… whether times are good or times are bad, there are always opportunities.

Abraham Lincoln learned the law by studying the books himself, and his advice to this young man was very simple: “Get the books and read or study them till you understand them in their principal features; and that is the main thing.”

One of the most pernicious sentiments to have spread in our society is the requirement for credentialing. In all states save California, one cannot be an attorney unless one goes to law school. This is not because all our lawyers today are now better attorneys than Abraham Lincoln was; it is because professional societies often function as labor guilds more focused on protecting their dues payers than the general public.

It is unfair to pick on lawyers. One can have a PhD in mathematics from MIT and in many states can’t teach high school math without going through a credentialing process.

These types of rules all restrict opportunity and make our society poorer. We hope that they will be changed.

Lincoln’s message though is that there are many roads to success and that one’s personal motivation is more important than general conditions.

It is always easy to blame one’s problems on the condition of the world, but Abraham Lincoln and Scott Danner remind us today that our own resolution… or lack thereof… is always more important in our ultimate success or failure than the general state of the economy or the attitudes of other people..

We thank them both for a well-timed reminder.

*****

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