Thursday, April 26, 2012

We Are Shocked About Walmex!

Wal-Mart's first international store opened in Mexico in 1991 through a joint venture with Cifra.  As retailing gurus spoke about the U.S. being overstored, shareholders wanted their companies to invest in future growth opportunities abroad.  Mexico, because of its proximity to the U.S., its large underserved consumer base, and its existing supply chain to the U.S. was a logical choice. Today, Wal-Mart de Mexico, SA is the largest retailer in Latin America, reporting first quarter net of about $166 million, up 35% due to a surge in Mexican consumer spending. Shareholders should be pleased, no?

Unfortunately, breaking news stories allege persistent, widespread violations of the U.S. Foreign Corrupt Practices Act (FCPA) by senior Wal-Mart executives, including former Wal-Mart Vice-Chairman Eduardo Castro-Wright and others. 
The FPCA talks about "corrupt intent" to persuade foreign officials to misuse their positions to direct business to a person.  The payment, or promise of payment, of money or anything of value is prohibited. 

Then, in a nod to the real world, the FCPA has a section the Justice Department brochure linked above describes as follows: "There is an exception to the anti-bribery prohibition for payments to facilitate or expedite performance of a "routine governmental action." The statute lists the following examples: obtaining permits, licenses, or other official documents; processing governmental papers, such as visas and work orders; providing police protection, mail pick-up and delivery; providing phone service, power and water supply, loading and unloading cargo, or protecting perishable products; and scheduling inspections associated with contract performance or transit of goods across country

The early news stories reported that much of the alleged illegal payments made by Wal-Mart were to municipal and local government officials in Mexico for the issuance of building permits and other approvals to open stores.  Would building permits fit into the exception language above?  The Mexican government's original position was that it was not going to launch a Federal investigation of Wal-Mex practices, as the alleged violations were a local matter.  As this story unfolds, they may choose to take a different position for PR purposes. 

Foreign expat executives moving into their houses in New Delhi probably have third party managers who make payments to the local utility clerks to turn on gas and electricity.  This baksheesh is a long-standing fact of life and would seem to be the intent of the exceptions.  Both in India and China, if a motorist knocks over a cyclist in traffic, in plain view of a policeman, the typical sequence of events  is a conversation between motorist and cyclist, expressions of concern, and the pulling out of a large wad of bills, and a settlement of the grievance in cash, without any intervention by the constabulary.  Is this corruption? 

The FCPA prohibits corrupt payments through third parties, which is a common mechanism for large companies operating overseas which may be required to employ local law firms, which bill at rates equal to or higher than their foreign counterparts.  If the foreign company tries to claim deliberate ignorance, then they run afoul of the law, but this would seem very expensive and hard to prove.  Would we be shocked if there were widespread violations of this kind by foreign companies doing business in China? 

Global medical device companies have long wrestled with these issues with respect to payments to physicians in Europe. Often times, they have tried to incorporate strict standards into their corporate codes of conduct.  However, European executives with MBA's from U.S. universities may see customary practice in a different way than we do. 

Aerospace procurement has been a classic breeding ground for FCPA actions, and it was probably one of the industries which led to the passage of the Act back in 1977.

What seems peculiar about the Wal-Mart story is how such a global corporate giant would not have had well-established, well-staffed corporate oversight for FCPA compliance that came into the board of directors independently, through either interal audit, corporate counsel or a combination.  One story alleges that an internal Wal-Mart investigation was quashed by executive management by itself without board oversight. 

Hopefully, in the coming days and weeks, we'll start to separate facts from the noise in the particular Wal-Mart case. 

Tuesday, April 24, 2012

Washington Irving on The Financial Meltdown

Thanks to Richard Fisher, President of the Dallas Fed for pointing me to Washington Irving's poetic and extremely insightful drawing of the psychological forces that lead us into financial bubbles and busts :

"Every now and then the world is visited by one of those delusive seasons, when the 'credit system' expands to full luxuriance: everyone trusts everybody; a bad debt is a thing unheard of; the broad way is certain and plain and open; and men...dash forth boldly from the facility of borrowing.

Promissory notes, interchanged between scheming individuals, are liberally discounted in the banks....Everyone talks in [huge amounts]; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums [are] made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital...

Speculative and their dreams and projects to the ignorant and credulous, dazzle them with golden visions and set them maddening after shadows.  The example of one stimulates another; speculation rises on speculation; bubble rises on bubble...

Speculation casts contempt on all the sober realities...It renders [the financier] a magician, and the [stock] exchange a region of enchantment...No 'operation' is thought worthy of attention that does not double or treble the investment.

No business is worth following that does not promise an immediate fortune...Could this delusion always last, life....would indeed be a golden dream; but the [delusion] is short as it is brilliant."

From: "The Crayon Papers," by Washington Irving about the Mississippi Bubble fiasco of 1719.

No economist could ever say it better!

Monday, April 23, 2012

Dutch Government Resignation Shows EU Failure

The shock resignation of the Dutch Prime Minister over the government's inability to negotiate an austerity package shows in stark terms the bankruptcy of the whole EU fiscal management paradigm. Government debt is 65% of GDP, and the ten year Dutch government bond spread over German paper is only 80 basis points, according to the Wall Street Journal. 

The forecast debt-to-GDP ratio in the Netherlands is 4.6%, above the arbitrary 3% benchmark set by the Eurocrats, and it's being driven primarily the the Dutch economy's sliding into recession as opposed to a bevy of new profligate government spending.  Unemployment is up and consumer spending is down.  So some members of the coalition felt that it was bad policy to force the government to hit the 3% target by 2013, which would only drive the economy deeper into a recession. 

Now, the credit rating agencies which had been partners in facilitating the real estate boom that created the mortgage debt overhang plaguing the Netherlands and other EU countries have now turned into knee-jerk alarmists who are not helping matters either.  Do they honestly believe, or can their models show, that there is an unwillingness or inability to pay on Dutch sovereign debt now?  Talk about a sovereign credit rating downgrade only adds to the pressure.

Meanwhile, back in Euroland, it is now all about getting President Sarkozy re-elected at all costs, which includes courting the execrable French far right.  Further back at IMF headquarters, meetings are being held, the coffee can is still waiting for contributions, and there aren't enough smoke and mirrors to make the fundamental issues go away.

Harmonization of fiscal policies, not centralization of control from Brussels, is a reasonable target for an economic union.  The problem is that for many years, Eurocrats looked the other way when any European knew that EU members like Greece, Italy and others were openly flouting the guidelines.  At this point in time, coming down on countries to hit arbitrary hard targets by a short-term deadline is irrational.  The leader of the Dutch Freedom party said, as would be his wont, that "damaging growth" to hit the arbitrary EU limit was something he couldn't support. 

There are no more rabbits to be pulled out of the hat for the austerity play book, and it needs to be scrapped for something more reasoned and reasonable.

Friday, April 20, 2012

Sequoia Fund Stands Tall For Better Governance

Investor activism has been all the rage for some time now, and it has been synonymous with hedge funds or with individual investors like Boone Pickens and others.  We've written about Sequoia Fund before; the late Bill Ruane, a founder of Ruane, Cunniff and Goldfarb, Inc., was a student of Ben Graham and consistently applied those value-oriented principles to a successful investment process that continues unchanged today.

 Now, the Sequoia Fund co-managers Rob Goldfarb and Dave Poppe have addressed a letter to their clients outlining in a measured but foreceful way the reasons for Sequoia casting its discretionary votes at the fund and in separately managed accounts, against the re-election of James A. Johnson as a Director of Goldman Sachs and as chairman of the compensation committee.  The managers don't have a quarrel with the corporate strategy or operating management of Goldman's businesss, which Sequoia clearly finds attractive.  They do, however, clearly make a case against having this particular individual as a director at their portfolio firm. The letter is great reading.

Sequoia is a long term shareholder by every measure.  For them to go public in this way is unusual, as most mutual fund managers routinely vote across the board for management proposals.  Now, for all the whining and complaining about the need for better corporate governance, we shall see how many other fund managers are willing to think hard and act as fiduciaries by voting for directors who bring high standards of competence, integrity and character to their roles.  Congratulations to Sequoia for standing tall.

Thursday, April 19, 2012

TARP Watchdog Warns on Too Big to Fail

The Wall Street Journal reports that Special Inspector General Christy Romero of TARP has issued a warning about complacency and the continued overhang of Too Big to Fail.  I look forward to reading the full report. We've written about the issues in the Journal article, and particularly about the research done by the Dallas Fed, which we discuss in the post linked to above.  Interested readers should also take views of experts from across the pond, namely those of Lord Adair Turner, which we've also written about.

As a "comprehensive" reform of the financial system, Dodd-Frank is proving an abject failure, and it hasn't even been implemented yet.  The risks in the global banking system, which inextricably includes the shadow banking system, are still enormous, despite some of the window dressing shown in recent mega-bank earnings reports.

EPA Fracking Regulations Not the End of Story

The new EPA regs covering pollution from oil and natural gas production include the first regulations covering pollution from natural gas wells, including hydraulic fracturing.  The regulations seem silent on critical issues and overly specific on smaller issues.

Recent research has suggested that leaks from gas wells in shale formatiosn can be prevented by careful construction of better concrete casings around wellheads.  This sounds reasonable and sensible.  I don't see such references in the new EPA regs.  Regarding the well casings, what to do about the many wells that are already producing and in place?  Are they to be inspected and retrofitted? 

The new regs speak about air pollution standards and not about water pollution.  Why?  Because, according to Scientific American, fracking is specifically exempted from the Safe Drinking Water Act of 1974. The Department of Energy has been charged with coming up with regulations covering sealing of wellheads and disposal of fracking liquids, composed of water and chemicals.  These are the regulations worth watching for because they should speak to the source of the bigger risks associated with producing unconventional natural gas.

Tuesday, April 17, 2012

Too Big To Fail Still Too Big

It's not often that a reader sees clear, unambiguous prose in economic writing from the Federal Reserve System, but the Federal Reserve Bank of Dallas has some plain speakers, including President Richard W. Fisher and Director of Research Harvey Rosenblum.  Let's start with Rosenblum's essay in the 2011 Annual Report of the Dallas Fed.

The basic economic argument is that our regulatory framework didn't allow Schumpeter's "creative destruction," the capitalist mechanism of failure and renewal to operate in our financial institutions sector during the global meltdown.  This despite the fact that we have always had in place battle-tested means of managing failure and resource reallocation, such as Chapter 7 and Chapter 11 bankruptcies, as well as buyouts of troubled financial insitutions.  Instead, the system turned to bailouts, which they point out "is a failure, just with a different label."  Most importantly, though, a bailout fosters no renewal, but rather a reduction in competition.

In 1970, the top five banks held 17% of the industry's assets, and in 2010, the top five held 52% of industry assets.  In 2008, "commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance."  Between 2008-2011, more than 400 U.S. financial institutions failed, the most since the 1960's.  Among these were the absolutely extraordinary failures of IndyMac Bank (7/08) and Washington Mutual (9/08), which had been a darling stock recommendation of bank analysts for many years leading up to 2008.

"All booms end up busts.  Then comes the sad refrain of regret: How could we have been so foolish?"   Concentration of assets amplified the pressures in the system and the transmission to the real economy.  Within individual firms, such as IndyMac, the concentration of an "originate and distribute" model in one type of asset, namely the Alt-A mortgage--a pig with lipstick--should have set off alarms throughout the system.  In fact the regulatory failure at IndyMac was the final straw that saw the demise of the Office of Thrift Supervision. 

Concentration, complacency, and then complexity led to balance sheets that were fraught with risk, which even public company boards and managements could not understand.  Auditors certainly failed to flash caution.  "..accounting expedients (mark to market and use of proprietary corporate models for asset valuation) allowed them (banks) to claim they were healthy--until they weren't."  Subsequent write-downs were later revised by "several orders of magnitude."  Listening to recent first quarter conference calls of Citi, Wells Fargo and JP MorganChase, the balance sheets are still opaque and painted with assets of questionable value. 

In the end, what's important is the transmission of fundamental, systemic banking issues to the real economy.  December 2007 began an 18 month recession, the longest in the postwar period, in which real output dropped 5.1 percent, resulting in the loss of nearly 9 million jobs.  Over the past 22 months of expansion to December 2011, Rosemblum's research shows that only 3.2 million jobs have been recovered.

In fact, in the same presentation linked above, in the Dallas Fed's 2012 outlook, they have a "worst case" scenario of zero GDP growth or worse, in which as many as 20 TBTF global banks "require assistance (i.e.--failure)"  Even if the global economy does muddle through, the fact that this kind of TBTF risk is still present is a deplorable failure of our regulatory system.  One of Dodd-Frank's worst features is a mechanism for again sidestepping the orderly resolution process for bank failure.  "In the future, the ultimate decision won't rest with the Fed, but with the Treasury secretary and, therefore, the president."  Not comforting.

Friday, April 13, 2012

Shadow Banking Is Still Here and Risky As Ever

With U.S. banks reporting today, I went back to re-read an article by one of my favorite financial experts, Lord Adair Turner, former head of the Financial Services Authority (FSA) in Great Britain and an investment banker with deep experience.  The article is a Cass Business School case of March 14, 2012, "Shadow Banking and Financial Instability."

Lord Turner uses the NY Fed's 2010 estimate of the shadow banking industry's size as being in the order of $25 trillion.  The SBS today is not separate from the traditional commercial banking sector, nor is it a parallel, "shadow" system any longer.  SBS is inextricably intertwined with commercial banking, whose leaders like JP MorganChase and Wells Fargo, reported earnings today.  Therefore, the shadow system cannot be regulated separately nor ring-fenced from the commercial banking system, as some commentators suggest. 

Turner defines the shadow banking system as one which creates credit flows outside the banking system, while at the same time, sharing some of the distinctive features of the commercial banking system: leverage, thin layers of equity, volatile assets, and maturity mis-matches between assets and liabilities.  Both systems therefore perform the value-added service of maturity transformation.  The SBS, however, distinctively does it through multple, opaque steps rather than through one single, corporate balance sheet. 

It's huge impact on transforming financial markets can be seen in a few statistics:

  • Between 1980-2008, the share of bank-originated mortgages which were retained on bank balance sheets went from 80% to 35%.
  • Over the same period, global securitised credit went from 6% of GDP to 80% of GDP.
In the U.S., the incredible expansion of mortgage credit was driven by the following factors, according to the author:
  • The insistence on providing a 30 yr., fixed rate, repayable at any time mortgage to the market.
  • The effect of Regulation Q, which gave money market mutual funds (MMFs) a huge advantage in being able to participate in financing this mortgage boom and getting higher yields.
  • The repeal of Glass-Steagall and the simultaneous practice of lightly regulating the broker-dealers, who were rapidly increasing their shadow banking functions.
The author notes that the crisis "was triggered by high levels of losses in U.S. subprime residential mortgage lending."  He also points out that the magnitude of the losses while very large, were not cataclysmic by themselves.

The European crisis, by contrast, was not precipitated by securitised lending, but by traditional bank lending, lax underwriting standards, and a concentration of the portfolio in residential and commercial real estate. 

Turner points out that the volume of securitised credit has fallen by 90% globally from peak-to-trough in the U.S. and by 95% peak-to-trough in Europe.  However, he says, this is simply a result of the global economic downturn and a significantly reduced demand for credit.  When the world economy recovers, then Turner says that the SBS will gear up again, with the same risk transmission mechanisms in place as before.  This is really not good news, even as markets are rising today.

The Volcker Rule, by itself, will not be effective, and it now appears to have little chance of being implemented.  The Financial Stability Board is supposed to propose regulations to the G20 by the end of 2012.  Although the quality of their output may be better than Dodd-Frank, it will be delivered to politicians whose qualities are no better than our own. 

The author makes an interesting comments about credit default swaps, a much ballyhooed "pricing mechanism" for risk.  Financial journalists dutifully reported CDS spreads on major banks in the run-up to the crisis, suggesting that there was little cause for alarm.  Unfortunately, these prices are not really a  market price because they are "self referential," in the words of the author who writes, CDS spreads for banks "provided no useful  pre-crisis warning of the impending disaster."  So, let's leave this indicator for the traders.

Wednesday, April 11, 2012

Can The U.S. Increase Natural Gas Exports?

Today's Wall Street Journal carries two headline stories about the glut of domestic natural gas.  The first points out current gas futures prices of $2.03 per MMBtus, a level not seen since 2002.  The second suggested that U.S. gas exports might surge, based on burgeoning supply and shrinking domestic demand.  Let's look at the export hypothesis.

Where would our exportable gas go?  The most logical market is the European Union, with its 27 members. 
According to statistics from BP, quoted by the Congressional Research Service's March 2012 report on Russian gas supplies, EU natural gas consumption in 2011 was 11.7 trillion cubic feet, comprised of 76% pipeline gas and 24% liquefied natural gas.  This is a large, attractive market with a varied pipeline infrastructure for distribution. 

The EU imports about 81% of its natural gas consumption, with its biggest supplier being Russia which supplies 34% of European gas imports, followed by Norway and Algeria.  These three account for about 81% of EU gas imports.  As we've written about before, protection of the Russia's export share to the EU is a pillar of Russian foreign policy, which aims to protect and grow the income stream to Gazprom oligarchs. 

What role could U.S. gas exports play?  In the short run, we believe that it is a relatively minor role at best.  U.S. exports would have be LNG, which is certainly possible, but one would have to expect political pressure from the Russians to prevent switching from pipeline gas to LNG. For higher LNG exports from the U.S. to the EU, there would have to be terminal and storage facilities constructed on both ends of the supply chain, which would take us to the 3-5 year horizon, at best of cases. 

A more economic source of incremental pipeline gas into Europe would be for Algeria to increase its reserve development and exports, but even this possibility is doubtful in the short run. 

U.S. gas exports increasing to Europe seems wishful thinking in the short run: interesting headlines, but I don't believe it's something Kremlin energy wonks are worrying about.

Monday, April 9, 2012

The Politics of Coal to Gas Power Plant Conversions

Xcel Energy operates in an eight state area, with its largest operations in Minnesota and Colorado, through its wholly-owned utilities Northern States Power--MN and Public Service Company of Colorado (PSCo).  NSP-MN provides between 34-45% of Xcel's net income, according to the 2011 I0-K.  Similarly, PSCo provides 45-55% of Xcel's net income. 

With the passage of Colorado's Clean Air Clean Jobs Act, a Democratic Governor, worked with Xcel Enegy and natural gas producers to craft legislation mandating reduction of pollutants such as nitrous oxides by 88% compared to a 2008 baseline, by 2017.  Since Colorado is a large producer of coal, the coal industry opposed the legislation.  PSCo came up with a plan to convert 3,000 MW of coal powered steam boilers to natural gas-fired combined gas turbine technology, powered by GE turbines. 

Over the planning period to 2017, the conversions in Colorado and in Minnesota would have required about $1.3 billion in capital expenditures by Xcel Energy.  Of course, the problem with environmental goodies is that someone has to pay for them, like everything else,  More about that at the end.

According to the 2011 Xcel 10-K, their 2011 fuel costs per MMBtu were:
  • $2.06 for coal
  • $0.83 for nuclear
  • $6.56 for natural gas
With the economic recession, warm winter, high inventories, and production surge from North American shale, spot prices in 2012 have been down to $2.50 for natural gas.  Because of higher efficiencies and lower heat factors, natural gas prices don't have to be at parity with coal for gas to be the preferred alternative.  At current prices, the economics are no contest.

So what is holding back the rational economic transformation?  Politics, as usual.  Xcel's proposed cost recoveries for the $1.3 billion in capital expenditures would have rate payers in CO paying 1-2% more per annum in electric rates over the planning horizon.  In the discussions at the Colorado Public Utilities Commission, this was deemed unacceptable.  Also, there was a blizzard of irrational comments to add more scrubbers to antiquated coal-burning technology instead of going to a more efficient and longer-lived combined cycle gas technology.  Right now, it appears that Xcel is reconsidering its plans and the conversion of 3,000 MW of coal-burning boilers to natural gas has been stalled.

Saturday, April 7, 2012

Yoram Bauman, Ph.D: Standup Economist

I found this post via Professor Greg Mankiw's blog.  It is hilarious, especially for anyone who has struggled to teach macroeconomic theory via the usual insufferably dull textbooks.  Bauman summarizes the whole corpus in three points!  Would that I knew then...The Calculated Risk blog pointed to a more Lenny Bruce-style PG-13 rendition of this presentation by Bauman.  This one is G and my wife, thankfully a non-economist, enjoyed it too.

Thursday, April 5, 2012

Our Troops Continue to Pay the Price in Afghanstan

Credit: Gul Elham for the Associated Press

This photo appeared on the front page of the print edition of the New York Times, but for some reason didn't appear in the Web edition.  It's 10:30 am, on a bright, sunny day in the northern Afghan city of Maimana. The scene shows the outskirts of a public park where a video was being made of an outdoor vegetable market, perhaps symbolizing the return to normalcy in this war-torn region of Afghanistan. 

As American soldiers and Afghan police were involved in filming interviews, a motorcyclist turned his bike into the soldiers and police, killing three G.I.'s  and six Afghans as the Times reports.  I can't get the image of these two soliders, contorted in pain, out of my mind.  The soldier on the left is holding his head, probably concussed from the exlplosion, while the soldier on the right has had his helmet torn from his head completely.  Neither can stand up, even as one of the soldiers looks with concern at what's happening with civilians and the Afghan police. These two soliders are paying the price for our continuing presence in a conflict zone where we appear to have lost our purpose and resolve.

As Christian Holy Week moves towards Easter, let's remember and pray for all those caught in this web of violence, especially our troops and their families.