August 1, 2011

Short-term solutions for a life-long problem

Just like a big playoff game, a forced shot in the last seconds has made it possible for the US Government to reach an agreement on raising the debt ceiling, see Reuters coverage. It has been, as basketball fans would call it, a buzzer beater.
However in this case, there is no real reason to high-five your teammates or to have even the smallest grin on your face. Because this is not a win, this has only been a disaster-avoiding move. Maybe the markets will see it differently during the first hours and recover some of the ground lost last week (gold is already down a little), but the situation is still critical, and the rating agencies' threat to slash USA's AAA rating is still there.

The last minute deal that has helped avoid the possibility of the US defaulting on its debt includes a 2.4$ trillion spending cuts package to be applied for the next ten years (no extra details are known yet about how and where they will be placed). However these cuts will not be introduced until at least 2013. The reason behind that? Sadly a partisan one, as 2012 is election year and neither Democrats nor Republicans want their chances of winning the presidential race altered because of something as ugly for voters as these spending cuts. Of course spending cuts are never popular or welcomed decisions, it is far easier to "buy" a vote by promising new social measures or tax reductions than by being responsible with your country's finances... but these cuts are sure needed and someone has to do them. Once again short-sighted and selfish political interests take the upper hand and put everyday's problems and the future of the economy to the background.

I must say something to justify Democrats and Republicans decision to delay the cuts until 2013 though, the US economic recovery is being quite weak and slow as of today, so applying extra spending cuts now could definitely stall said recovery. And the last thing the US needs now is an economic contraction, as it would be devastating, specially regarding unemployment. But once we have reached this point we can say that this is (once again) delaying the problem, not solving it. 

We are in a situation where people should already notice that a great part of the economic growth of the pre-2008 years was debt-based rather than real growth. Financial irresponsibility has been the most common behavior regarding government spending and debt issuing, not only in the US but elsewhere. Now the time to pay the bills has come, but nobody seems to be up for the challenge.

July 12, 2011

Lehman On My Mind

The US government still has not reached an agreement on raising the debt ceiling, the markets turn their backs on Spain and Italy, stocks worldwide erase all their recent month's earnings in two days, gold is near its historic high again... Everybody seems to be expecting another big hit to the economy sooner rather than later. We have already been there, we should know what to do. Quoting the great Ray Charles "No peace I find, just this old sweet song keeps Georgia on my mind". In this case the name may not be Georgia but Lehman Brothers, and the 'song' may not be sweet at all, but we should have it on our minds...

Because while preparing for this kind of impact, what people are not figuring out is that they are inadvertently paving the way for said impact to be much stronger. Nobody seems to trust anybody else these days, and this is bad, very bad for market stability. No matter how long you have traded or invested with a counter-party, no matter how strong and risk-averse you have been for years; in the eyes of others nobody seems safe against what is coming. 

Lehman Brothers' situation was really bad, but it was the mistrust from its clients, partners and rivals that put it into a corner and accelerated its demise. This mistrust seems to be the general rule in financial markets these days. Today everybody is hedging against everybody else, buying insurance and taking CDSs (Credit Default Swaps) through the roof. This mistrust has enough power to stall the global financial markets; and as we recently became aware of, a financial crisis can transform in a fully fledged economic crisis in the blink of an eye. If that was to happen we would find ourselves in the much feared double-dip recession. I do not want to even think about what another economic crisis would mean globally when we are still struggling to make our ways out of the first one. However there is something I can be totally sure of: if such a double-dip recession happened, a lot of players would be out of the game very soon. A lot of companies, and most importantly some countries, would be unable to dodge a second punch when they are still dizzy from the first one.

July 6, 2011

A skyrocketing euro for a deep diving Europe

Although it is not the first time I write about why I think the actual exchange rate of the euro against other currencies is wrong (see here and here), the latest developments on the Eurozone's life well deserve a revision of the subject. A quick look at the Eurozone lets one see some not very encouraging facts. The Greek tragedy has been quieted down in the last days but is far from over. In fact almost everybody with eyes in the matter is expecting a default sooner rather than later. The only uncertainty seems to rest in knowing if it would be an orderly default, basically a giant debt restructuring effort (hopefully...), or a messy one.

On the opposite side of Europe we have Portugal, but it seems to be in the opposite side only geographically speaking, because its bonds have also been kicked out of investment grade and are now officially  'junk' grade like Greece's. This will make Portugal financing efforts (even) more difficult, which in turn could end with Portugal asking Europe for more money soon. And to complete the domino effect, this troubles are putting extra pressure into Italy's and Spain's not-exactly-buoyant finances.

Credit: Yahoo! Finance

But the euro simply does not care. As seen in the graph above, the euro is rising against the US Dollar, the British Pound and the Chinese Renminbi, and it is doing so with a specially notable rally in the actual week despite all the bad news surrounding the Eurozone. The european currency is spiking also against special cases like the Japanese Yen and the Swiss Franc, although this is a totally different matter. The Yen has its own set of playing rules because of the Fukushima incident, and the Swiss Franc had been overtly growing uncomfortable with its strength against the euro affecting their exports competitiveness. The case with China's Renminbi is a difficult one to analyze, but what happens with the Dollar and the Sterling Pound?

June 21, 2011

Too public to fail? The moral hazard with public institutions.

Although it copes most of the headlines lately by being the most extreme case, the financial problems of Greece's public institutions are not one of a kind... If you have a quick look worldwide you will see cities, councils, regions... having similar problems to pay their bills. You can find near-bankrupt cities in the US (specially in California and Florida) Italy, Spain, Ireland, Portugal, Japan... Public management at its worst seems to be the common factor, with some institutions walking on the edge of default.
We are not talking about having trouble finding money for new investments or projects, as this would be a totally normal (although not desirable) situation in the actual environment. They are struggling even to pay the most basic of services, like electricity or waste disposal. This problem may not be totally evident to citizens because said services are still being provided, but it is serious enough for everyone to be concerned about it. 

The question is, why are services still being provided if they are not being paid? Well, because public institutions enjoy preferential treatment from their suppliers and vendors. This preferential treatment is not precisely earned by being a good customer, but because of their size. The public sector represents a very big part of the total earnings for some of these suppliers and vendors, so they can not afford to stop providing them. They prefer the prospect of being paid ten months later (and this is not an exaggeration) than losing such a big client. They simply have no other option but to bear this load, specially when talking about local companies whose only client is the city council.

This creates a big problem though, as the inability of public institutions to pay their bills creates a highly destructive domino effect. Suppliers and vendors do not enjoy the same preferential treatment with their own business partners; they must pay on time as specified on their agreed terms or otherwise their partners will immediately stop serving them. As they do not get the money public institutions owe them, the disruption in their cash-flow creates a need for factoring or other ways of financing. And while this can be good for the financial sector, it is devastating for the companies being forced to use it. Some companies get strangled by those extra financial costs to the point their business is no longer profitable. In the end, this companies are forced to close or go bankrupt, leaving their employees jobless just because they had the worst client possible, a public institution.

June 9, 2011

The problem with subsidies

There has been much talk lately about whether the United States Government should stop subsidizing domestic oil companies like Exxon, Chevron or ConocoPhilips to name a few. Tax breaks to oil companies are an old time practice in the US and no government, either democrat or republican, has dared to eliminate them. The reason why these tax breaks still exist is not clear for me, as oil has always been a profitable industry, even through energy crisis like the ones in the 70's or the Gulf war crisis in 1990. However, recent talks about the need to eliminate those tax breaks and focus the money on alternate energy have spiked some heated debates across the US, mainly due to the already high prices of gas and the multi-billion benefits of oil companies worldwide. This has put the problem with subsidies back in the spotlight. 

People (and corporations) get used to subsidies really fast and once they are fully integrated in daily life they are just perceived as an acquired privilege, rather than what they really should be: a temporary boost to an ailing or complicated situation/sector. This is a big problem for two main reasons. The first one is that, after their initial effect on containing or lowering prices, the subsidized good or service generally goes up as if nothing had happened, thus rendering the subsidy useless. The second reason is, when government retires said subsidy, prices are expected to go up even more, so people will complain about it. And that people will complain is not an expectation but a true fact.

But despite energy subsidies having a distorting effect on the economy, the clearest and biggest examples of the danger of subsidies I can think of are the homeownership subsidies that caused the Irish and the Spanish housing bubbles. Yes, over-optimistic lending by numerous banks makes them guilty by association,  but they are businesses and they responded to the needs of a market. A market governments artificially created. Governments were the true enablers of said bubbles. I will never understand what (if any) is the noble idea behind subsidizing homeownership through mortgages. If said noble idea was giving access to a decent house to low-income citizens renting subsidies would have worked similarly well, yet they did not appear anywhere. Maybe the reason was that buying a house provides far more tax revenue for a government than renting one does... Whatever the reason was, for me homeownership is not a security but a limiting factor, as discussed in this article.

The only thing these housing subsidies have achieved in both of the examples given is a construction boom together with a price spike, and a quite heavy one. In a normal, not mortgage-subsidized market, even after assuming the natural demand increase caused by higher demographics in the period, the situation would have been very different. A housing and construction boom would have led to lower or stable house prices, never to sky-rocketing ones! Sky-rocketing prices that ended busting the bubble that we can easily trace to the drowning of Ireland and Spain economies in the past two years.

The supply and demand law is at the base of economic liberalism for a reason. It is a force powerful enough to shape any given economic sector with common sense. The market is wise enough to decide on the evolution of a sector. Subsidies should only be used in exceptional cases, or to protect distressed citizens from being excluded from the system (think health for example) but never on a generalized scale or on a long-term basis.

June 4, 2011

Blaming the coming 2.0 bubble on Facebook

Some time ago, a social network called Facebook raised 500$ million from Goldman Sachs (450 million) and Russian firm Digital Sky Technologies (50 million). This operation valuated Facebook at an astonishing 50$ billion. This is more than other well-established digital firms like eBay or Yahoo and double the market cap of Sony. Yes, I know Facebook has 600 million users or 'potential clients' (in business terms), but until now it has failed to monetize them. Its main source of revenue is advertising, and according to reports Facebook's success in it is far lower than the rest of the web. Its users have a clear objective in mind, communicating with friends, thus they do not pay attention to banners. Brands however, have found in Facebook the perfect channel to communicate with their clients; but Facebook itself is not seeing any money from this... In marketing, having a large audience and knowing a lot of information about said audience is key for success; but until know Facebook has been unable to use this at full power (conspiracy theories of Facebook selling user's personal data to other companies aside) so the 50$ billion market cap comes basically from estimations of the company's potential.

Valuating a company based just on its potential is a tricky thing to do, as subjectivity comes to play. In the example of Facebook, maybe it has the necessary ingredients to earn lots of money, but nobody is cooking them into an edible product as of now. This takes us to the point where some very risky bets are done based purely on instinct, not real-world results or prospections. But investors around the world, sad with the absence of  'bulls' to ride on the way to market recovery did not mind that. They began to salivate on the thought of being part of the rise of a new giant, the social internet companies (commonly called 2.0). As such, when the invitation to the party appeared in the form of the LinkedIn IPO, and later the Yandex (the leading search engine in Russia) IPO the market was all-in.