When Will They Ever Learn?

Leisure Suits and the Fashionable Dollar

As I marvel at our disastrous monetary policy, I keep hearing in my head Pete Seeger's haunting refrain "When will they ever learn? When will they evvvver learn?" it is from his poignant anti-war song, "Where have All the Flowers Gone?" made popular in this country by the Kingston Trio. It's their version I am hearing in my head right now. I also have a fond spot for Marlene Dietrich's rendition of the German translation ("Sag mir, wo die Blumen sind") by Max Copet.

"When will they ever learn?" That is Alan Metzler's question in his commentary in yesterday's Wall Street Journal. He wonders if we are returning to the monetary disasters that brought us the rising cycles of inflation and unemployment during the 1970s. The economic folly of that decade evidenced as much wisdom as its fashions: fads like bell bottoms, leisure suits (modeled above), and granny dresses. Professor Metzler reminds us that "An independent central bank is supposed to maintain the value of the currency and prevent inflation. In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten"

How well has our independent Fed done? Inflation is back up t 4.3 percent. The Euro hit $1.51, Oil is trading at $102 a barrel, and Gold is over $900 an oz. The "mighty greenback" is in about as much demand as those polyester leisure suits.

In tomorrow's Journal, the editors take Fed Chairman Ban Bernanke directly to task: "First, Fed Vice Chairman Don Kohn declared that, while inflation was worrisome, the Fed now views recession as the more urgent danger to fight. Then on Wednesday, Fed Chairman Ben Bernanke told Congress that the Fed will do whatever it takes to stop the credit squeeze from becoming a recession. That's about as close as a central banker will get to saying that he's thrown price stability to the wind. If inflation rises -- as it now surely will -- then the Fed will worry about that later, after the economy is safely past the credit crunch."

The Fed can flood the banking system with reserves, but it can not replace bankers' capital once those gray flannel mavens have lost it.

When WILL they ever learn?

Aussie Bonds Look Good: The Reserve Bank Has Guts

Bill Gross manages big money: $120 billion in bonds. He does this on behalf of California-based Pacific Investment Management Co. (PIMCO.) PIMCO's bond fund is the world's largest.

Guess what he likes: Aussie bonds.


According to a report on Bloomberg this morning, "'The Reserve Bank of Australia should be commended for [its] inflation targeting,'' Gross said. 'Australia has some of the most attractive real interest rates in the world.'' In other words, the Reserve Bank of Australia takes seriously its job of maintaining the value of the Australian dollar. The Australian central bank pursues a policy of keeping inflation between two and three percent a year.

Bloomberg News, based on a near unanimous poll of economists, predicts "Australia's central bank Governor Glenn Stevens will raise the benchmark interest rate by a quarter-percentage point to 7.25 percent at the next policy meeting on March 4."

Chrysler Pulls out of the Clone Wars

Joseph B. White writes in today's Wall Street Journal that Detroit is rethinking the wisdom of selling three or four versions of the same car under three different brands. Why? "[I]n a market with more than 300 different models -- depending on how you count -- fielding two or three or even four of the same basic car can lead to some very thin slices of pie, especially when increasingly well-informed shoppers can figure out in two or three mouse clicks that a Saturn Outlook and a Buick Enclave and a GMC Acadia are just three different styling takes on the same large crossover wagon."

White continues, "Chrysler's senior management recently declared that it wants out of the clone game. The company, which has the advantage of being closely held and thus not as concerned about what outsiders think, has outlined plans to kill a flock of its slow-selling clones, and focus its efforts on selling more of each model that remains."

After all, "Customers don't care whether they buy a minivan from a Dodge dealer or the Chrysler dealer just down the street. They just want a good minivan. In these difficult times, Chrysler can't really afford the capital and marketing effort to promote two functionally similar versions of a three-row box on wheels."

Read "Send Out the clones."
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Cynthia Jacobs talks to CFO magazine

Cynthia Jacobs is the internal auditor who blew the whistle at MCI-Worldcom, got herself fired, and exposed one of the most spectacular frauds and bankruptcies of the dot.com boom and bust era. One can argue, with some justice, that she is the "mother of 404," the provision in Sarbanes-Oxley that requires publicly traded companies to have their internal controls externally tested and certified.

Her book, Extraordinary Circumstances, has just been published and this interview speaks about it and the conflicts of interest that test men's moral fiber.

Financial Terms and Concepts

1) IRR: the Internal Rate of Return. The IRR is the discount rate that equates the present value of the future cash flows to the initial investment. More generically, the IRR is the discount rate that makes the sum of the present values of the cash flows zero when the investments are considered negative cash flows. The Internal Rate of Return on a bond is the yield to maturity.

2) Free cash flow (FCF): is the cash flow that a business generates and is available for distribution to debt holders and equity holders. It consists of the cash flow thrown off by operations minus the use of funds from the growth in its net working capital and from its capital expenditures required to maintain the firm's growth. It is commonly approximated by:

free cash flow = EBIT plus depreciation expense minus income taxes
minus the change in net working capital minus capital expenditures

This definition has the advantage that an external analysts can find the data on published financial statements. However, it has two disadvantages:

• It does not adjust for other accruals which may be distorting EBIT.
• The proper measure of FCF would use the required growth in net working capital and the required capital expenditures not the actual amounts. These requirements, of course, are not published. An analyst might estimate the firm's growth requirements and substitute his own estimates for the published actuals.

3) Operating Leverage: a firm's dependence on fixed costs rather than variabble costs. The greater a firm's operating leverage, the greater its business risk: i.e., the greater the impact of fluctuating demand or cost shocks on its profitability.

Interest rates & The Economy

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently to the other party's peril. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlords require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than he or it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions.

Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me for the true risk of my living less the actuarial tables predict.

In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's managers do?

They note that if the bank can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.

The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from the new loans to get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for higher interest, but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off even if the loans go sour.

Neither the the bank nor the depositors are behaving the way they would in the absence of deposit insurance. That is the essence of moral hazard.

Is The Creation of Citigroup in the Running for the "Deals From Hell?" Award?

Wichita's Unemployment Rate is 3.9%

The Bureau of Labor Statistics announced that the unemployment rate in Wichita was 3.9 percent in November. This comes after Friday's report that the national unemployment rate rose to 5.0 percent in December. Although Wichita's November unemployment rate was up from October, I believe the rate reported for October was low due to sampling error.

While the national economy has slid into an economic recession, Wichita's economy led by aerospace and natural resources continues to grow. The number of jobs grew 3.9 percent over November, 2006.