Monthly Archives: February 2010

The Volcker rule for banks

February 22, 2010 By in Banks, Current Market Thoughts, economics, Industry Analysis Tags: , , , , , , , , Leave a comment

Glass-Steagall

In the late Nineties, Congress repealed the Glass-Steagall Act (aka the Banking Act of 1933).  Glass-Steagall mandated that commercial banking and investment banking activities could not both be conducted in or by the same legal entity.  The Act was a reaction to abuses that led to the collapse of the stock market in the US during 1929 and beyond.

Gramm-Leach-Bliley

The bill that repealed Glass-Steagall was the Gramm-Leach-Bliley Act of 1999.  Although formulated by Republicans and passed along party lines in the Senate, the bill received bipartisan support in the House and was signed by Bill Clinton, a Democratic president.  The ostensible purpose of Gramm-Leach-Bliley was to allow American banks to expand activities to compete better with the big foreign “universal” banks, primarily in Europe.  But by once again permitting commercial banks to also do investment banking activities inside one entity, GLB opened the floodgates to the unfettered proprietary trading that has yielded such disastrous results over the past several years.

The ensuing problem

Part of the problem with the American commercial bank/investment bank conglomerates that were spawned by GLB was that the investment bankers and traders working at these entities turned out to be, by and large, either incompetent or dishonest.  In addition they were supervised by commercial bank executives cut from the same cloth, who seem to have had no clue about what the investment bankers they supervised were doing.

In the simplest terms, GLB allowed the investment banks in the combined entities to use the stronger credit rating of the commercial bank parent to lower their borrowing costs.  This financing advantage would in theory lead to “extra” profits in the investment bank and increased financial strength in the parent.

What happened instead was that the investment bankers in these conglomerates “bought” business by accepting lower anticipated returns on the high-risk deals they took part in.  The could do this only because their own cost of funds was so low.  When these marginal deals started to turn sour (it turned out the returns were overestimated in the first place), they ended up not only hurting the investment banks but also destroying the credit ratings of the commercial bank parents.

What is the Volcker rule? Continue reading →

Recovery evidence–Whole Foods’ customers are coming back

February 21, 2010 By in Current Market Thoughts, earnings conference calls, Recent Market Action, Stock ideas Tags: , , , , Leave a comment

The first fiscal quarter was strong

I’m not sure what I think of Whole Foods (WFMI) as a stock.  But the company’s recently-reported first quarter (ending January 17th) results are a solid indicator that the US economy is on the recovery path, in my opinion.  The evidence? –customers are coming back to the company’s stores for the first time since recession hit.

Earnings per share for the quarter were $.36 (excluding a $.04 charge for anticipated losses on store closings) vs. $.20 in the year-ago period.  More important as an economic indicator, though–

Comp store sales are now positive

Comp store sales for WFMI continued to rebound from an early 2009 low and have emerged into positive territory.  The progression is as follows:

2Q 2009     -4.8%

3Q 2009     -2.5%

4Q 2009     -0.9%

1Q 2010   first five weeks     +1.5%

rest of quarter                     +4.3%

2Q 2010  to date                     +7.0% Continue reading →

The Fed just raised the discount rate–what does it mean?

February 19, 2010 By in Current Market Thoughts, discount rate; Fed Funds rate, economics, Recent Market Action, Vocabulary Tags: , , , , , , , , Leave a comment

The discount rate is going up to .75%

After the close of stock market trading yesterday, the Federal Reserve announced that it was going to raise the discount rate from .5% (annual rate) to .75%, effective today.  It will also limit the maturity of “discount window” loans to overnight, effective March 18th.  Previous policy allowed loans of up to 90 days.

What does this mean?

Some background

the Fed Funds rate

Federal banking laws require that each bank keep deposits, called reserves, with the central bank equal to a specified proportion of the loans it makes.  The proportion varies with the kind of loan.

Banks don’t always have the exact amount of money they need to have on deposit with the Fed.  Some have more than they need, some less.  Under normal circumstances they borrow and lend with each other in the market for overnight bank deposits, called the Federal Funds market.

The Fed uses this market as its principal tool for setting money policy.  It announces its desired level for the fed funds rate.  The Fed also trades in this market as necessary to keep the rate at the designated level.  The current fed funds policy, which is to keep that rate under .25%/year, remains unchanged by the rise in the discount rate.

the discount rate

The Fed has another tool for controlling short-term rates, the rate for borrowing funds directly from the Fed rather than from other banks.  This rate, which was a prominent Fed tool a generation ago but is no longer particularly relevant, it called the discount rate. Banks who use this rate are said to be going to the Fed’s “discount window.”

Under normal circumstances, the discount rate is higher than the fed funds rate.  Just before the financial crisis, the discount rate was 1% more.  Banks have no absolute right to borrow from the discount window, but must ask the Fed for permission to do so.  Discount window borrowing normally carries a stigma with it, since it implies that the bank in question has either hugely messed up its planning of reserve deposits, or that other banks are unwilling to lend to it.  Serial discount window borrowers may face Fed disciplinary action.

The situation up until today

With the onset of the financial crisis in 2007, interbank lending, even overnight lending, started to dry up.  At the height of the crisis, no one would buy bank commercial paper.  No one would lend in the fed funds market.  Therefore, banks couldn’t raise money to make loans to customers.  Even worse, banks that were borrowing to have money to meet minimum reserve requirements on outstanding loans were faced with the prospect of having to call in loans to satisfy the reserve rules with the cash they had on hand.

The Fed dealt with this mess by becoming an active lender to any and all member banks at the discount window, by lowering the premium over the fed funds rate, in stages, from 1% to .25% and ultimately extending the maturity of discount window loans from overnight to 90 days.

At the height of the financial crisis discount borrowing was extremely important, reaching well over $100 billion.  Today it has shrunk to less than $15 billion.

Why the changes?

Two reasons:

–the short-term lending market has pretty much returned to normal.  The only reason for a bank to borrow from the discount window today is that the rate is better than a weak bank could get in the open market.  By ending this subsidy, the Fed is sending a message to these institutions to get their houses in order.

–it’s a signal to the financial markets that the Fed intends to act responsibly and return money policy to normal when conditions are right.  Remember, in its announcement, the Fed stressed that for now the Fed Funds rate, the key policy rate, will remain unchanged.  The Fed has already withdrawn a couple of its support programs, but an increase in the discount rate is a much more visible step.  So it has much greater psychological value.

Market reaction

So far, reaction has been muted but slightly negative for stocks and positive for the dollar.  Treasury bonds are up, but that’s because of favorable inflation data announced this morning.

The rise in the discount rate will have no practical effect on world economies.  As a statement, I think it should be read as a mild positive, that the US economy is healthy enough that it no longer needs this support (which wasn’t doing that much any longer, anyway).  I think stock markets should be up on the news.

Looking at Inventory (I): general

February 18, 2010 By in Accounting, FIFO and LIFO, Vocabulary, working capital Tags: , , , , , , Leave a comment

Two posts

I’m going to cover this topic in two posts.  This one will be about what inventories are:  the sub-categories of the inventory entry on the balance sheet, and three main ways companies choose to account for inventories.  Tomorrow’s post will cover what kinds of information you can get about a company from comparing the inventory entries from different time periods.

Here goes:

There are three sub-categories of inventory on a company’s balance sheet:

—raw materials.  This is pretty straightforward.  Raw materials are inputs to production that the company owns but has not yet begun to process.  They might be a pile of iron ore outside a steel mill or a bunch of windshield wipers stacked in a warehouse next to an auto assembly plant.

This entry records what the company owns, which may be something very different from what’s at the production site.  The idea of “just in time” manufacturing is that the component suppliers have warehouses full of their wares that they deliver on the day they’re needed.

In today’s world, financing cost aren’t the big issue.  Instead, it’s who takes the risk that the stuff in the warehouse falls in price while it’s just sitting there.  The answer is whichever party has less market power, typically the component supplier.

—work in process (which a lot of people incorrectly call “work in progress”).  This is stuff that has entered production and is in the process of being turned into finished goods.  The increase in value of the raw materials will be a mix of direct costs involved in making the item, like salaries of assembly workers, and indirect, or period costs, like the cost of renting/leasing the production site, utilities (heating, lighting), and salaries of foremen and the plant manager.

The amount of work in process varies widely from industry to industry.  Assembly of a PC or a cellphone may take a day.  A semiconductor may take several months.  Wine or whiskey may ferment for years.

—finished goods.  This one is also straightforward.  It’s the final products a company makes that are waiting in storage for a buyer to pick them up–or in some cases, to materialize in the first place.

How finished goods move from the balance sheet to the income statement Continue reading →