reducing government debt: the Carmen Reinhart cookbook (I)

“The Liquidation of Government Debt”

Over the Memorial Day weekend, I was catching up on my reading–including some back issues of the Financial Times that I just hadn’t gotten to in recent weeks.  That’s how I found out that Gillian Tett had written an article on May 10th, titled”Policymakers learn a new and alarming catchphrase.” 

The article calls attention to recent research by Carmen Reinhart (of This Time is Different; Eight Centuries of Financial Folly fame) and M. Belen Sbrancia, called “The Liquidation of Government Debt.”  Ms. Tett says the work is getting a lot of attention in Washington.  The paper is simultaneously a history of government strategies for reducing excessive debt, accumulated in the developed world mostly as a result of world wars.  More importantly, it also serves as a recipe book of sorts for the US and the EU to do so again today to shrink the liabilities created in the financial crisis.

opening points

Ms. Reinhart makes two opening points:

1.  As a percentage of GDP, the current surge in government debt in advanced economies, which stems from what she calls the Second Great Contraction, is stunningly large.  It dwarfs what was accumulated during the Great Depression.  It also exceeds the amounts amassed in fighting World War II.  (Alone, checking out the chart she uses to illustrate this is worth downloading the article for.)

2.  Growing out of debt of this magnitude is highly unlikely.  This is at least partly because the large debt burden itself acts to slow economic growth.  Yes, the popular myth is that the US grew out from under its WWII debt, but it didn’t happen that way.

shrinking post WWII debt:  “financial repression”

How did the US free itself from WWII liabilities?  …through “financial repression.”   Basically, this means the government of a country engineers a situation of:

–negative real interest rates and

–forced investor purchase of government bonds,

–over a very long period of time.

In the post-WWII US, which implemented such a regime, the country reduced its outstanding debt at the rate of 3%-4% of GDP yearly–suggesting “financial repression” would have to remain in place of at the very least ten years to get government borrowings under control.

two elements to financial repression

Financial repression has two elements:

1.  ceilings on nominal interest rates.  This would mean caps on the interest that banks or other financial intermediaries could pay to savers, as well as ceilings on the rates at which they could lend, either to all borrowers or at least to the government.

2.  forced lending to the government, including:

–capital controls to prevent money from leaving the country for more lucrative investments elsewhere, making government securities more attractive by default,

–high bank reserve requirements, i.e., mandated low- or no-cost loans to the government,

–“prudential” regulatory requirements that institutional investors–insurance companies, pensions funds, bond mutual funds–hold significant amounts of government debt in their portfolios.

financial repression is politically attractive…

As Ms. Reinhart points out, what makes financial repression especially attractive to politicians is its “steath” nature.  Unlike increases in taxes or cuts in government programs, it leaves no fingerprints that can be traced back to individual officeholders and foil their reelection chances.  Imagine trying to explain what’s going on in an election speech without having your listeners’ eyes glaze over.

…but very bad for bond returns

The bottom line:  in its simplest terms, financial repression is a hidden tax on bonds that could be in place for ten or twenty years.  From an investor’s point of view, having the government do this–and it might be the easiest choice for Washington–would return bonds to being the unattractive holdings they were in the pre-Volcker years.  No wonder bond fund managers are beginning to squawk.

Tomorrow, the effect of  financial repression on stocks.







US unemployment problem: is it structural or cyclical?

In February, I wrote a post on unemployment in the US, titled “JP Morgan’s forex + IBM’s Watson = problems for Wal-Mart?”.

A couple of days ago, a reader pointed out that my conclusion didn’t follow from the argument I made.  After rereading my post, I think he’s right.   This post is an elaboration/clarification of my earlier comments.

cyclical vs. structural unemployment

I have a number of uncles who, when they were young, worked as longshoremen on the docks in New York.  They unloaded ships.  That business ebbed and flowed with the business cycle.  As a result, they went through periods where they worked a lot, and through periods when they worked only a little.  That’s cyclical unemployment.

Then, the transport industry innovated by introducing container ships, which didn’t require more than a few longshoremen to operate machinery.  That’s structural unemployment.

shift of manufacturing to developing countries

The failure of central planning in places like China in the late Seventies-early Eighties has fueled the gradual development and expansion of efficient, low-cost export-oriented industries in these countries.  It has also led to the courting of US and European manufacturing companies, in a (successful) effort to persuade them to open manufacturing operations in these areas, as well.  This is the process of technology transfer.

The result has been the continuing structural migration of labor-intensive jobs away from high-cost regions like the EU and the US.  During the speculative housing boom of the last decade in the US, new job entrants with manual labor skills and laid-off manufacturing workers were easily able to find employment in the construction industry.  This delayed their adjustment to the new realities of global commerce.  But no more.

Eventually, the US will digest the massive housing and retail overcapacity that was created several years ago.  But it will be an extremely long time, in my opinion,–if ever–before the construction industry in the US again employs as many as it did in 2006.  If so, there’s a considerable structural element in construction-related unemployment, not just a cyclical one.

In addition, increasing global competition isn’t letting up.  It’s pressing firms in the US to accelerate replacement of clerical labor with machines.  The examples of JP Morgan, which is only now substituting computers for typists earning $100,000 a year, and IBM, which is developing computers that have deep databases and understand ordinary language, suggest that this process is nowhere near completion.  The recent realization of bricks-and-mortar retailers that they need a bigger online presence and fewer, smaller stores, is still another trend that doesn’t favor the job prospects for clerical or manual laborers.

More evidence of this continuing pressure on low-skilled workers comes from Wal-Mart, a third or so of whose customers are among the least affluent Americans.  Its same-store sales in the US continue to fall, while, say, Tiffany’s business is booming.

government response

There’s been little effective response to the problem from the White House and none from Congress that I can see.  Only the Fed has been acting.  And all it can do is  keep interest rates ultra-low.  But if the basic problem is structural, rather than the business cycle, keeping rates low won’t have much effect.  It’s a little like hoping that low rates will induce manufacturers to ship their goods without using containers, thus offering the possibility of work to my uncles again.

my conclusion, and where I was mistaken

In my earlier post, I said that there would be adverse long-term consequences for the country if my description that we’re experiencing structural unemployment that Washington refuses to recognize or address, is correct.  I’m still fine with that opinion.

In the near-term, however, I said that Washington’s actions make no difference for the stock market.  That’s where I’m mistaken.

If I’m correct that there’s an overhang of unemployable workers, the economy will continue its sub-par recovery, interest rates will stay low, and today’s winners–multinational and globally focused firms, and companies catering to the more affluent–will continue to prosper.

On the other hand, if Washington’s policy of inaction is the right thing to do, then hiring will accelerate much sooner than I think and the economy will pick up speed as it heals itself.  Success will feed on success. The Fed will then begin to raise interest rates.

In the past, in such periods the stock market has continued to make some upward progress.  But the winners and losers among publicly traded companies would most likely change places.  Domestic firms, and those that focus on ordinary Americans rather than the affluent, would become relative winners, in my opinion.  Today’s top dogs would likely end up trailing the pack for a while.

Personally, I don’t think this will happen.  But because this is such a fundamental tenet of my portfolio positioning, I should have been paying more attention to the consequences of my being wrong.

Tiffany’s dazzling 1Q11

the results

TIF reported results for its 1Q11 (TIF’s fiscal year ends on January 31st of the following calendar year) before the New York market opened on Thursday, May 26th.  The company posted earnings of $.63 per share on revenues of $761 million.  This compares with per share profits of $.50 in the year-ago quarter on sales of $633.6 million.  The Wall Street consensus was $.57.

The report represents a 26% gain in earnings on a 20% advance in sales.  TIF’s performance for the quarter was considerably better than these strong comparisons suggest, however.  TIF posted a one-time tax benefit worth $.02 a share in last year’s first quarter; this year’s income statement had in it $.04 in non-recurring costs for moving TIF’s headquarters.  Ex these items, earnings were up 39% year on year.

In its conference call, TIF raised its full year guidance by $.10 a share, to $3.45-$3.55 (excluding $.19 in non-recurring moving charges).  A few days before the report, the company upped its quarterly dividend by 16%, from $.25 a share to $.29.

The stock made an odd little rally in the closing hour of trading on Wednesday.  It gained another 8.6% on Thursday.

the details

Yes, analysts had penciled in $.57 a share in earnings, based, I think, mostly on company guidance.  But I can’t imagine anyone was super-comfortable with the number.  The two big imponderables:

1.  How would Japan perform in the aftermath of the earthquake and tsunamis that occurred on March 11th north of Tokyo?  How many stores would be damaged by the resulting power shortages, and for how long?  Would TIF’s sales be hurt by an attitude of “self-restraint” (jishuku), i.e., postponement of consumption, in sympathy with earthquake victims?  If so, would that be contained to the Tokyo area or would it spread to the rest of the country?

When TIF reported 4Q10 results on March 21st, the company said it expected Japanese sales to be down by 15% year on year in 1Q11, reducing total company eps by about $.05.  …but who knew?   …and the company had already booked half a quarter of “normal” sales–would 2Q11 be worse?

2.  Would the US business slow?  After all, the prevailing sentiment on Wall Street has been that domestic unemployment is still high, job growth is lackluster and the overall economy is being hurt, possibly more seriously than expected, by high gasoline prices.  Maybe economic doldrums would have an adverse effect on TIF customers–not only aspirational buyers but the wealthy as well.

Japanese results were unexpectedly good

Instead of down 15%, Japanese sales (which accounted for 17% of total company sales in the quarter) were up by 7%.  This was due completely to a 10% gain of the yen vs. the dollar during the quarter.  Nevertheless, same store sales were only down by 3%.  The Osaka area was relatively unaffected.  Nationwide comps were +3% in February, -16% in March (implying to me that Tokyo-area sales fell by about a third during the month), +6% in April.  Jishuku may have also had some unusual effects:  sales in Guam and Hawaii, traditional Japanese tourist destinations, were up 30% year on year for the quarter.

TIF now thinks that, while Japan won’t be a source of strength this year, it won’t be a significant drag on the rest of the company, eitherSounds reasonable.

to me, the US was a bigger positive surprise

I know sales of luxury goods are going very well, and I expected that TIF’s sales in the Americas ( 48% of the company) would easily be up in double digits.  But the 19% gain TIF achieved was considerably higher than I expected. Comparable store sales at the flagship store in NYC were up 23%, year on year; comps in the rest of the US were up by 15%.  High-end jewelry did the best, as has been the case for some time.  However, there was even some strength in the silver jewelry that TIF’s less affluent clients favor.  US sales growth was “solid from coast to coast.”  Comps got better as the quarter progressed.

the rest of the world continues to show amazing gains

Sales were up by 37% year on year in Asia-Pacific (23% of TIF’s total) thanks mostly to Greater China.  Currency accounted for 6% of that, and new stores another 5%.  But comps were up 26%, after a 21% year on year gain in 2010.  Wow!

Sales in Europe (12%) were up 25%.  Currency gains made up 6% of the increase, and new stores 4%.  But comps were up 15%, due mostly to strength in continental Europe, after a 14% increase last year.

the stock

I haven’t changed my mind about TIF since I wrote about the stock after the 4Q11 earnings release.  I still think the company can earn $3.75 a share this year and $4.50 or so next.  Applying a 20x multiple to these figures gives us a $75 target based on 2011 eps and $90 on 2012.  Applying 25x gets correspondingly higher figures.

One thing is different, however.  TIF is no longer the sub-$60 stock it was in March.

TIF has exceptionally strong management, a wonderful brand name, and it’s also in the right place at the right time.  So I think it will continue to be an outperformer.  I’m happy to hold the stock.  I’ve trimmed my own position a bit, though, mostly because of its size.  I’d be an eager buyer on weakness.

what the big Sony writeoff means

Sony’s fiscal 2010 results

Sony reported its fiscal year 2010 earnings (the company’s fiscal year ends, as is customary with Japanese companies, on March 31st) in Japan overnight.  Tokyo Stock Exchange requires that all listed firms both make an official estimate of anticipated results.  The TSE also requires companies to publish a revision–prior to releasing the actuals–as/when it realizes the actual results will differ from the official estimate by more than 30%.  In line with this requirement, Sony announced a downward revision to earnings last Monday.

the writeoff

The issue is deferred taxes in Japan.  Sony wrote off US$4.3 billion.

The company points out that:

–the writeoff is a non-cash charge,meaning no money has been lost,

–this doesn’t preclude use of  tax-loss carryforwards in the future, and

–the charge “does not reflect a change in Sony’s view of its long-term corporate strategy.”

what this means

Unlike most Japanese firms, Sony keeps its official financial reporting books according to US Generally Accepted Accounting Principles.  GAAP uses deferred taxes.

Let’s say a company loses money this year–thereby establishing a tax-loss carryforward that can be used to offset taxes on future income.  GAAP tells the company that it should record a credit for this possible future tax benefit in this year’s financials.  In other words, if you have a loss of $100 this year, but anticipate that you will have enough profit, say, five years from now to employ this loss to offset $30 in income tax that would otherwise be payable, you should take the $30 gain in the current year.  You record a loss of $100 on your income statement plus a deferred tax benefit of $30.  The net loss you report to shareholders is $70, not the full $100 amount.

One proviso, though.  You have to have a reasonable basis for thinking that you’ll have enough future profit to use the potential tax benefit that today’s loss represents.  And your auditor has to agree with you.

Sony has been in loss in Japan for three years now.  The writeoff means that Sony’s accountants no longer think the company will be able to generate enough taxable income to use $4.3 billion of future tax credits it had previously expected to enjoy.

my thoughts

Sony cites the March earthquake/tsunamis as a reason for this re-evaluation.  But at the same time it notes that the damage to its businesses in Japan haven’t been that great, are mostly covered by insurance, and that it’s confident it will collect on its policies.

The benign reading of the big writeoff would be that Sony’s overall internal profit projections haven’t changed much and the important thing to note is the “in Japan” part of the company statement.  It could be the writeoff means that Sony is going to make a major shift of production away from Japan.  It will continue to make the same profits, just not in its home country.

In my experience, though, events rarely follow the benign path.  I don’t know today’s Sony well enough to judge in this case, but typically a firm’s accountants notice business deterioration and propose a writeoff–and management reluctantly (sometimes, very reluctantly) falls in line.  It may be that the operative word in Sony’s statement of confidence in its prospects is “long term.”

SNE as a stock

I don’t know the company well enough to have an opinion.  I know what I’d look for, though.

Sony has two main businesses:  consumer electronics and video games.  The company has lost ground in the first to Samsung and Apple.  In the current generation of game consoles, Sony has regained past form after turning first-mover advantage over to X-Box, allowing MSFT to gain a market share I don’t think it could otherwise have achieved.  But rival Nintendo is already talking about a new game console.  And the game business is morphing into one favoring simple games played on a cellphone or through a social network.  What are Sony’s plans?

Ideally, one would like to see both main businesses in sync and operating profitably–not strength in one being offset by weakness in the other.

two stages in a US prospectus: preliminary and final

As long as I’m writing about IPOs, I thought I should make a comment about prospectuses.

hire an investment bank; prepare a prospectus

In the US, the first step on the road to offering securities to the investing public (“going public”) is to hire an investment bank to act as lead underwriter.  The underwriter will, among many other things, help the firm create the prospectus, an offering document that discloses to potential investors all material and relevant company information.

There are two stages in the life of a prospectus:  the preliminary and the final.

file the preliminary prospectus with the SEC

Once the prospectus is completed, it’s marked as preliminary and submitted to the SEC for approval, in a form S-1, or registration statement. 

Here’s the one LNKD filed. If you scroll down past the cover page of the S-1 to the prospectus itself, you’ll see that the first page has a lot of blanks, where the offering price and number of shares will eventually be filled in.  As well, there’s a narrow band of bright red print at the top.  It’s the following notice:

“The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

PROSPECTUS (Subject to Completion)

Issued January 27, 2011”

becoming “effective”

The SEC staff reviews the preliminary prospectus for compliance with the disclosure requirements of US securities laws.  It may ask the filing company for further detail or clarification.  Once the agency is satisfied, it declares the prospectus as “effective,” or in legal compliance.  When this happens, the prospectus may be distributed to potential investors.  But it’s still preliminary and contains the red warning notice.

the sales campaign

The preliminary prospectus is the main sales tool for the IPO.  One or more teams of top company management members may tour the country meeting investors, either one-on-one or in large groups.  There may be “virtual” meetings through audio or video conference, as well.  But these events tend to be heavily rehearsed and scripted.  The issue?  The prospectus is supposed to contain all material information about the offering.  So the last thing the firm’s legal advisers want is for some company representative to make an off-the-cuff remark that’s not in the prospectus, that someone later on tries to construe as relevant.

the IPO date; the final prospectus

Investors give their indications of interest.  The underwriter buys the issue from the company and resells it to clients (this is a more convoluted process than it seems, but that’s a topic for another day).

Only then does the final prospectus appear.  It’s distributed to investors after they’ve already bought stock.

Here’s the final prospectus for LNKD.   Note that the blanks have been filled in and that the red warning label, which includes the key statement:”is not complete and may be changed” has been removed.

the significance of “final”

In my experience, everyone does analysis of an offering using the preliminary prospectus.  When the final comes, it’s just stuck in a file–unread.  Legally, however, the final prospectus is important.  It is the official, complete disclosure of all facts relating to the offering.  Technically, investors have a short period of time in which to read the final.  They can return the stock to the underwriter if they don’t like what they see.

I’ve never heard of a case of an investor exercising this right.  My impression is most investors are unaware they can do so.

preliminary and final aren’t always the same

Nor do they know that last-minute changes to the prospectus can be inserted into the final that aren’t in the preliminary.  I’ve only seen this happen once.

Armand Hammer, the corporate buccaneer who was CEO of Occidental Petroleum years ago, decided to spin off IBP, a meatpacking subsidiary, in 1987.  The final prospectus revealed that Occidental had allocated to IBP an extra $1 billion in corporate debt above what was stated in the preliminary.  The move made the deal worth about 10% less, by my reckoning, than the preliminary prospectus made it seem.

Not a nice thing to do.  Not something calculated to make you ever trust anyone associated with the deal again, ever.  But, however ethically suspect, legally permitted.  This would have been a famous incident, and might have spurred regulatory changes, had the IPO not come in mid-October, the week before the crash on Black Monday.

“LinkedIn Scammed”–what were you thinking, Joe?

“Was LinkedIn Scammed?”

A friend who’s a regular reader asked for my comments on the LinkedIn article that reporter Joe Nocera wrote for the op-ed page of the New York Times last Friday. (See my post describing the offering.)

Nocera’s comments about LinkedIn

The article makes two assertions:

–underwriters Merrill Lynch and Morgan Stanley (I don’t know why JP Morgan, listed as a first-rank underwriter on the prospectus, isn’t included)  “scammed” LKND–which is an NYSE stock, by the way, despite the four-letter ticker symbol.  They deliberately priced the IPO too low, he says, in order to shift tens, maybe hundreds, of millions of dollars out of the pockets of LKND and into those of favored clients.

–this damaged LKND, for whom the money left on the table may one day be the difference between success and Chapter 11.

Wow!!  Strong stuff.  What’s the evidence?  I can’t see much.

my thoughts


Of course, anything’s possible.  And I think it’s clear that the sell side’s primary loyalty is to its largest brokerage customers, not to one-time investment banking clients.  But the acknowledgement of status involved in dispensing and receiving a large allocation of a “hot” IPO is, to my mind, far more important to the broker-client relationship than whether the price is $45 a share or $65.  For large clients, the money difference is a rounding error in their performance calculations.

In addition, I don’t see why an industry so deeply distrusted by most Americans and under continuing scrutiny from Washington would take the chance of deliberately mispricing an offering–especially when campaigning for the next election has already begun.  Also, why jeopardize your chances of being in the running to manage the really big social networking IPOs, like Facebook or Groupon?

the example of Renren (RENN, also a NYSE stock)

LKND followed close on the heels of RENN, a Chinese social networking stock that came public on May 4th.  RENN was priced at $14.  It opened at $19.50, quickly reached a high of $24 and closed that day at $18.01.  But by the time LKND was being priced, RENN had fallen below its IPO price–the last thing any party to a public offering wants to see.

RENN had to be an argument for more cautious pricing of LNKD.   It suggests, as well, the jury is still out on whether LNKD should have been priced more aggressively than it was.

the LNKD valuation

LKND earned $.17 a share last year.  At the initial suggestion of a $32 offering price, that would have been a PE of 188x.  At $45, the actual IPO price, the multiple is 265x.  Is Mr. Nocera actually saying the stock should have been priced at 350x earnings?

is LNKD hurt financially by an IPO price of $45, instead of, say, $60?

an opportunity loss of $90 million?

In one sense, yes, because at $60 a share, LNKD would have taken in $340 million or so instead of $250 million.  But at $60 the risk of a failed IPO would have been higher.  Remember, too, that LNKD wasn’t exactly a babe in the woods.  It had a list of professional investors who were already shareholders that it could call on for advice.  Goldman was the only one to take the money and run, but still…

Use of Proceeds

There’s a section of any prospectus called “Use of Proceeds.”  When I looked at this section of the LNKD document, I almost started to laugh.  I’ve never seen a company struggle so much to explain what they’re going to do with the money.  Here’s a sample:

“The principal purposes of this offering are to increase our capitalization and financial flexibility, increase our visibility in the marketplace and create a public market for our Class A common stock. As of the date of this prospectus, we cannot specify with certainty all of the particular uses for the net proceeds to us of this offering. However, we currently intend to use the net proceeds to us from this offering primarily for general corporate purposes…”

In other words, LNKD can’t imagine how it will spend the money.  By the way, the company already had over $100 million on the balance sheet on March 31st and had just started to generate enough cash flow to cover all its expenses.

employee stock options gain $1 billion+ in value

What LNKD really needed was a way for its 990 employees to cash in the tons of stock options LNKD has issued to them (page F-24 of the prospectus tells us that there are 16+ million of them, with a weighted-average exercise price of $5.86).  That works out to over $1 million apiece–a billion dollars in compensation that LNKD doesn’t have to come up with itself.

lapses in logic

Mr. Nocera asserts that the investment bankers “with their fingers on the pulse of the market, absolutely must have known” that LNKD would double on the first day.  He forgets to mention that the only investment bank among the insiders, Goldman, cashed out completely at $45.

He starts out the article by saying that during the past decade investment banks routinely tricked their institutional clients into buying dud securities at wildly high prices.  He then uses this as support for the assertion that Morgan Stanley and Merrill are now doing the opposite.  Huh?

Mr. Nocera cites two “authorities” in support of his contentions.  Both are web postings.

One is by an employee of social games maker Zynga.

The other is by Henry Blodget, the former Merrill internet analyst who is barred from the investment industry for having lied, in glowingly positive reports, about his negative investment opinion for companies under his coverage.     Maybe Bernie Madoff was unavailable.

All in all, not your best day, Joe.