Monday, June 30, 2008

what happened to truth?

I was recently listening to Jim Cramer's Mad Money. he made the point that GM and Ford can go all the way to 0 because of their massive debt loads. this is the simple truth that many stock investors forget most of the time: credit ratings matter. it's amazing to think about: people would consider CCC rated debt, such as GM's, highly risky. but they wouldn't worry for a second about going even lower in the capital structure: common stock.

we take debt and equity for granted, but at times like this, it's worth examining their natures more closely...

DEBT is a defined obligation, whether it's fixed at a number like 6% or pegged to a floating index like libor or prime. as long as the borrower meets this defined obligation, the creditor is happy.
when a company pays its debts on time, bondholders have essentially no rights. they only gain control when the contract is breached. then they can take all actions necessary to demand the contract be fulfilled. all they care about is getting their legally defined payments.

EQUITY is everything else -- ownership net of obligations. as long debts are paid on time, the equity (stock) holders have complete control. they hire management teams, who are sworn to enhance their wealth. (this is called "fiduciary" duty.)

unlike debt investors, stock investors have no defined rights to get any money from anyone. they hope for dividends and stock price appreciation. their only right is to demand that management at least try to make them money. that's why people like carl icahn buy stocks and try to change things to make them go higher. common stock can go up forever, and exists solely to enrich its owners.

essentially, stock investors have the potential to collect infinite profits -- as long as they pay their debts.
and debt investors have the absolute right to recieve defined payments -- and they can take eveything from the stock investor to get that amount.

people buy stocks on hope. after all, you never know how many times it will double.
people buy bonds on need because they have expenses to cover... they are insurance companies, or pensions, that make defined cash payments to their own customers.

I think this explains the difference in temperment between stock and bond investors. credit investors, who I know better, pour over the details of companies' assets, doing great amounts of math and estimates. they consider how much they will get back if the company defaults, etc. I would often ask how anyone can do so much work for a mere 6% interest rate? the reason is that the coupon is all they get: they're not shooting for the stars, they're just looking to plug a gap in their cash flow 5 years from now.

on one hand, you have the valiant stock portfolio manager, heroically chalking up double-digit gains with clever stock picking. people put him on TV and treat him like a rock star.
on the other hand, we have a bookish accountant-type. one who's more confortable with columns of numbers and hedges everything with statements like "the evidence would suggest." he's more of a financial scientist. instead of going on TV, he speaks before groups like the NYSSA, a huge fraternity of CFA nerds and accountants.
as Cramer pointed out, this pocket protector crowd (I have seen used in real life at bond conferences) can become quite nasty when their interest payments aren't met. they take everything, leaving common stock holders with nothing.

it's amazing that a company like GM, a cornerstone of american society for nine decades, can lose half its value in less than two months. in another 2-3 months, it could be halved yet again. in a year, it may be worth nothing. people thought they had real value here. after all, it was "GM".. or it was "Citigroup" or "Lehman"... names have been so reliable for so long.. companies like that can't really collapse!
it turns out these companies are worth a lot less than people thought. when your debts equal 90% of all your assets -- as in the case of lehman brothers -- do people really want to buy the stock? what if you're lehman and your assets -- things like mortgage securities -- lose 10% of their value? what if they can't roll over their $428 billion of short term their? (I still can't believe I typed that number. can you believe that between feb 29 2008 and one year later, lehman brothers will have to pay back or refinance the entire Swiss economy??)

in the next year, GM has $6bln of debt coming due, a little less than their entire market cap...

when you have debt like that, things we all took for granted stop being true. this is true for companies like GM and Lehman, and it's true for people who borrowed heavily to against their homes. things we thought were true seem to dissolve.

this crisis of truth in the stock market is no exception to the general condition of our society and culture. veracity is becoming an increasingly scarce commodity.

let's consider the blatant lies of people like our president and treasury secretary. they speak endless about the need for a strong dollar, then watch it lose value. the same president then complains how china isn't doing enough to make its own currency stronger. he never acknowledges this actually means a weak dollar... an entire media corps covers wall street and politics, and I have never heard anyone cite this obvious contradiction. (again, how can you be for a strong dollar and a strong renminbi at the same time? currencies trade in pairs.)

another example is the notion that inflation will subside on its own as the economy slows. this is pure faith, unfounded in any serious example of real cases. inflation is a monster that must be killed. it cannot be tolerated, or coddled because it doesn't seem that dangerous. there is no reasoning with this brute. it must simply be destroyed.
as I noted in a recent posting, inflation is so dangerous because it creates leaves a series of repressed price increases. these spring at people unexpected, ripping into companies and individuals with big price increases.

for example, a one-month unlimited pass to ride NYC subway now costs about $78. I think it cost $70 when I moved to the city more than 4 years ago. I know an 11% increase may sound like a lot, but I suspect it doesn't go far enough to cover the 380% increase in oil prices over the same period. (after all, they operate plenty of buses and other vehicles as well.) somehow, they will hide this problem in their complex web of capital spending, but at a certain point, it costs them money. as a government body, they have limited ability to hike fares. so, the increase sits there, unmet, like a sprung coil. then when everybody thinks everything is ok, and inflation's ok because the economy is slowing, the MTA raises its fare 30-40%. then everyone else who's in pain raises their fares. taxis win increases.. then all the car services follow.
even if the economy goes into recession, millions of these price-increase traps are laid and inflationary pressures continue -- even after GDP goes negative.

the only real solution, of course, is to raise interest rates. but that would be mean to all the companies like lehman or all the homeowners.

our own political system is riddled with lies. yes, I know politicians say anything. but consider this: much of our political growth after the 1920s and 1930s required the absolute distortion of our constitution's plain meaning.
most important... the interstate commerce clause: "congress shall have power ... to regulate commerce ... among the several states " (article 1, section 8). it was barely used until the 1930s, when the new deal expanded it to mean the entire national economy. consider things like the americans with disabilities act and the endangered species act, which regulate businesses and people directly. what does it have to do with trade "among the several states?"

the answer, of course, is nothing. rather, we must accept an open lie. we have to break our own constitution to do what we believe is right. we want to clean up the environment, promote workplace safety and protect the cute animals on nova. so we tolerate a lie because we think we're doing the right thing.
it's somewhat like Enron CFO Jeffrey Fastow saying he committed fraud to protect the shareholders. after all, if the company's true state were known publicly, all those teachers' pension funds and grandmothers would lose money!

we americans have tolerated many lies on a similar line of reasoning. these things seemed like the right thing to do, so they must be ok. after all, who has ever stood up to challenge the notion of "freedom of speech?" on the surface, what's more american than that?

in truth, the history is a giant paradox:
FACT: the bill of rights (amendments 1-10 of the US constitution) was originally created to restrict the Federal Government. in the 1780s, many states were scared of this new government and demanded the bill of rights to ensure it wouldn't encroach on their liberties. at no point in the 18th century is there any notion the bill of rights was meant to restrict the states. everyone knew it was to limit the federal government only. that's why the states-rights people accepted the constitution. they only ratified it once the bill of rights was added.

it's an incontrovertable piece of historical fact: the bill of rights was intended to restrict the federal government.

then in 1925, the gitlow case comes before the court. they take the completely novel step of deciding that the states must respect first amendment free speech rules. (the court had recently invented the "clear and present danger notion" .. basically, Congress can only bar people from "yelling fire in the theater"...). amazingly, no one really cared at the time. the gitlow case was expanded in coming years, producing red-hot issues like abortion, prayer in public schools, gay rights, miranda, manger scenes, etc.

we all love to argue about these issues. but to me, these are not the real issues. the issue is how we have managed to twist reality so that up becomes down. how is it possible that the first amendment, intended to protect states from federal power, is now used to subject states to federal power?

the truth is it isn't possible. it's a lie we've been forced to endure as a body politic. and like all lies, it's kind of like inflation. it lays all kinds of traps forcing people to distort reality... like the house appraisor who collects $100 to price a condo based on a computer program -- without even seeing the home. good things are built on bad foundations when you lie.

(it may be the symptom of the common law, where bizarre lies are common place, such as a lord closing a gate once a year to prevent people from claiming a permanent right of way through his property. ... see this..

much of the last 90-100 years has been a lie. "houses never lose value". "I didn't inhale" "we're for a strong dollar"... "iraq has weapons of mass destruction" .. etc.

I know not many people will agree with me or see the relevance of the bill of rights...
but there's one lesson we all should take from any asset bubble bursting: truth matters and is real. things like culture and money (all of which are based upon people's ability to assume a lot of things in common) can let people ignore truth for very long times. but the truth always comes out in the end. even if we think we were doing the right thing by spreading the freedom of speech, or protecting the environment, we ruined it when we lied to accomplish our goal.
as we enter a period of $4 gasoline, falling home prices, banks with broken kneecaps and plunging confidence, we're likely to see many former truths questioned. the notion that you could live a middle-class lifestyle somewhere like NJ, running up debts and consuming energy wantonly -- that was "true" for the last 40 years. what happened this year?

a related point to the bill of rights: building basic rights upon a big lie is rather sloppy. we have been similarly negligent in running other parts of the government.. and it is these key areas that our country needs help immediately: health care, riddled with government funding and regulations, is a mess. subsidies programs to farmers, etc. the whole thing is really just a big mess.
because we've been so sloppy, fixing things will take years. barney frank will be playing the blame game on capitol hill while the entire banking industry slips to GM-like levels (BAC at $23!!?!?! 7 years of gains erased?!?)

we've had many bubbles.. many are part of a larger bubble that has manifested itself ever since the 1980s or so: a complacency bubble.

after being taught to think of common ideals (WWII egalitarianism, the great great society, etc), it was suddenly ok for people to raid companies, fire workforces, gut assets and walk away. we swung from the america of JFK's inauguration to the land of gordon gekko.
people in the 1970s wanted to save the environment and to cut oil use. then oil prices plunged in the 1980s and we ditched all of those notions. we tried to do "the right thing" and cut energy use, and we couldn't afford it. then we did "the wrong thing" like buying SUVs and building more sprawl...

we did "the wrong thing" and were rewarded each time..we got richer. everyone was happy. comforted by the assurances of people like ayn rand and milton friedman, we accepted the new reality and everything was fine.. no problem.

another key aspect of the bubble is that it destroys the morale of its opponents: house prices shot up for years. everyone said it was a bubble and people got killed shorting home builders. those people then are afraid to come out and help the next time around. (it's kind of like how inflation leaves little spring loaded surprises ready to inflict injuries on an economy.)
this is all part of how our complacency bubble developed. along the way it created financial bubbles and enabled politicians. it will be huge multi-stage process affecting all aspects of our society. sometimes it will feel like the end of the world... a facinating time to live. but probably a bad period for for stocks.

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