Alan Greenspan blames Irrational Risk-Taking and not his Keynesian Policies for the Subprime Mortgage Crisis

Posted by PITHOCRATES - October 26th, 2013

Week in Review

Since the Keynesians took over monetary policy we’ve had the Great Depression, the inflation racked Seventies, the dot-com bubble/recession of the late 1990s/early 2000s and the subprime mortgage crisis.  It’s also given Japan their Lost Decade, a deflationary spiral that started in the late Eighties that they are still fighting today.  As well as the sovereign debt crisis still ongoing in Europe.  So Keynesian economics has a record of failure.  Yet governments everywhere embrace it.  Why?  Because they love having the power to create money.  Especially when it’s ostensibly for helping the economy.  Which it never does.  As efforts to do so resulted in the carnage noted above.  But it always gives a good excuse for another surge in government spending.  And Keynesians love government spending.

Why does Keynesian economics fail?  Alan Greenspan, former chairman of the Federal Reserve whose policies helped create some of this carnage (dot-com bubble and subprime mortgage crisis), explains (see Greenspan ponders the roots of a financial crisis he failed to foresee by Martin Crutsinger, The Associated Press, posted 10/21/2013 on The Star).

Now, Alan Greenspan has struck back at any notion that he — or anyone — could have known how or when to defuse the threats that triggered the crisis. He argues in a new book, The Map and the Territory, that traditional economic forecasting is no match for the irrational risk-taking that can inflate catastrophic price bubbles in assets like homes or tech stocks.

This is why the Soviet Union lost the Cold War.  Because their managed economy failed.  As all managed economies fail.  Because it is impossible to know the decisions of hundreds of million people in the market.  These people making decisions for themselves result in economic activity.  But when governments try to decide for them you get Great Depressions, debilitating inflation, bubbles and nasty recessions.  As well as the collapse of the Soviet Union.

People only took irrational risks when the Federal Reserve (the Fed)/government interfered with market forces.  The dot-com bubble grew because the Fed kept interest rates artificially low.  So was it irrational for people to take advantage of those artificially low interest rates and make risky investments they otherwise wouldn’t have made?  Yes.  But if the Fed didn’t keep them artificially low in the first place there would have been no dot-com bubble in the second place.

Was it irrational for people to buy houses they couldn’t afford when the Clinton administration forced lenders to qualify the unqualified for mortgages they couldn’t afford?  Was it irrational behavior for people to buy houses they couldn’t afford because of artificially low interest rates, ‘cheap’ adjustable rate mortgages, zero-down mortgages, interest only mortgages and no-documentation mortgages?  Yes.  But if the Fed/government did not interfere with market forces in the first place to increase home ownership (especially among those who couldn’t qualify for a conventional mortgage) there would have been no subprime housing bubble in the second place.

The problem with Keynesians is they call anyone who doesn’t behave as they hope to make people behave with their policies irrational.  That is, people are irrational if they don’t think like a Keynesian and therefore cause Keynesian policies to fail.  But before there could be irrational exuberance there has to be a climate that encourages irrational exuberance first.  For if we went back to the banking system where our savings rate determined our interest rates as well as the investment capital available there would be no bubbles.  And no irrational exuberance.  What kind of a banking system would that be?  The kind that vaulted the United States from their Founding to the number one economic power in the world in about one hundred years.  And they did that without making money.  Unlike today.

Q: The size of the Federal Reserve’s balance sheet stands at a record $3.7 trillion, reflecting all the Treasurys and mortgage-backed securities the Fed has bought to push long-term interest rates down. You have expressed concerns about this size, which is more than four times where the balance sheet stood before the start of the financial crisis. What are your worries?

A: My basic concern is that we have to rein this thing in well before the demand for funds picks up and makes it very difficult to rein in. (Inflation) is not immediate. It is down the road. But historically, there are no cases where central banks blow up their balance sheets or where countries print money which doesn’t hit (with higher inflation).

The balance sheet is four times what it was before the Great Recession?  That’s an enormous amount of new money created to stimulate the economy.  And yet we’re still wallowing in the worst economic recovery since that following the Great Depression.  I don’t know how much more you can prove the failure of Keynesian economics than this.  About five years of priming the economic pump with stimulus stimulated little.  Other than rich Wall Street investors who are using this easy money to make more money.  While the median household income falls.

Keynesian economics attacks the middle class.  While enriching the ruling class.  And their crony friends on Wall Street.  These policies further the divide between the rich and everyone else.  Yet they continually say these same policies are the only way to reduce the divide between the rich and everyone else.  The historical record doesn’t prove this.  And those familiar with the historical record know this.  Which is why the left controls public education.  So people don’t learn the historical record.  Because once they do it becomes harder to win elections when you’re constantly lying to the American people.

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Trend Analysis – Liquidity

Posted by PITHOCRATES - January 7th, 2013

Economics 101

Liquidity can be More Important than Profitability to a Small Business Owner

Small business owners lose a lot of sleep worrying if they will have enough cash for tomorrow.  For next week.  For next month.  You can increase sales and add new customers but unless this creates cash those new sales and new customers may cause more problems than they help.  For a lot of businesses fail because they run out of cash.  Often times learning they have a cash problem only when they don’t have the cash to pay their bills.  So savvy business owners study their financial statements each quarter.  Even each month.  Looking for signs of trouble BEFORE they don’t have the cash to pay their bills.

Investors poor over corporations’ financial statements to make wise investment decisions.  Crunching a lot of numbers.  Analyzing a myriad of financial ratios.  Gleaning a lot of useful information buried in the raw numbers on the financial statements.  Small business owners analyze their financial statements, too.  But not quite to the extent of these investors.  They may look at some key numbers.  Focusing more on liquidity than profitability.  For profits are nice.  But profits aren’t cash.  As a lot of things have to happen before those profits turn into cash.  If they turn into cash.  The following are some balance sheet and income statement accounts.  Following these accounts are some calculations based on the values of these accounts.  With four quarters of data shown.

So what do these numbers say about this year of business activity?  Well, the business was profitable in all four quarters.  And rather profitable at that.  Which is good.  But what about that all important cash?  With each successive quarter the business had a lower cash balance.  That’s not as good as those profitability numbers.  And what about accounts receivable and inventory?  There seems to be some large changes in these accounts.  Are these changes good or bad?  What about accounts payable?  Accrued expenses?  Current portion of long-term debt?  These all went up.  What does this mean in the grand scheme of things?  Looking at these numbers individually doesn’t provide much information.  But when you do a little math with them you can get a little more information out of them.

In Trend Analysis a Downward sloping Current Ratio indicates a Potential Liquidity Problem

Current assets are cash or things that a business can convert into cash within the next 12 months.  Current liabilities are things a business has to pay within the next 12 months.  Current assets, then, are the resources you have to pay your current liabilities.  The relationship between current assets and current liabilities is a very important one.  Dividing current assets by current liabilities gives you the current ratio.  If it’s greater than one you are solvent.  You can meet your current financial obligations.  If it’s less than one you will simply run out of current resources before you met all of your current liabilities.  In our example this business has been solvent for all 4 quarters of the year.

Days’ sales in receivables is one way to see how your customers are paying their credit purchases.  The smaller this number the faster they are paying their bills.  The larger the number the slower they are paying their bills.  And the slower they pay their bills the longer it takes to convert your sales into cash.  Days’ sales in inventory tells you how many days of inventory you have based on your inventory balance and the cost of that inventory.  The smaller this number the faster things are moving out of inventory in new sales.  The larger this number is the slower things are moving out of inventory to reflect a decline in sales.  These individual numbers by themselves don’t provide a lot of information for the small business owner.  Big corporations can compare these numbers with similar businesses to see how they stack up against the competition.  Something not really available to small businesses.  But they can look at the trend of these numbers in their own business and gain very valuable information.

The above chart shows the 4-quarter trend in three important liquidity numbers.  Days’ sales in receivables increased after the second quarter upward for two consecutive quarters.  Indicating customers have paid their bills slower in each of the last two quarters.  Days’ sales in inventory showed a similar uptick in the last two quarters.  Indicating a slowdown in sales.  Both of these trends are concerning.  For it means accounts receivable are bringing in less cash to the business.  And inventory is consuming more of what cash there is.  Which are both red flags that a business may soon run short of cash.  Something the three quarters of falling current ratio confirm.  This business is in trouble.  Despite the good profitability numbers.  The downward sloping current ratio indicates a potential liquidity problem.  If things continue as they are now in another 2 quarters or so the business will become insolvent.  So a business owner knows to start taking action now to conserve cash before he or she runs out of it in another 2 quarters.

Keynesian Stimulus Spending can give a Business a Current Ratio trending towards Insolvency

In fact, this business was already having cash problems.  The outstanding balance in accounts payable increased over 100% in these four quarters.  Not having the cash to pay the bills the business paid their bills slower and the balance in outstanding accounts payable rose.  Substantially.  As the cash balance fell the business owner began borrowing money.  As indicated by the increasing amounts under current portion of long-term debt and interest expense.  Which would suggest substantial borrowings.  Putting all of these things together and you can get a picture of what happened at this business over the past year.  Which started out well.  Then experienced a burst of growth.  But that growth disappeared by the 3rd quarter.  When sales revenue began a 2-quarter decline.

Something happened to cause a surge in sales in the second quarter.  Something the owner apparently thought would last and made investments to increase production to meet that increased demand.  Perhaps hiring new people.  And/or buying new production equipment.  Explaining all of that borrowing.  And that inventory buildup.  But whatever caused that surge in sales did not last.  Leaving this business owner with excess production filling his or her inventory with unsold goods.  And the rise in days’ sales in receivables indicates that this business is not the only business dealing with a decline in sales.  Suggesting an economic recession as everyone is paying their bills slower.

So what could explain this?  A Keynesian stimulus.  Such as those checks sent out by George W. Bush to stimulate economic activity.  Which they did.  Explaining this sales surge.  But a Keynesian stimulus is only temporary.  Once that money is spent things go right back to where they were before the stimulus.  Unfortunately, this business owner thought the stimulus resulted in real economic activity and invested to expand the business.  Leaving this owner with excess production, bulging inventories, aging accounts receivable and a disappearing cash balance.  And a current ratio trending towards insolvency.  Which is why Keynesian stimulus spending does not work.  Most businesses know it is temporary and don’t hire or expand during this economic ‘pump priming’.  While those that do risk insolvency.  And bankruptcy.

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Balance Sheet, Financial Ratios, Private Equity, Toys “R” Us, Bain Capital, Leveraged Buyout and Initial Public Offering

Posted by PITHOCRATES - May 29th, 2012

History 101

Private Equity guides a Business foundering in Rough Seas into a Safe Harbor to Refit it for Profitability

The balance sheet is the one of the two most important financial statements of a business.  It’s a snapshot in time of the financial position of a company.  In the classical format all assets are on the left side.  And all liabilities and equity are on the right.  And the total value of all assets equals the total value of all liabilities and equity.  In other words the business bought all of their assets with money raised by borrowing (liabilities), with money raised by selling stock (equity) or with money generated by the business (retained earnings/profits). 

Everything you ever wanted to know about a business you can find on the balance sheet.  Through numerous financial ratios you can determine if the business is using their assets efficiently.  Or have too many assets that cost more to maintain for the revenue they produce.  You can tell if a business has too much debt.  Or has so little debt that new debt can finance growth and expansion.  Which could attract new equity investors for further growth.  You can see if they’re matching the terms of their debt with the life of their assets.  Or if they’re taking on long-term debt obligations to provide short-term working capital.  A review of a firm’s balance sheet can also tell how well the management team is doing.  Or how poorly.

The financial picture the balance sheet provides of a business is an objective picture.  It gives an outsider a different view of the company than an insider.  Who may have a more subjective view.  They may not want to shutter a poorly utilized factory because of pride, sympathy for the employees or unfounded hope that business will improve soon.  So they will risk losing everything by not accepting that they must let some things go.  Like a cargo ship foundering in rough seas.  To save the ship and most of its cargo a captain may have to jettison some cargo.  If he or she doesn’t the captain can lose the ship.  The cargo.  And the lives of everyone on board.  Perhaps having a life or death decision in the balance makes it easier to make those hard decisions.  Perhaps that’s why some CEOs can’t let some things go.  Because they never accept the seriousness of their situation.  Perhaps this is why an outsider can read a balance sheet and see what the CEO can’t.  And act.  Like the captain of a ship foundering in rough seas.  And this is what private equity does.  Guides a foundering business into a safe harbor.  Refits it.  And then re-launches it on a course of profitability.

Toys “R” Us

Toys “R” Us was hitting its stride in the Eighties.  They were dominating the retail toy business.  Even expanding internationally.  And into other lines.  Children’s clothing.  Kids “R” Us.  And baby products.  Babies “R” Us.  There was no stopping them.  The secret to their success?  Sell every hot new toy kids wanted.  And sell it cheap.  At or below cost.  Using these loss leaders to get people into their stores.  Where they could sell them more expensive goods in addition to the most popular ‘must have’ toys. 

Then came the Nineties.  And serious competition.  From the big department stores, discount chains and warehouse clubs.  Target.  Wal-Mart.  Costco.  And then the Internet.  Who could use the Toys “R” Us strategy just as well.  And do them one better.  Toys “R” Us focused on selling the ‘must have’ toys at the lowest price.  Where customers came in knowing what they were looking for.  Finding it.  And heading to the checkout.  With a plan like that you don’t need customer service.  So when the competition matched them on selection and price they also threw in better customer service.  Wal-Mart surpassed Toys “R” Us.  Which was by then losing both profitability and market share. 

In 2004 a consortium of private equity (KKR and Bain Capital) and Vornado Realty Trust bought Toys “R” Us for $6.6 billion in a leveraged buyout.  And they turned the corporation around.  With a new management team.  Made the corporation more efficient.  In the brick and mortar stores as well as online.  The company is better and stronger today.  But it has delayed its Initial Public Offering (IPO) for about 2 years now due to a couple of lackluster Christmas seasons during the Great Recession.  They will use the capital raised from the IPO to pay down the debt from the leveraged buyout now sitting on Toys “R” Us’ balance sheet.  Making the turnaround complete.  Allowing the private equity firms to exit while leaving behind a healthier and more profitable company.

The Goal of the Leveraged Buyout was to make Toys “R” Us a Stronger Company

Private equity was successful at Toys “R” Us because Toys “R” Us was a good company.  From 1948 it consistently did the smart thing and grew into the giant it is.  But then it matured.  And the market changed.  Like a ship foundering in rough seas they just needed a little help to captain them through those rough seas.  And that’s what private equity did. 

Many will criticize the sizable debt they’ve left on their balance sheet.  But the plan was always to take the company public again.  Using the proceeds from the IPO to clean up the balance sheet.  Yes, the equity partners will also make a fortune.  But Toys “R” will emerge from this process a stronger company.  Which was the goal of the leveraged buyout.  They did not chop up the company and liquidate the pieces.  They purchased it in 2005.  And the company is still around today in 2012.  What have they been doing all this time?  Trying to make the company the best it can be.  So they can profit greatly from the IPO. 

No doubt the balance sheet of Toys “R” Us has never looked better.  Other than the debt added for the leveraged buyout.  Which they have been able to service since 2005.  So clearly the company is doing something right.  And just imagine how well they will do after they clean that debt off of their balance sheet.  After the IPO.  Suffice it to say that our grandchildren will be shopping there for their own children one day.

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