Capital Markets, IPO, Bubbles and Stock Market Crashes

Posted by PITHOCRATES - April 22nd, 2013

Economics 101

Entrepreneurs turn to Venture Capitalists because they Need a Lot of Money Fast

It takes money to make money.  Anyone who ever started a business knows this only too well.  For starting a money-making business takes money.  A lot of it.  New business owners will use their lifesavings.  Mortgage their home.  Borrow from their parents.  Or if they have a really good business plan and own a house with a lot of equity built up in it they may be able to get a loan from a bank.  Or find a cosigner who is willing to pledge some collateral to secure a loan.

Once the business is up and running they depend on business profits to pay the bills.  And service their debt.  If the business struggles they turn to other sources of financing.  They pay their bills slower.  They use credit cards.  They draw down their line of credit at their bank.  They go back to a parent and borrow more money.  A lot of businesses fail at this point.  But some survive.  And their profits not only pay their bills and service their debt.  But these profits can sustain growth.

This is one path.  Entrepreneurs with a brilliant new invention may need a lot of money fast.  To pay for land, a large building for manufacturing, equipment and tooling, energy, waste disposal, packaging, distribution and sales.  And all the people in production and management.  This is just too much money for someone’s lifesavings or a home mortgage to pay for.  So they turn to venture capital.  Investors who will take a huge risk and pay these costs in return for a share of the profits.  And the huge windfall when taking the company public.  If the company doesn’t fail before going public.

The Common Stockholders take the Biggest Risk of All who Finance a Business

As a company grows they need more financing.  And they turn to the capital markets.  To issue bonds.  A large loan broken up into smaller pieces that many bond purchasers can buy.  Each bond paying a fixed interest rate in return for these buyers (i.e., creditors) taking a risk.  Businesses have to redeem their bonds one day (i.e., repay this loan).  Which they don’t have to do with stocks.  The other way businesses raise money in the capital markets.   When owners take their business public they are selling it to investors.  This initial public offering (IPO) of stock brings in money to the business that they don’t have to pay back.  What they give up for this wealth of funding is some control of their business.  The investors who buy this stock get dividends (similar to interest) and voting rights in exchange for taking this risk.  And the chance to reap huge capital gains.

The common stockholders take the biggest risk in financing a business.  (Preferred stockholders fall between bondholders and common stockholders in terms of risk, get a fixed dividend but no voting rights.)  In exchange for that risk they get voting rights.  They elect the board of directors.  Who hire the company’s officers.  So they have the largest say in how the business does its business.  Because they have the largest stake in the company.  After all, they own it.  Which is why businesses work hard to please their common stockholders.  For if they don’t they can lose their job.

During profitable times the board of directors may vote to increase the dividend on the common stock.  But if the business is not doing well they may vote to reduce the dividend.  Or suspend it entirely.  What will worry stockholders, though, more than a reduced dividend is a falling stock price.  For stockholders make a lot of money by buying and selling their shares of stock.  And if the price of their stock falls while they’re holding it they will not be able to sell it without taking a loss on their investment.  So a reduced dividend may be the least of their worries.  As they are far more concerned about what is causing the value of their stock to fall.

Investors make Money by Buying and Selling Stocks based on this Simple Adage, “Buy Low, Sell High.”

A business only gets money from investors from the IPO.  Once investors buy this stock they can sell it in the secondary market.  This is what drives the Dow Jones Industrial Average.  This buying and selling of stocks between investors on the secondary market.  A business gets no additional funding from these transactions.  But they watch the price of their stock very closely.  For it can affect their ability to get new financing.  Creditors don’t want to take all of the risk.  Neither do investors. They want to see a mix of debt (bonds) and equity (stocks).  And if the stock price falls it will be difficult for them to raise money by issuing more stock.  Forcing them to issue more bonds.  Increasing the risk of the creditors.  Which raises the bond interest rate they must pay to attract creditors.  Which makes it hard for the business to raise money to finance operations when their stock price falls.  Not to mention putting the jobs of executive management at risk.

Why?  Because this is not why venture capitalists risk their money.  It is not why investors buy stock in an IPO.  They take these great risks to make money.  Not to lose money.  And the way they expect to get rich is with a rising stock price.  Business owners and their early financers get a share of the stock at the IPO.  For their risk-taking.  And the higher the stock trades for after the IPO the richer they get.  When the stock price settles down after a meteoric rise following the IPO the entrepreneurs and their venture capitalists can sell their stock at the prevailing market price and become incredibly rich.  Thanks to a huge capital gain in the price of the stock.  At least, that is the plan.

But what causes this huge capital gain?  The expectations of future profitability of the new public company.  It’s not about what it is doing today.  But what investors think they will be doing tomorrow.  If they believe that their new product will be the next thing everyone must have investors will want to own that stock before everyone starts buying those things.  So they can take that meteoric rise along with the stock price.  As this new product produces record profits for this business.  So everyone will bid up the price because the investors must have this stock.  Just as they are sure consumers will feel they must have what this business sells.  When there are a lot of companies competing in the same technology market all of these tech stock prices can rise to great heights.  As everyone is taking a big bet that the company they’re buying into will make that next big thing everyone must have.  Causing these stocks to become overvalued.  As these investors’ enthusiasm gets the better of them.  And when reality sets in it can be devastating.

Investors make money by buying and selling stocks.  The key to making wealth is this simple adage, “Buy low, sell high.”  Which means you don’t want to be holding a stock when its price is falling.  So what is an investor to do?  Sell when it could only be a momentary correction before continuing its meteoric rise?  Missing out on a huge capital gain?  Or hold on to it waiting for it to continue its meteoric rise?  Only to see the bottom fall out causing a great financial loss?  The kind of loss that has made investors jump out of a window?  Tough decision.  With painful consequences if an investor decides wrong.  Sometimes it’s just not one individual investor.  If a group of stocks are overvalued.  If there is a bubble in the stock market.  And it bursts.  Look out.  The losses will be huge as many overvalued stocks come crashing down.  Causing a stock market crash.  A recession.  A Great Recession.  Even a Great Depression.

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Inventories

Posted by PITHOCRATES - July 23rd, 2012

Economics 101

Before a Business Earns any Sales Revenue they have to Spend Cash to Build an Inventory

To sell something a business needs to have it on hand first.  Because when it comes to manufactured goods we rarely custom manufacture things.  No.  When businesses sell something it’s something they already have in their inventories.  So how do they get things into inventory?  With cash.  Businesses buy goods and place them in their inventories.  They exchange some of their cash for the goods they hope to sell at a later date.  And the bigger the inventory they maintain the more cash it will take.  Cash they have to spend before they sell these goods.  Which requires financing.  Each large business, in fact, has a finance department.  That works to raise cash.  So the businesses can buy inventory (and pay their operating and overhead expenses) before they start selling anything.

This is how the retail stores work.  For manufacturers it’s a little different.  They make things.  Out of other things.  Things that go through various stages of production before becoming a finished good.  So to make these things requires different types of inventories.  Raw goods.  Work in process.  And finished goods.  When they pull raw goods out of inventory and begin working with them they become work in process inventory.  When finished goods come off the final production line they enter finished goods inventory.  The finance department secures the cash to buy the raw materials.  And for the equipment and labor used through the stages of production to produce a finished good.  Which enters finished goods inventory until they sell and ship these goods.

Before a business earns any sales revenue they have to spend huge amounts of cash first to move material through these inventories.  Cash they can’t use for anything else.  Like paying their overhead expenses.  Or servicing their debt.  So it’s a delicate balancing act.  You need inventory to produce revenue.  But if you run out of cash you can’t produce any inventory.  Or pay your bills.  A large inventory creates a large variety of things for customers to buy.  But if customers aren’t buying that large inventory will consume cash leaving a business struggling to pay its bills.  If they become so cash-strapped they will cut their prices to unload slow moving inventory.  Cut back on production rates.  Even cut back on expenses.  As in cost-cutting.  And lay-offs.

Good Inventory Management is Crucial for the Financial Health of a Business

A business doesn’t start generating cash until they start selling their finished goods.  Sales numbers may sound high but most sales revenue goes to pay for the costs of producing inventory.  A firm’s accounting department records these revenues.  And matches them to the cost of goods sold.  Which in a retailer is what they paid to bring those goods into inventory.  A manufacturer may use a term like cost of sales.  Which would include all the costs they incurred throughout the stages of production from bringing raw material into the plant.  To the labor to process that material.  To the energy consumed.  Etc.  Everything that was an input in the production process to place a finished good into inventory.  So from their sales revenue they subtract their costs of goods sold (or cost of sales).  The number they arrive at is gross profit.  Which has to pay for everything else.  Rent, utilities, marketing and advertising, non-production salaries and benefits, insurances, taxes, etc.  And, of course, interest on the cash their finance department borrowed to start everything off.

There is a unique relationship between inventories and sales.  There are countless things that happen in a business but what happens between inventories and sales receives particular attention.  A business’ greatest cost is the cost of goods sold.  Or cost of sales.  Everything that falls above gross profit on their income statement (the financial statement that shows a firm’s profitability).  This cost is a function of inventory.  The bigger the inventory the bigger the cost.  The smaller the inventory the smaller the cost.  This is a direct relationship.  You move one the other follows.  Whereas the relationship between sales and inventory is a little different.  The higher the sales revenue the bigger the inventory cost.  Because you have to have inventory to sell inventory.  However, there is no such corresponding relationship for falling sales.  As sales can fall for a variety of reasons.  And they can fall with a falling inventory level.  They can fall with a steady inventory level.  And they can fall with a rising inventory level.

In business sales are everything.  There are few problems healthy sales can’t solve.  It can even overcome some of the worst cost management.  So rising sales revenue is good.  While falling sales revenue is not.  There are many reasons why sales fall.  But the reason that most affects inventories is typically a bad economy.  When people scale back their purchases in response to a bad economy a firm’s sales fall.  And when their sales fall their inventories, of course, rise.  Until management scales back production to reflect the weaker demand.  Because there is no point building things when people aren’t buying.  Those who don’t scale back production will see their sales fall and their inventories rise.  Creating cash problems.  Because sales aren’t creating cash.  And a growing inventory consumes cash.  Making it difficult to meet their daily expenses.  Such as payroll and benefits.  As well as paying interest on their debt.  Which can lead to insolvency.  And bankruptcy.  So good inventory management is crucial for the financial health of a business.

If Retail Sales are Falling and Inventories are Rising Bad Times are Coming

Businesses target specific inventory levels.  During good economic times they increase inventory levels because people are buying more.  During bad economic times they decrease inventory levels because people are buying less.  And they monitor changes in the actual sales and inventory levels continuously.  Adjusting inventory levels to match changes in sales.  To balance the need to have an inventory flush with goods to sell.  While keeping the cost of that inventory to the lowest level possible.  All businesses do this.  And if you track the aggregate of the inventory levels of all businesses you can get a good idea about what’s happening in the economy.

John Maynard Keynes used inventory levels in his macroeconomics formulas.  The ‘big picture’ of the economy.  Looking at inventories tied right into jobs.  If sales are outpacing inventory levels then businesses hire new workers to increase inventory levels.  So sales growing at a greater rate than inventory levels suggest that businesses will be creating new jobs and hiring new workers.  A good thing.  If inventory levels are growing greater than sales it’s a sign of an economic slowdown.  Suggesting businesses will be reducing production and laying off workers.  Not a good thing.

Because of the stages of production changes in finished goods inventories can create or destroy a lot of jobs.  For if the major retailers are cutting back on inventory levels due to weak demand that will ripple all the way through the stages of production back to the extraction of raw materials out of the ground.  Which makes inventory levels a key economic indicator.  And when we combine it with sales you can pretty much learn everything you need to know about the economy.  For if retail sales are falling and inventories are rising bad times are coming.  And a lot of people will probably soon be losing their jobs.  As the economy falls into a recession.  Which won’t end until these economic indicators turn around.  And sales grow faster than inventories.  Which indicates a recovery.  And jobs.  As they ramp up production to increase inventory levels to meet the new growing demand.

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Classical Greece, Persian Empire, Hellenistic Period, Roman Empire, Italian Renaissance, Venice, Florence and Government Bonds

Posted by PITHOCRATES - January 17th, 2012

History 101

The High Cost of Mercenary Soldiers and a Bloated Bureaucracy brought down the Western Roman Empire

Classical Greece dates back to the 5th century BC.  Lasted about 200 years.  And was the seed for Western Civilization.  Classical Greece was a collection of Greek city-states.  There was no Greek nation-state like the nation of Greece today.  The city-states were independent.  And often waged war against each other.  Especially Sparta and Athens.  Athens is where we see the beginnings of Western Civilization.  Sparta was a city-state of warriors.  While Athens kicked off science, math and democracy, Sparta bred warriors.  And boys trained from an early age.  Or were abandoned to die in the wilderness.

Adjacent to Classical Greece was the great Achaemenid Empire.  The First Persian Empire.  The empire of Cyrus the Great.  Which extended from the eastern Mediterranean all the way to India.  Some of those Greek city-states were on the eastern coast of the Mediterranean.  Did not like Persian rule.  And the Ionians revolted.  Supported by Athens.  The Ionian Revolt (499 BC) was the first in a series of Greco-Persian Wars.  Persia’s Darius the Great was tiring of the Greek’s insolence.  And set out to conquer the Greek mainland.  Only to get turned back at the Battle of Marathon.  His son Xerxes returned to Greece to complete the work his dad started.  King Leonidas of Sparta delayed him at the Battle of Thermopylae for three days.  But he defeated the vastly outnumbered Spartans and marched on to Athens.  Where he sacked the abandoned city.  But he would lose the subsequent Battle of Salamis naval engagement.  Losing his navy.  Forcing Xerxes to retreat.

The Greek city-states united to fight their common enemy.  And won.  With the common enemy defeated, Sparta and Athens returned to fighting each other.  In the Peloponnesian War.  Where Sparta emerged the dominant power.  But the constant fighting weakened and impoverished the region.  Making it ripe for conquest.  And that’s exactly what Phillip of Macedon did.  He conquered the great Greek city-states.  And Phillip’s son, Alexander the Great, succeeded his father and went on to conquer the Persian Empire.  Creating the great Hellenistic Period.  Where the known world became Greek.  Then Alexander died.  And his empire broke up.  Then the Romans rose and pretty much conquered everyone.  And the known world became Romanized.  Built upon a Greek foundation.  Until the western part of that empire fell in 476 AD.  Due in large part to the high cost of mercenary soldiers.  And a bloated bureaucracy.  That was so costly the Romans began to debase their silver coin with lead.  To inflate their currency to help them pay their staggering bills.

In Exchange for these Forced Loans the City-States Promised to Pay Interest

The history of the world is a history of its wars.  People fought to conquer new territory so they could bring riches back to their capital.  Or to defend against someone trying to conquer their territory.  And take their riches.  Taking riches through conquest proved to be a reliable system of public finance.  For the spoils of war financed many a growing empire.  It financed the Roman Empire.  And when they stopped pushing out their borders they lost a huge source of revenue.  Which is when they turned to other means of financing.  Higher taxes.  And inflation.  Which didn’t end well for them.

With the collapse of the Western Roman Empire the world took a step backwards.  And Europe went through the Dark Ages.  To subsistence farming on small manors.  The age of feudalism.  Serfs.  Wealthy landowners.  And, of course, war.  As the Dark Ages drew to a close something happened in Italy.  At the end of the 13th century.  The Italian Renaissance.  And the rise of independent Italian city-states.  Florence.  Siena.  Venice.  Genoa.  Pisa.  Much like the Greek city-states, these Italian city-states were in a state of near constant war with each other.  Expensive wars.  That they farmed out to mercenaries.  To expand their territory.  And, of course, to collect the resulting spoils of war.  These constant wars cost a pretty penny, though.  And built mountains of debt.  Which they turned to an ingenious way of financing.

These Italian city-states could not pay for these wars with taxes alone.  For the cost of these wars was greater than their tax revenue.  Leading to some very large deficits.  Which they financed in a new way.  They forced wealthy people to loan them money.  In exchange for these loans these city-states promised to pay interest.

Renaissance Italy gave us Government Bonds and a new way for a State to Live Beyond its Means

The vehicle they used for these forced loans was the government bond.  Used first by the Italian city-states of Venice and Florence.  Which were very similar to today’s government bonds.  Other than the being forced to buy them part.  The bond had a face value.  An interest payment.  And the bondholders could then buy and sell them on a secondary market.   The market set interest rates then as they do now.  The market determined the likelihood of the city-state being able to pay the interest.  And whether they would be able to redeem their bonds.

When there was excessive outstanding debt and/or war threatening a city-state’s ability to service their debt interest rates rose.  And the face value of existing bonds fell.  Because if the state fell these bonds would become worthless.  When state coffers were full and peace rang out interest rates fell.  And bond prices rose.  Because with a stable state their existing bonds would still be good.  Just like today.  So if you’re into government bonds you can thank Renaissance Italy.  And their wars.  Which gave birth to a whole new way for a state to live beyond its means.

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Stocks and Bonds

Posted by PITHOCRATES - January 9th, 2012

Economics 101

When Companies grow their Capital Requirements grow beyond a Bank’s Lending Ability

We note a civilization as being modern when it has vigorous economic activity.  Advanced economies around the world all have the same things.  Grocery stores.  Clothing stores.  Electronic stores.  Appliance stores.  Coffee shops and restaurants.  Factories and manufacturing plants.  And lots and lots of jobs.  Where people are trading their human capital for a paycheck.  So they can take their earnings and engage in economic activity at these stores, coffee shops and restaurants.

To buy things off of shelves in these stores things have to be on those shelves first.  Which means selling things requires spending money before you earn money.  Businesses use trade credit.  Such as accounts payable.  Where a supplier will give them supplies and send them an invoice typically payable in 30-90 days.  They will establish a credit line at their bank.  Where they will borrow from when they need cash.  And will repay as they collect cash (such as when their customers pay their accounts payable).  And take out loans to finance specific things such as a delivery van or restaurant equipment.

Businesses depend on their bank for most of their credit needs.  But when companies grow so do their capital requirements.  Where capital is large amounts of money pooled together to purchase property, buildings, machinery, etc.  Amounts so great that it exceeds a bank’s ability to loan.  So these businesses have to turn to other types of financing.  To the equity and debt markets.

Investors Invest in Corporations by Buying their Stocks and Bonds

Equity and debt markets mean stocks and bonds.  Where we use stocks for equity financing.  And bonds for debt financing.  Stocks and bonds allow a corporation to spread their large financing needs over numerous people.  Investors.  Who invest in corporations by buying their stocks and bonds.

When a business ‘goes public’ they are selling stock in their company for the first time.  We call this the initial public offering (IPO).  If the company has a very promising future this will bring in a windfall of capital.  As investors are anxious to get in on the ground floor of the next big thing.  To be a part of the next Microsoft.  Or Apple.  This is when a lot of entrepreneurs get rich.  When they are in fact the next big thing.  And if they are, then people who bought stock in their IPO can sell it on the secondary market.  Where investors trade stocks with other investors.  By buying low and selling high.  Hopefully.  If they do they get rich.  Because the greater a company’s profits the greater its value and the higher its stock price.  And when a company takes off they can sell their stock at a much higher price than they paid for it in the IPO.

When a corporation needs to borrow more than their bank can loan and doesn’t want to issue new stock they can sell bonds.  Which breaks up a very large amount into smaller amounts that investors can buy.  Typically each individual corporate bond has a face value of $1000.  (So a ten million dollar ‘loan’ would consist of selling ten thousand $1,000 bonds).  Like a loan a corporation pays interest on their bonds.  But not to a bank.  They pay interest to the investors who purchased their bonds.  Who can hold the bonds to maturity and collect interest.  Or they can trade them like stock shares.  (Changes in the interest rates and/or corporate financial strength can change the market value of these bonds.)  When a bond reaches maturity (say in 20 years) the company redeems their bonds from the current bondholders.  Hopefully with the new profits the bond issue helped to bring into the corporation.  Or they just issue new bonds to raise the money to redeem the older bonds.

A Company Usually has a Mix of Equity and Debt Financing that Balances all the Pros and Cons of Each

There are pros and cons to both equity and debt financing.  Selling stock transfers ownership of the company.  Sell enough so that someone can own more than 50% and that someone can replace the board of directors.  Who in turn can replace the CEO and the other corporate officers.  Even the business founder.  This is the big drawback of going public.  Founders can lose control of their company.

Stocks don’t pay interest.  So they are less threatening during bad economic times.  As business owners, stock shareholders are there for the long haul.  During the good times they may expect to collect dividends (like an interest payment).  During bad times they will wait it out while the company suspends dividend payments.  Or, if they lose confidence, they’ll try and sell their stock.  Even at a loss.  To prevent a future greater loss.  Especially if the corporation goes bankrupt.  Because stockholders are last in line during any bankruptcy proceedings.  And usually by the time they pay off creditors there is nothing left for the shareholders.  This is the price for the chance to earn big profits.  The possibility to lose everything they’ve invested.

Bonds are different.  First of all, there is no transfer of ownership.  But there is a contractual obligation to make scheduled interest payments.  And if they fail to make these payments the bondholders can force the company into bankruptcy proceedings.  Where a corporation’s assets can be liquidated to pay their creditors.  Including their bondholders.  Which, of course, often means the end of the corporation.  Or a major restructuring that few in management enjoy.

Stockholders don’t like seeing their share value diluted from issuing too many shares.  Bondholders don’t like to see excessive debt that threatens the corporation’s ability to service their debt.  So a company usually has a mix of equity and debt financing that balances the pros and cons of each.  A financing strategy that has been working for centuries.  That allows the advanced civilized world we take all too much for granted today.  From jetliners.  To smartphones.  To that new car smell.  For none of these would be possible without the capital that only the equity and debt markets can raise.

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LESSONS LEARNED #24: “You cannot lobby a politician unless he or she is for sale.” -Old Pithy

Posted by PITHOCRATES - July 29th, 2010

BUILDING A RAILROAD ain’t cheap.  It needs dump trucks of money.  Especially if it’s transcontinental.  And that’s what the Union Pacific and the Central Pacific were building.  Starting during the Civil War in 1863 (the year Vicksburg fell and Lee retreated from Gettysburg).  The Union Pacific was building west from Iowa.  And the Central pacific was building east from California. 

For the most part, Protestant, English-speaking Americans settled Texas.  Mexico had encouraged the American colonists to settle this region.  Because few Mexicans were moving north to do so.   The deal was that the colonists conduct official business in Spanish and convert to Catholicism.  They didn’t.  These and other issues soured relations between Mexico and the American Texans.  The Republic of Texas proclaimed their independence from Mexico.  America annexed Texas.  Mexico tried to get it back.  The Mexican-American War followed.  America won.  Texas became a state in 1845.  And that other Spanish/Mexican territory that America was especially interested in, California, became a state in 1850.  Hence the desire for a transcontinental railroad.

The U.S. government was very eager to connect the new state of California to the rest of America.  So they acted aggressively.  They would provide the dump trucks of money.  As America expanded, the U.S. government became the owner of more and more public land.  The sale of new lands provided a large amount of revenue for the federal government.  (Other forms of taxation (income taxes, excise taxes, etc.) grew as the amount of public lands to sell decreased.)  Land is valuable.  So they would grant the railroad companies some 44 million acres of land (i.e., land grants) for their use.  The railroad companies, then, would sell the land to raise the capital to build their railroads.  The government also provided some $60 million in federal loans.

But it didn’t end there.  The federal government came up with incentives to speed things up.  They based the amount of loans upon the miles of track laid.  The more difficult the ground, the more cash.  So, what you got from these incentives was the wrong incentive.  To lay as much track as possible on the most difficult ground they could find.  And then there were mineral rights.  The railroad would own the property they built on.  And any minerals located underneath.  So the tracks wandered and meandered to maximize these benefits.  And speed was key.  Not longevity.  Wherever possible they used wood instead of masonry.  The used the cheapest iron for track.  They even laid track on ice.   (They had to rebuild large chunks of the line before any trains would roll.)  And when the Union Pacific and Central Pacific met, they kept building, parallel to each other.  To lay more miles of track.  And get more cash from the government.

PAR FOR THE COURSE.  When government gets involved they can really mess things up.  But it gets worse.  Not only was government throwing dump trucks of American money down the toilet, they were also profiting from this hemorrhaging of public money.  As shareholders in Crédit Mobilier.

Thomas Durant of Union Pacific concocted the Crédit Mobilier Scandal.  As part of the government requirements to build the transcontinental railroad, Union Pacific had to sell stock at $100 per share.  Problem was, few believed the railroad could be built.  So there were few takers to buy the stock at $100 per share.  So he created Crédit Mobilier to buy that stock.  Once they did, they then resold the stock on the open market at prevailing market prices.  Which were well below $100 per share.  Union Pacific met the government requirements thanks to the willingness of Crédit Mobilier to buy their stock.  The only thing was, both companies had the same stockholders.  Crédit Mobilier was a sham company.  Union Pacific WAS Crédit Mobilier.  And it gets worse.

Union Pacific chose Crédit Mobilier to build their railroad.  Crédit Mobilier submitted highly inflated bills to Union Pacific who promptly paid them.  They then submitted the bills to the federal government (plus a small administration fee) for reimbursement.  Which the federal government promptly paid.  Crédit Mobilier proved to be highly profitable.  This pleased their shareholders.  Which included members of Congress who approved the overbillings as wells as additional funding for cost overruns.  No doubt Union Pacific/Crédit Mobilier had very good friends in Washington.  Including members of the Grant administration.  Until the party ended.  The press exposed the scandal during the 1872 presidential campaign.  Outraged, the federal government conducted an investigation.  But when you investigate yourself for wrongdoing you can guess the outcome.  Oh, there were some slaps on the wrists, but government came out relatively unscathed.  But the public money was gone.  As is usually the case with political graft.  Politicians get rich while the public pays the bill.

(Incidentally, the investigation did not implicate Ulysses Grant.  However, because members of his administration were implicated, this scandal tarnished his presidency.  Grant, though, was not corrupt.  He was a great general.  But not a shrewd politician.  Where there was a code of honor in the military, he found no such code in politics.  Friends used his political naivety for personal profit.  If you read Grant’s personal memoirs you can get a sense of Grant’s character.  Many consider his memoirs among the finest ever written.  He was honest and humble.  A man of integrity.  An expert horseman, he was reduced to riding in a horse and buggy in his later years.  Once, while president, he was stopped for speeding through the streets of Washington.  When the young policeman saw who he had pulled over, he apologized profusely to the president and let him go.  Grant told the young man to write him the ticket.  Because it was his job.  And the right thing to do.  For no man, even the president, was above the law.)

THE FINANCIAL WORLD fell apart in 2007.  And this happened because someone changed the definition of the American Dream from individual liberty to owning a house.  Even if you couldn’t afford to buy one.  Even if you couldn’t qualify for a mortgage.  Even, if you should get a mortgage, you had no chance in hell of making your payments.

Home ownership would be the key to American prosperity.  Per the American government.  Build homes and grow the economy.   That was the official mantra.  So Washington designed American policy accordingly.  Lenders came up with clever financing schemes to put ever more people into new homes.  And they were clever.  But left out were the poorest of the poor.  Even a small down payment on the most modest of homes was out of their range.  Proponents of these poor said this was discriminatory.  Many of the inner city poor in the biggest of cities were minority.  People cried racism in mortgage lending.  Government heard.  They pressured lenders to lend to these poor people.  Or else.  Lenders were reluctant.  With no money for down payments and questionable employment to service these mortgages, they saw great financial risk.  So the government said not to worry.  We’ll take that risk.  Fannie Mae and Freddie Mac would guarantee certain ‘risky’ loans as long as they met minimum criteria.  And they would also buy risky mortgages and get them off their books.  Well, with no risk, the lenders would lend to anyone.  They made NINJA loans (loans to people with No Income, No Job, and no Assets).  And why not?  If any loan was likely to default it was a NINJA loan.  But if Freddie or Fannie bought before the default, what did a lender care?  And even they defaulted before, Fannie and Freddie guaranteed the loan.  How could a lender lose?

Once upon a time, there was no safer loan than a home mortgage.  Why?  Because it would take someone’s lifesavings to pay for the down payment (20% of the home price in the common conventional mortgage).  And people lived in these houses.  In other words, these new home owners had a vested interested to service those mortgages.  Someone who doesn’t put up that 20% down payment with their own money, though, has less incentive to service that mortgage.  They can walk away with little financial loss.

ARE YOU GETTING the picture?  With this easy lending there was a housing boom.  Then a bubble.  With such easy money, housing demand went up.  As did prices.  So housing values soared.  Some poor people were buying these homes with creative financing (used to make the unqualified qualify for a mortgage).  We call these subprime mortgages.  They include Adjustable Rate Mortgages (ARMs).  These have adjustable interest rates.  This removes the risk of inflation.  So they have lower interest rates than fixed-rate mortgages.  If there is inflation (and interest rates go up), they adjust the interest rate on the mortgage up.  Other clever financing included interest only mortgages.  These include a balloon payment at the end of a set term of the full principal.  These and other clever instruments put people into houses who could only afford the smallest of monthly payments.  The idea was that they would refinance after an ‘introductory’ period.  And it would work as long as interest rates did not go up.  But they went up.  And house prices fell.  The bubble burst.  Mortgages went underwater (people owed more than the houses were worth).  Some people struggled to make their payments and simply couldn’t.  Others with little of their own money invested simply walked away.  The subprime industry imploded.  So what happened, then, to all those subprime mortgages?

Fannie and Freddie bought these risky mortgages.  And securitized them.  They chopped and diced them and created investment devices called Collateralized Debt Obligations (CDOs).  These are fancy bonds backed by those ‘safe’ home mortgages.  Especially safe with those Fannie and Freddie guarantees.  They were as safe as government bonds but more profitable.  As long as people kept making their mortgage payments.

But risk is a funny thing.  You can manage it.  But you can’t get rid of it.  Interest rates went up.  The ARMs reset their interest rates.  People defaulted.  The value of the subprime mortgages that backed those CDOs collapsed, making the value of the CDOs collapse.  And everyone who bought those CDOs took a hit.  Investors around the globe shared those losses. 

Those subprime loans were very risky.  Lenders would not make the loans unless someone else took that risk.  The government took that risk in the guise of Fannie and Freddie.  Who passed on that risk to the investors buying what they thought were safe investments.  Who saw large chunks of their investment portfolios go ‘puff’ into thin air.

SO WHAT ARE Freddie and Fannie exactly?  They are government-sponsored enterprises (GSEs).  They key word here is government.  Once again, you put huge piles of money and government together and the results are predictable.  In an effort to extend the ‘American Dream’ to as many Americans as possible, the federal oversight body for Freddie and Fannie lowered the minimum criteria for making those risky loans.  Even excluding an applicant’s credit worthiness from the application process (so called ‘no-doc’ loans were loans made without any documentation to prove the credit worthiness of the applicant.)  To encourage further reckless lending.  Ultimately causing the worst financial crisis since the Great Depression. 

And, of course, members of Congress did well during the good times of the subprime boom.  They got large campaign contributions.  Some sweetheart mortgagee deals.  A grateful voting bloc.  And other largess from the profitable subprime industry.  Government did well.  Just as they did during the Crédit Mobilier Scandal.  And the American taxpayer gets to pay the bill.  Some things never change.  Government created both of these scandals.  As government is wont to do whenever around huge piles of money.  For when it comes to stealing from the government, someone in the government has to let it happen.  For it takes a nod and a wink from someone in power to let such massive fraud to take place. 

www.PITHOCRATES.com

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FUNDAMENTAL TRUTH #11: “Before you condemn capitalism, imagine a world without professional sports, movies, cell phones and tampons.” -Old Pithy

Posted by PITHOCRATES - April 27th, 2010

PEOPLE HAVE SOME strong opinions about capitalism.  Both good and bad.  So what is it?  What is capitalism?

Merriman Webster OnLine defines it as:

An economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market.

To explain this let’s start by explaining what it replaced.  In fact, let’s go further back.  A few hundred years when life truly sucked by our standards.  During the Middle Ages, people barely lived.  People worked very hard and had little time off.  When they did they usually spent it sleeping, being sick, dying or being dead.  You grew or killed what you ate.  You built your own house.  You made your own clothes.  You died probably no further than a short walk from where you were born.  And you worked your whole life somewhere in between.

Think of peasant or serf.  That’s what most were.  Tied to the land.  You had no choices.  If you were born on the land you worked the land.  Until you died.  The land owned you and someone owned the land.  You worked the land at the grace of the owner.  You helped produce his food and, in return, he let you have a small parcel of land to grow your food.  There was a bond of loyalty between landlord and tenant.  Land and protection in exchange for backbreaking, never-ending labor.  Doesn’t sound good until you consider the alternative.  Death by famine.  Or death by murder at the hands of roving bands of outlaws.

Improvements in farming led to more food production.  Eventually, there were food surpluses.  This meant not everyone had to farm.  Some could do other things.  And did.  They became specialists.  Artisans.  Craftsmen.  Cities grew in response to commerce.  People went to market to trade for things they wanted.  Then they started using money, which made getting the things they wanted easier (it’s easier to go to the market with a coin purse than with a sack of grain or a side of beef).  Life got better.  People enjoyed some of it.

THUS BEGAN THE rise of a middle class.  Those city folk making things or doing something.  They were good at what they did and people gladly paid for what they did.  These specialists then improved what they did and thought of new things to do.  They created things to make their work easier.  These individual specialists grew into manufacturing shops.  The cost of production only limited their output.  And banking solved that problem.

Alexander Hamilton, one of America’s Founding Fathers, was a capitalist.  And he thought big.  Money is nice but what can it get you?  A few things for the home?  Something for the wife?  Maybe some new farm tools.  Good stuff, yes, but nothing big.  Lots of little sums of money all over the place can buy lots of little things.  But when you pool lots of little sums of money you get one big-ass pile of it.  That money is now capital.  And you can do big things with it.

And that’s what banking has given us.  People with ideas, entrepreneurs, could now borrow money to bring their ideas to market.  And this is, in a nutshell, capitalism.  The free flow of ideas and capital to make life better.  Making life better wasn’t necessarily the objective; it’s just the natural consequence of people mutually partaking in a free market.

BUT WHAT ABOUT the Soviet Union?  Didn’t they do big things, too?  They built jetliners.  They had a space program.  They had factories.  They did these and other things without capitalism.  They did these things for the good of the people, not for profits.  Isn’t that better?

Talk to someone who wiped their ass with Soviet-era toilet paper.  Let me save you the trouble.  It didn’t feel good.  Unless you enjoy the feel of sandpaper back there.  And to add insult to injury, you had to wait in line to get that toilet paper.  If it was available.

When you think of the Soviet economy you have to think of stores with empty shelves and warehouses full of stuff no one wants.  This is what a command economy does for you.  Some bureaucrat, not the consumer, determines what to sell.  And one person simply cannot figure out what a hundred million plus want.  To get an idea of how difficult this is, pick a movie that 4 of your friends would love to see.  Pick a couple of guys and a couple of girls.  For diversity.  And remove the possibility of sex completely from the equation.  Now pick.  Not so easy, is it?  Now try to pick a movie a hundred million people would love to see.  Can’t do it, can you?  No one can.  Because people are diverse.  One size doesn’t fit all.

Soviet president Mikhail Gorbachev asked Margaret Thatcher how she made sure her people had enough food to eat.  The Soviets were having difficulty feeding theirs.  In fact, they were importing grain from their archenemy.  The United States.  The answer to Gorbachev’s answer was that Thatcher did nothing to feed her people.  The free market fed her people.  Capitalism.

As far as those other big things the Soviets did, they acquired a lot of the knowledge to do those things through an elaborate network of espionage.  They stole technology and copied it.  And they were the first into space because their captured Nazi rocket scientists did it before our captured Nazi rocket scientists did.  (The seed of the space industry was the Nazi V-2 rocket that reigned terror on London and other cities during World War II).

(Lest you think that I’m ripping on the Soviet/Russian people, I’m not.  Just their economic system during the Soviet era.  Their people have suffered.  And persevered.  It was them after all who first threw back Napoleon in Europe.  And it was them who first threw back the Nazis in Europe.  They gave us Pyotr Ilyich Tchaikovsky, Sergei Rachmaninoff, Leo Tolstoy, Fyodor Dostoyevsky, Mikhail Dolivo-Dobrovolsky and, of course, Maria Sharapova to name just a few of the greats.  Good people.  Just sometimes bad government.  As in most nations.  Even in the U.S.)

SO WHAT IS the basic difference between capitalism and a command economy like that of the former Soviet Union?  Probably the freedom to take and accept risk.  Bankers take a risk in loaning money.  They analyze the risk.  If the return on the loan is greater than the risk, they’ll make the loan.  It’s their call.  And they’re pretty good.  Their successes are far greater than their failures.

Some loans are riskier than others.  There’s a greater chance of failure.  But it could also be the next, say, Microsoft.  Or Apple.  If so, even though there’s great risk, the potential of reward is so great that people will want to loan money.  They’ll buy junk bonds (high risk/high yield) or an initial public offering of stock.  They’ll risk their money for a greater return on their investment.  If it pays off.  And they don’t always do.  But good ideas with potential typically find financing.  And investors typically make more money than they lose.  It’s a pretty good system.  Capitalism.

WHEN YOU HAVE risk takers who choose to participate in the free flow of ideas and capital, great things happen.  Modern AC electrical power that we take for granted is invented (thank you Nikola Tesla for the genius and George Westinghouse for taking the risk).  You develop modern commercial jet aviation (thank you Boeing for the 707, 727, 737, 747, well, you get the picture).  You transform the world when you add impurities to semiconducting material and sandwich them together (thank you John Bardeen, Walter H. Brattain and William B. Shockley for the transistor).

These great things, along with others, give us professional sports (stadiums, transportation to and from the stadium, jetliners to take teams to other stadiums, oil exploration and refining for jet and car fuel, etc.).  They give us movies (financing, cameras and production equipment, special effects, theaters, popcorn, DVDs for home viewing, etc.).  They give us cell phones (cellular towers, switching networks, compact and long lasting batteries, interactive handheld devices, voicemail, email, texting, etc.).  And they liberated women to do whatever they want wherever they want by making feminine hygiene protection portable and plentiful (mass production, rail and truck transport, retail and vending outlets, etc.) and by providing convenient privacy (public toilet facilities with vending machines and disposal bins). 

Imagine any of these things provided by the same people who renew our driver’s license.  Do you think any of it would be as good?  Or do you think it would be more like Soviet-era life?  There’s so much we take for granted in capitalism because we can.  It’s a system that works on basic human nature.  It doesn’t require sacrifice.  It doesn’t depend on consensus.  It just needs the free flow of ideas and capital.  And great things follow.

www.PITHOCRATES.com

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