Author: sgstofka

Budget Buster

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In his weekly WSJ Capital column of 4/9/09, David Wessel reviews the CBO projections for President Obama’s proposed budget.

“The issue isn’t today’s deficit. Deficits are supposed to widen at times like this. The issue is the size of the deficit .. when the recession is past.” A CBO graph of U.S. debt, the deficit, is not pretty going forward. In 2007, the deficit was a little over a third of GDP. It is projected to go to 54% of GDP.

Rising health care cost have become the primary concern of budget projections, as the Director of the CBO notes. “Over the past 30 years, total national spending on health care has more than doubled as a share of GDP.” That doubling is not double the cost, but double the percentage of GDP. GDP has grown six-fold, meaning that health care costs have risen by a factor of 12.

This CBO graph from January 2009 of Debt Held by the Public as a Percentage of GDP from 1968 to 2010 is interesting. (Scroll down a few graphs to get to this one) Now look at a comparison of the January projection and the revised projection based on Obama’s budget. By 2012, projected Federal revenues will be about 18% of GDP and continue at that level for 7 years, till 2019. Spending will be 23% of GDP and climb to almost 25% of GDP.

Wessel notes that “Republicans, such as Wisconsin Rep. Paul Ryan, counter with proposals that combine tax cuts with spending cuts so severe that even a Republican Congress probably wouldn’t pass them – and still show significant deficits through 2019. So either taxes as a share of GDP rise or spending on those popular benefit programs (or everything else) is throttled back.” Wessel concludes his article with a sobering summary: “For 15 years, the Americans people have been told they could have it all. They deserve to be told that they can’t have it all in the future.”

For a historical perspective, take a look at CBO projections in 2003, forecasting an approx $16B GDP in 2009 and an unemployment rate of 5.2%. Recent, and more accurate, projections for 2009 are $14.2B in GDP with an unemployment rate of 8.3%.

As we can see, projected deficits for the coming years look bad and those projections do not take into account unpredictable events like another attack on the U.S., an escalation of violence in Iraq, a continuing cascade of business failure leading to unemployment above 10%.

Every year the Social Security Administration sends each of us a statement of projected monthly benefits when we retire. Don’t count on getting all of that.

The Tax Man Cometh

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In a 4/10/09 WSJ op-ed, Nina Olson, the national taxpayer advocate at the IRS, presents her case for a simpler tax code.

Her office estimates that taxpayers and businesses spend 7.6 billion hours complying with IRS tax code. This does not include state and city tax codes. That amount of hours would make tax compliance one of the largest in the U.S., requiring 3.8 million full-time workers.

Her office calculates that taxpayers spend the dollar equivalent of 14% of the income tax collected to meet tax code requirements.

Her recommendations as guiding principles for tax reform:
Don’t create traps for the unwary.
Simple enough that a single form can be used to report tax liability.
Anticipate areas of non-compliance and make it less inviting.
Some choices, but too many are confusing.
Refundable credits should be simpler to understand, apply for and administer.
Incorporate a periodic review of the tax code.

I have a better idea. No Federal income taxes. Politicians are wanna be car mechanics. As long as they breathe, they will want to amend the tax laws in order to “fix” something.

If there are no income taxes, how to replace the $1.4T – $1.5T in personal and corporate income taxes? Tax stock and bond trades.

In the five day period ending 2/18/09, daily average total notational volume was $229B on 10 million shares traded per BATS. This volume included the Chicago Options Exchange, NYSE, Nasdaq, Boston Exchange, International Stock Exchange. That is $229B traded in one day. 1/2 of 1% (.005) of that trading volume would be $1.145B. There were 250 trading days in 2008 = $1.145B per day * 250 days = $286B. For an individual making a $10,000 stock purchase, that would be a $50 fee.

The volume of bonds sold dwarfs that of the stock market. Construct a smaller percentage fee structure for the bond market. Financial institutions who buy and sell securities with the savings deposits of their customers would pass the cost on to their customers in the form of lower interest returns. Those institutions who traded less would incur less cost and theoretically be able to offer their customers a slightly higher return.

While there will always be the issue of non-compliance, the problem will be greatly reduced, thereby enhancing revenues. Inevitably, there will be investment banks who will construct legal dodges but the IRS should be able to deal with these much more straightforwardly than they currently do with the complexity of the tax code.

Under this simple system, we would implicitly be taxing those who have more than others. That is essentially what this country does with all the complexity of its tax code. Let’s admit it and at least make it simple.

Three Days of the Condo

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Like Robert Redford’s character in the movie “Three Days of the Condor”, some condo developers may feel like they went out to the deli to get a few things and, when they got back, found that the world had changed drastically.

Fannie Mae, the quasi-government agency that backs a majority of the mortgages in the U.S., announced that, effective March 1st, it would stop “guaranteeing mortgages in condo buildings where fewer than 70% of the units have been sold”, according to the weekly Property Report in WSJ, 3/18/09. The previous minimum was 51% units sold.

A N.Y. real estate firm “estimates that 93,000 new condo units will be completed this year, a 28% increase in new inventory from last year.” At the end of 2008, there was a 14 month condo supply, a decade long high. Some developers are turning their buildings into rental apartments. There is demand for the condos but a lack of financing. Some buyers, who put down deposits on unfinished condos, are walking away.

We interrupt this broadcast to bring you an important message from History, a sponsor of our show, the Present:
“Sales of apartment buildings to condo converters reached a record $13.3 billion last year, up from $3 billion in 2003, according to Real Capital Analytics.” This was reported in a NY Times article in May 2005.

The article notes that “the trend is driven by low mortgage interest rates that have encouraged renters to become homeowners, leaving landlords in many areas with falling occupancy rates and forcing them to lower rents and make other concessions to keep their buildings full.”

Office Vacancies

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Thought the housing market was bad?

WSJ reported 4/3/09 that the office vacancy rate for the U.S. rose to 15.2% for the first quarter of 2009, up from 14.5%. Three years ago, in the first quarter of 2006, it was 7.1%, according to Reis. The vacancy rate has been rising for almost two years.

In 2006, Reis analyzed construction and absorption of newly constructed space, as well as economic and demographic trends, and predicted an 11% vacancy rate in 2009. However, their predictions were that vacancy rates would be falling from a high of 12% in 2007.

2008 turned out to be the “rare event”, that event in any series of events that throws off all projections. Job layoffs have been responsible for the glut of supply of office space being dumped on the market. If U.S. companies shed another 1.5 million jobs in 2009, the supply of vacant office space may push the vacancy rate to 20%.

CEO Chairman Split

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A long time shareholder proposal at many large U.S. companies has been to separate the roles of CEO and Chairman. CEOs resist this “attack” on their power by the owners of the company.

Joann Lublin reports in a 3/30/09 WSJ article that corporate leaders are now recognizing that splitting these two roles would help companies perform better. The article cites a Corporate Library report that “37% of companies in the Standard and Poor’s 500-stock index have separate chairmen and CEOs, up from 22% in 2002”.

Many European companies have these roles split. U.S. corporate bylaws are structured so that it is difficult for a stockholder proposal challenging the CEO to win a majority of votes. Many mutual fund shares are not voted, defaulting the vote to the company’s management.

Many CEOs want tight control of the corporation, believing in the strength of their vision and execution. When the company’s performance doesn’t measure up, these CEOs look more like a wily fox with a key to the hen house. The shareholders get a key to the poor house.

CEO Pay Survey

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On April 3rd, 2009 WSJ reported the results of their annual CEO Pay Survey.

Median salary and bonus in 2008 was $2.24M, a drop of 8.5% from the previous year. But that’s not the total package. Total CEO compensation also includes stock, stock options, stock appreciation rights (SAR), restricted stock units (RSU) and other long term incentives. That brought the median figure to $7.6M, a drop of only 3.4%.

Long time shareholders, who dutifully read the annual reports of the companies whose shares they own, will recognize this decades long ploy. No matter how much the company’s profits drop, most CEOs find a way to dip into the pockets of the owners, the shareholders of the company. The footnotes to the financial statements are where shareholders may find that performance goals for the CEO were changed during the year to reflect the “challenging environment”. The company’s profit may have fallen by 50% but the CEO met these new performance goals, enabling them to take home a fat bonus or other incentive. In short, shareholder dividends are reduced and the money put into the pockets of the executives.

Shareholders who have joined together to protest these sham practices are effectively brushed off by the executives. Mutual fund managers who, by proxy of the funds customers, own a sizeable portion of the company’s stock, are reluctant to confront the executives of the company to demand changes. The board can often be comprised of those who are either allies of the CEO or unlikely to challenge the CEO – a practice called “packing the board”. Some CEOs defend this practice as being in the “long term interests” of the shareholders on the basis that the board and CEO agree on the strategic approach to running the company.

The board, whose duty is to act in the interests of the shareholders, are reluctant to confront the CEO and, in effect, act in the interests of the top executives. An example of this practice is Rick Wagoner, the recently ousted chairman and CEO of General Motors (GM). When Wagoner assumed the role of Chairman in addition to his duties as CEO, seven out of 11 directors were replaced. For an interesting look back on this example of the principal-agent problem, see this 2005 Slate article.

There may be some hope for shareholders. The anger over AIG has “given boards the backbone to write stricter standards on pay”, reports WSJ.

As a disclaimer, I used to be a GM shareholder several years ago. I got wise to Wagoner for a small cost.

Cheating

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Investigations into the origins of the credit and housing crisis have revealed that it was a confluence of cheating.

AIG, the mega insurance company and hedge fund, bundled bad mortgage loans with good and wrapped the resulting loan package with a AAA safe credit paper of approval. Under pressure from the banks that securitized housing loans, ratings agencies developed an underwriting formula that would stamp these products as safe. Some mortgage brokers falsified credit applications for home loans or encouraged home buyers to do so. Home buyers fudged their income and expenses to buy houses that they could not afford.

Dan Ariely, a behavioral economist who wrote Predictably Irrational, reveals the results of several experiments on cheating in this video, beginning from about the 5 minute marker and ending at the 13 minute marker in the video.

Household Debt

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David Greenberg, author of Nixon’s Shadow in WSJ 3/21/09: “Reagan was struggling to pass his tax cuts when John Hinckley’s bullets landed him in the hospital. The outpouring of sympathy, aided by Reagan’s winning bedside humor, buoyed his popularity and helped him win a big victory. But that success didn’t foreshadow any continued mastery of Congress; his relations with the Democratic House, and later, the Senate, would deteriorate.”

For the first 6 years of the two term Reagan presidency, the Republicans controlled the Senate while the Democrats controlled the House. The last two years of his presidency, the Democrats controlled both houses.

In 1980, total Federal receipts, including Social Security taxes of almost $120B, were $517B. In 1988, total receipts were $909B, including SS taxes of almost $264B (U.S. Dept of Treasury).

In 1980 the Federal Debt was $907.7B; in 1988 it was $2602.3B. The deficit had almost tripled.

At the end of 1980, the CPI-U index was 86. It was 120 when Reagan left office.

In 1988, the top marginal tax rate was 28%. In 1980, it was 70%. Some argue that lowering tax rates dramatically raises tax revenues. The data above shows that tax revenues did increase, although the increase was not dramatic. Excluding Social Security tax receipts and adjusting for inflation, net tax revenues increased 16% in 8 years. Will lowering marginal income tax rates always produce increased tax revenues? Is there some optimal income tax rate? I’ll look at different theories on that subject in a future blog.

How much of this tax revenue increase came from capital gains taxes? The Dow Jones index stood at 930 when Reagan took office. It was 2239 when he left. I will take a look at that in a later blog but here is a 1997 congressional committee discussion of capital gains tax rates.

The data does show one very clear point. Increasing tax revenues can not offset runaway spending.

Buffett Sense

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Berkshire Hathaway, the holding company headed by Warren Buffett and Charlie Munger, owns Clayton Homes, the largest producer of manufactured housing in the U.S. Clayton Homes finances almost 200,000 homeowners. The market they serve is below average in credit risk and with a thin cushion, at best, when times get tough.

From Warren Buffett’s annual letter to shareholders: “[Clayton’s homeowners’] median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated ‘sub-prime.'” Yet, they have had no unexpected losses.

The “delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.” In contrast, TransUnion reported that the national average for mortgage delinquency was 4.58%.

“Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.”

“The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down paymentof at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.”

“Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”

Amen, Warren.

House Walkaway

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The following is not a script from a Monty Python episode.

In a 3/29/09 NY Times article, Susan Saulny reports: “Banks are quietly declining to take possession of properties at the end of the foreclosure process, most often because the cost of the ordeal – from legal fees to maintenance – exceeds the diminishing value of the real estate.”

After vacating the house in anticipation of foreclosure, the “former” homeowner finds that, to the city, they are still the “current” homeowner and the city wants them to clean up and maintain the abandoned property.

It does sound like the “dead parrot” episode from Monty Python, doesn’t it?