unsettling economics

Regarding the meltdown in Bear Stearns’ The Economist writes:

“But perhaps the most worrying thing for financial institutions holding mortgage-backed paper is not the subprime market itself, but the unnerving parallels with an even bigger one to which they are also exposed: leveraged loans to companies. As Daniel Arbess of Xerion Capital Partners points out, corporate lending’s giddy leverage echoes the high loan-to-value ratios in subprime; the explosion of “covenant-lite” deals and payment-in-kind notes mirrors that of interest-only and negative-amortisation mortgages; and leveraged buy-outs have their own form of mortgage refinancing in the so-called dividend recapitalisation. Subprime, says Mr Arbess, might well be “a dress rehearsal for something bigger and scarier.”

http://economist.com/finance/displaystory.cfm?story_id=9378742

This is a very important analysis of one crucial weak spot in the whole private equity setup. When the deal is started, the takeover artists borrow money from the banks — a bridge loan to pay off the shareholders. Then the LBO and the banks sell bonds to the public to pay off the bridge loans.

The banks make hefty fees. The people who buy the bonds also profit royally — so long as the bonds are paid off. The problem is that the companies are so loaded up with debt that they may have difficulty in paying off the debt.

Now the people who are supposed to buy the bonds are catching on, possibly leaving some of the banks holding the bag. Will you cry for them? Read more »

In January 2006, the Patent Office released its annual announcement of Top 10 Organizations Receiving Most U.S. Patents. They were, in descending order: International Business Machines Corporation, Canon Kabushiki Kaisha; Hewlett-Packard Development Company; Matsushita; Samsung; Micron Technology; Intel Corporation, Hitachi, Toshiba, and Fujitsu Limited.

In short, the U.S. has 4 representatives out of 10. While I have attacked the patent system in Steal This Idea, the low ranking of the U.S. companies reflect the energies that go into short run financial manipulation rather than investing for the long run.

http://www.uspto.gov/web/offices/com/speeches/06-03.htm

Soon afterwards, the agency announced that it would cease issuing this information.  It claims that the quality of patents is more important than the quantity, without giving any indication of how a quality measure would come out.

United States Patent and Tradmark Office. 2007. “USPTO Statement on Ceasing Annual Top 10 Patents Holders List (24 January).

http://www.rethinkip.com/rssmojo/archives/uspto_statement_on_ceasing_annual_top_10_patents_holders_list_22jan2007.html

Today’s Wall Street Journal has a good article regarding Collateralized Loan Obligations, which are bundles of loans which are then divided up according to the degree of risk. The CLOs allow companies taken over by private equity operators to float the enormous debt that makes the deals work.

The most risky parts of the securities pay very high interest rates, which make them appealing to pension funds that want to register high rates of return — the problem is they’re very risky. My own pension fund, California’s Public Employee Retirement System, which has a very good record, is putting money into these very risky investments. I assume it is not a major portion, but it lost a bundle on Enron.

The article cites two authorities supporting the CLOs:

“CLOs have been lauded by former Federal Reserve chairman Alan Greenspan and others for dispersing risk. Michael Milken, whose underwriting of junk bonds at Drexel Burnham Lambert Inc. during the 1980s ignited that decade’s buyout boom, has said that CLOs are among the most important financial innovations of the past quarter century.”

Milken, of course, went to jail for his shenanigans, but remained a billionaire. Greenspan for all his supposed genius earned $40,000 for writing a letter in support of Charles Keating’s Lincoln Savings and Loan. He also recommended variable-rate mortgages as beneficial for consumers — some of which no doubt have lost their homes.

So, perhaps we should take Journal’s warning to heart, and be leery of the impending consequences are bursting bubble.

Ng, Serena and Henny Sender. 2007. “CLOs Spark Worries of Volatility and Risk; Loan Standards Loosen.” Wall Street Journal (26 June): p. A. 1

I’m trying to get caught up with the unread journals piling up on my couch. Last night I rummage through the May issue the American Economic Review with the papers from the most recent conference, organized by Thomas Sargent. With the glaring exception of a paper by James Heckman on education, I found very little of interest. Usually, the papers and proceedings have at least a few good sessions.

Today I picked up the March issue with a address by the past president, George Akerlof. What a stunning contrast! Akerlof trounces the abstract nonsense that passes for economic theory today. He rummages other social sciences order to inject some realism back into economics.

I understand my own sense of isolation within the discipline; I wonder how George must feel.

Keynes, General Theory

158-9: As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation … is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, ‘for income’; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

This article describes “Future Combat Systems …. a vast computerized network, FCS would link soldiers and commanders to a galaxy of sensors, satellites, robots, drones, and armored vehicles, both manned and unmanned.” The project requires 63 million lines of code and the price tag has already more than doubled since 2003.

The government has already abandoned its FBI software overhaul. Imagine how buggy this would be. Microsoft has had 20 years since Windows 95 was released. Vista has 50 million lines of code.

According to a 1988 presentation by Nance Goldstein, the Air Force claimed that software problems were responsible for 7 of 10 weapon systems in trouble in 1983; see USAF. 1983. Report of the USAF Advisory Board Ad Hoc Committee on the High Cost of
Mission-Critical Software.

A blue screen of death on a FCS system might not be a metaphor. The military already has a poor record of targeting.

Also, this system has another interesting feature. The lead contractor, Boeing, has designed the vehicles to be to heavy to fly on the intended Lockheed C-130 planes. Only the Boing C-17’s are capable of carrying the load. What follows are notes from Business Week and the GAO.  The GAO information also appeared in Business Week. Read more »

Not really. Here is how BusinessWeek sums up the dysfunctional management structure that Ford:

Kiley, David. 2007. “The New Heat On Ford.” Business Week (4 June): pp. 33-38.

36: “In the royal hierarchy at Ford, an elaborate system of employment grades clearly established an employee’s rank in the pecking order. The grades also had the unintentional effect of quashing ideas and keeping information tightly controlled. When (Mark) Fields, now president of Ford Americas, first arrived at the company from IBM in 1989, he couldn’t make a lunch date with an executive who held a higher grade. People asked him what his grade was “as a condition of including me or socializing with me,” Fields recalls. And he was discouraged from airing problems at meetings unless his boss approved first.”

36: Ford … is today: a balkanized mess. It has four parallel operating units worldwide, each with its own costly bureaucracy, factories, and product development staff. According to a Mulally (Alan Mulaly, CEO) audit designed to uncover cost-cutting opportunities, no two vehicles in Ford’s lineup share the same mirrors, headlamps, or even such mundane pieces as the springs and hinges for the hood. And that’s just taking into account the Ford brand. Add Volvo, Jaguar, and Land Rover to the mix, and the company has more than 30 engineering platforms worldwide. That leaves Ford at a big cost disadvantage.”

36: “Examples of Ford losing opportunities because of its byzantine corporate structure abound. A recent example involves Sync, a system that allows voice-command control of a cell phone and MP3 player. It was a big success at last January’s North American International Auto Show. Ford developed it with Microsoft Corp. last year and will start rolling it out this fall. Although Volvo and Land Rover are also dying to offer Sync, neither will get the system because the electrical architectures of the Swedish and British cars are incompatible with Ford’s. Mulally finds that incomprehensible, considering that Ford has owned the European brands for nearly a decade.”

This video shows how you can appear to be recruiting Americans so that you can get to hire a cheaper employee from elsewhere.

http://www.youtube.com/watch?v=TCbFEgFajGU&eurl=http%3A%2F%2Fwww%2Ebusinessweek%2Ecom%2F%40%405m5Us2UQmD726gAA%2Fbwdaily%2Fdnflash%2Fcontent%2Fjun2007%2Fdb20070621%5F912042%2Ehtm%3Fchan%3Dtop%2Bnews%5Ft

Economics has long prided itself as a science, modeled after physics. From time to time, the glaring differences between economics and physics become embarrassingly apparent. I was just reading a review by Herb Gintis that reminded me of another comparison between the two disciplines which described a meeting between physicists and economists.

Gintis’s review recalls his experience reading two graduate texts, one on quantum mechanics and another on economics. Read more »