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Tuesday, December 5, 2017

Will the Tax Cut Make a Difference?



By Roy C. Smith

Leaving aside how the sausage got made, the Trump administration got its tax cut and all the bragging rights related to it. But will it boost growth?

Here are some things we know already. The US economy has recovered momentum in the last two quarters, perhaps inspired by Mr. Trump but it is hard to tell. Goldman Sachs is now optimistically forecasting a 2.5% growth rate in 2018, a big improvement from the average of 2% for the last decade. Goldman Sachs includes in its forecast a growth pickup of 0.3% from the tax cuts. This is nice, but seems rather small for a tax cut that, even with dynamic scoring (that takes the new growth into account), still has a price tag of about $1 trillion to be added to the national debt.

There is, however, a lot of uncertainty with this tax bill which favors the corporate sector over consumers. Most of the tax revenues from corporations come from the 3,600 publicly traded corporations and large privately-owned companies that don’t actually pay the 35% maximum rate, but a lower rate that averages around 24%. Cutting the maximum rate to 20% won’t make much difference. The rest of corporate taxes are collected from the 5 million or so small businesses that generally don’t make enough profit, especially after expensing family payrolls and other things, to pay the full rate, so there shouldn’t be that much revenue lost from their cuts. In any event, not all the tax savings will be reinvested in new plant and equipment – some will be used for dividends, stock buybacks or debt reduction that contributes much less to GDP growth. Estimating such things and future corporate tax revenues to the government is done more by modeling than by knowing a lot about how corporations will act. This suggests that both the net benefit and the revenue loss from the corporate tax cuts may be much less than expected.

Further, the “middle-class” taxpayers (those who rank in the upper 50% to 90% of income earned) will receive a mixed bag of benefits and added costs from the tax bill. The wealthier end of this group is likely to lose more in deductions than they gain in cuts. And, 47% of all citizens don’t pay federal income tax at all, so won’t benefit from cuts. How much of a net increase in consumption will result from what Mr. Trump calls the “biggest tax cut is history” is hard to know, but it could be quite modest.

In any case, the tax bill occurs when the economy is experiencing a growth spurt following a decade of slow-growth recovery from the financial crisis. Annualized growth for the last two quarters has averaged 3.2% with unemployment expected to drop below 4%. Adding a stimulus now may boost inflation more than real growth.

More worrisome, however, is the longer-term growth outlook. Even with the tax cuts, several growth forecasts, including Goldman Sachs’, fall off again to the 1.9% area after 2018 due to labor shortages, impeded by tougher immigration policies, and rising inflation and interest rates.

Meanwhile, the federal deficit is increasing because Social Security and Medicare costs are expanding to accommodate the retiring baby-boomers. According to a June 2017 report by the Congressional Budget Office, the fiscal deficit reached 3.7% of GDP (up from 3.0) and is estimated to be 5.2% by 2027. With the tax cuts added, the deficit will reach 5.1% in 2021, according to Goldman Sachs, and total debt will be nearly as high a percentage of GDP (110%) as it was at its peak year in 1945. This would represent a serious increase in the deficit burden that traditionally has been a concern to Republicans, but is not now (except for one Senator, Bob Corker, who is retiring). Of course, if the tax cuts, on balance, don’t reduce revenues as much as expected, the deficit will increase less than otherwise.

The tax cut is mainly a political event. Their economic impact is likely to be less than advertised.


Friday, November 24, 2017

A Parable of a Tax Bill



By Roy C. Smith

An economist, a politician and a Wall Street banker sat down to craft a tax bill.

The politician kicks things off. “Guys, the boss has asked us to come up with a tax cut plan that will fulfill his campaign promises to give the middle class a break and to increase growth and jobs.”

The banker jumps in. ”Right, the markets, which have priced in a tax cut, are booming so we have to deliver.”

The economist, more troubled by the task than the others, says: “it’s not that simple. We are already at full employment (unemployment is 4.1%) with an immigration-impaired workforce that is growing at only 0.5% per year, so where are the workers for the new jobs going to come from? The economy is finally starting to grow out of the slump it has been in for the last decade, so adding stimulus from a tax cut now is likely to produce mainly inflation. But the cost of a tax cut, around $1.5 trillion over ten years, will have to be added to the national debt which is already very high. Anyway, growth and jobs do not always follow stimulus measures. We had ten years of fiscal stimulus under Obama, with low interest rates and aggressive quantitative easing by the Federal Reserve, and, even so, growth only averaged about 2%. A tax cut is just more stimulus; it may push growth above its trend line for a time, but the cost of the tax cuts must be funded with additional government borrowings that involve interest costs that will rise, especially if the total amount of government debt is seen to be too high, or inflation sets it.  Our national debt is now (107% of GDP) almost as large as it was at the end of WWII (118%), which was the highest in our history. When Reagan was president, debt to GPD was only 37% and unemployment was 8.3% when he passed his tax cut in 1983.

The banker says, “so what, interest rates are still low and the government bond market is very strong, despite the downgrading of the US credit rating by Standard and Poor’s in 2011. When folks get nervous, they still buy Treasuries. Of course, there is a limit to how much debt we can have without it hurting us; we don’t know where that limit is, but we’re not at it yet.”

The politician: “Some of our guys say that a tax cut will add $4,000 a year in wage increases for workers. If we keep saying it, maybe it’ll be true. Maybe not, but our voters are expecting it. That’s where the rubber hits our road.”

The banker: “If we fail to get a tax cut through, we will look like we don’t have any economic policy at all and are incapable of governing. That could frighten the markets into a major correction.”

The economist says, “I understand, but wouldn’t it be better to focus instead on a revenue-neutral program of tax reform that would get rid of ancient subsidies, loopholes and preferences that block market forces from determining an optimal allocation of resources to maximize growth and productivity over the long run. The best way to achieve it this to eliminate all deductions and apply the combined savings to an across the board tax reduction of 20% or so. It will be revenue neutral, but the structural changes will enable more growth.”

The politician says, “that would be a terrible idea. Eliminating deductions for mortgages and credit card debt, for state and local taxes and for medical expenses and charitable contributions would be a disaster. People will think you are taking something that is theirs by right away from them. And, they would see it as unfair to some taxpayers and benefitting others disproportionately. Our major donors would desert us. What they want is a real tax cut, without taking anything away.”

“Well,” said the banker, “a corporate tax cut will increase corporate cash flows, improve profits and increase equity valuations. Stocks will rise, so will household wealth and folks will spend more of it. Besides, our corporate rate (35%) is the highest in the world, so lowering it will make us more competitive in the world.”

“Except,” said the economist, “our major corporations, because of large deductions, only really pay about 24% in taxes, about the average for all companies in the industrialized world, so they are not really uncompetitive. Those that do get rate cuts might just spend it on increasing dividends or stock buy-backs ($500 billion in 2017), or on overpriced mergers that result in major cost cutting. But, in any case, the vast majority of the 5.5 million US corporations are small to mid-sized privately-owned companies that have mastered the art of minimizing taxes and don’t pay 35% either. Some use pass-through mechanisms to transfer losses and capital gains to lower their wealthy investors’ tax rates. All corporate taxpayers are good at gaming the system. The best way to address corporate taxes is through reforms that eliminate all corporate deductions and lower all rates from the savings.”

The politician: “There you go again. Our donors don’t want their corporate deductions taken away either.”

The banker adds, “the market likes traditional tax cuts that benefit people who will spend the money or invest more. It doesn’t like complex reforms with a lot of unforeseeable consequences.”

So, the banker and the politician combine forces and brush the economist’s idea aside. They say we need a middle-class tax cut that will put money in just about everyone’s pocket. And, besides, the banker says, it will pay for itself by increasing growth to more than 3%, which will generate a lot of new tax revenues. 

“We still have the deficit problem,” said the economist. Our fiscal deficit today is 3.5% of GDP; the $1.5 trillion cost of the tax cut is up front, so we would have to increase debt early on, taking the debt to GDP ratio up to around 112% and the fiscal deficit about 5.0%. Our fiscal hawks opposed to increasing the debt ceiling won’t like this at all. And, we will need their votes to get this thing through.”

The politician: “The deficit is still important to a lot of our voters. But given a choice between a rising deficit and more money in their pockets, they will usually pick the latter, which is why we have always been for tax cuts. But, it can help a lot if we can persuade them that the economists’ studies are fake, or flawed, or produced by liberals, and not to be taken seriously. They like the idea of a tax cut being something for nothing, even if they know in their hearts that it’s not true.

The economist then added, “there is something in what you say, behavioral economics shows that perceptions can count more than reality. “

“And perceptions are what win elections,” said the politician.

So, they say down and wrote up a list of public perceptions that they wanted to reinforce, and that might help sell a tax bill. The government was helping the middle class and hard-working Americans, it was creating jobs, and making corporations more competitive, all things they had promised to do. Besides, their plan will pay for itself; deficits don’t matter, it's the American entrepreneurial spirit that will Make America Great Again.

Then they went on the write the tax plan they wanted Congress to approve. It was a mess, but it was the best they could do. Sausages are made in sausage factories.

Economists know that tax cuts always add debt to the system, but they don’t always provide the stimulus they are supposed to. Bankers know they can result in a bullish anticipation of results, but yield a bearish response when results are disappointing. But even though politicians know that both may be true, none of it matters if their side isn’t reelected.



 
 
 

Friday, October 20, 2017

Black Monday Recalled



By Roy C. Smith

October 19th is the thirtieth anniversary of “Black Monday,” the great US equities market crash in which the Dow Jones dropped 22.6 %, the largest single day decline then or since, and instantly spread to other markets in the world’s first massive liquidity event .

The event was sparked by the usual suspects – an overvalued five-year bull market (the S&P 500 index was up 44% on the year at its peak in August), some near-the-top volatility, and an early morning panic in Hong Kong that passed through Europe and hit NY like a hurricane.

When it did, it forced aggressive margin calls, revealed structural weakness in US trading systems, and sank the then new computer-based, automatic “program trading” and “index arbitrage” schemes.

The speed at which the crash developed created problems of its own. Price information was hard to get; many NYSE stocks (for which markets were made by “specialists” on the trading floor) failed to open on time, and closing prices from the day before quickly became meaningless. Program trading that required the purchase of futures contracts and simultaneous selling of shares in the cash markets quickly became disorderly and unbalanced, and further accelerated price declines, overwhelming whatever opportunistic buying there was. All this accompanied “defensive” (i.e., panic) selling by traditional institutional investors.

This crash spread instantly to other markets around the world. Global linkages and technology improvements had made this possible, but the consequences were severe. All markets with more-or-less modern trading platforms were affected, and most suffered plunges worse than in the US. Markets were down 27% in the UK, 31% in Spain, 46% in Hong Kong and, surprisingly, down 60% in far off New Zealand. Coping with shocks requires a large and well developed institutional base of investors with liquid reserves, which were scarce. This kind of global market contamination is now baked-in to our global financial system, and has occurred on several other occasions, most notably in 2008.

The crash also halted two related dynamic actvities that had developed during the 1980s, a global mergers and acquisitions boom, and a series of very large privatization sales of stock in nationalized companies by the UK government of Margaret Thatcher.

I was meeting with Sir Patrick Sheehy, CEO of BAT Industries, whom I was advising on a prospective $13 billion takeover offer for Farmers Insurance, a California company whose management and regulators would probably resist the deal. We were devising a price range for the yet unannounced deal and plotting our initial moves. I was nervous about the market that had been turbulent all the prior week. So, I got up periodically to check the office “Quotron” machine (a sort of electronic ticker tape) that was located outside my office. It was clear by early afternoon that all hell was breaking loose, and our merger experts advised me that we should postpone the deal until market conditions improved. This was because we would need the support of M&A arbitrageurs and other institutional investors to buy up stock on the contested deal’s announcement to show support for it. But the arbitrageurs were badly hurt by losses in their existing positions, so they had little room for new ones. My clients were disappointed, and left in a bit of a huff, ending our hopes for completing one of the largest deals of the year that we had been working on for months. (The transaction was completed in the next year).

At the same time, Goldman Sachs was in the middle of leading an underwriting of the US tranche of a $12.2 billion privatization sale of British Petroleum shares. This deal was truly enormous by 1987 standards. It was being conduicted under UK underwriting rules in which a price/per share was fixed at the announcement of the offering, which was followed by a two-week “subscription” period for investors to take up the shares. Any shortfall was left to the underwriters, which in the UK already had been placed with institutional investor sub-underwriters.  But, the crash occurred in the middle of the subscription period, and dropped the market price of BP shares to 224p., about 25% below the subscription price of 330p., which meant that no one would subscribe for the shares and they would all be left with the underwriters. The four US underwriters, under US rules, could not close on stock sales until the end of the subscription period, so they took a loss of about $250 million on this one deal alone, enough to threaten the viability of some of the firms.

There were a lot of other losses that day too, from trading positions and cancelled deals, which was frightening to everyone on Wall Street, but especially so to the partners of Goldman Sachs, a New York partnership with unlimited personal liability of partners, with all their money tied up in the firm.
 
So, it is understandable that October 19, 1987 was and is still very memorable to me. At the end of the year I retired as the senior international partner of the firm to join New York University as a finance professor, something that had been in the works before the crash.

After the crash, the market recovered quickly and by the end of December closed 2%  above where it had begun in January. (Overseas equity markets, however, recovered much more slowly). The government appoint a commission to consider causes, etc. and some reforms were put in place.  The “Roaring Eighties” did not end, however, until late December in 1989, when there was a mini-crash and a recession began. The merger boom died out then too, after the junk bond market that had financed a large part of it collapsed with the failure of Drexel Burnham, its principal advocate.

As bad as the 1987 crisis was, however, the event did not trigger any significant form of government intervention. The Federal Reserve said it would do its job to provide liquidity to banks wanting to lend to security firms on good collateral, but not much else. The exchanges stayed open, losses were absorbed, wounds licked and business went on. The market’s quick recovery eased the pain considerably.

Indeed, in the case of the massive BP stock offering, the US underwriters did what they could to persuade the UK government to postpone the deal because of force majeure; they had help in this from some sympathetic government officials worried about systemic failure, but Mrs. Thatcher said Absolutely Not! – contracts must be honored in free markets – and the deal went on despite the massive losses. If it had been pulled, then the value of underwriting contracts (especially under the UK system) may have been subject to question.

Thirty years later, we operate in markets that are ten times larger (in today’s dollars) than in 1987. Today’s US equity markets have a market capitalization of $27 trillion; but all the world’s stock, equities and tradable bank loans, according to McKinsey, are valued at over $300 trillion. Liquidity panics and global linkages continue to present a serious systemic risk to the system, as was demonstrated in 2008. New measures to contain such risks have been adopted, but are untested.

Not much is predictable about the future, but another financial crisis probably is.

Roy C. Smith, an Emeritus professor at New York University,  was a partner of Goldman Sachs in 1987.

From: Financial News, Oct 19, 2017





Monday, October 9, 2017

Will Trump Take Half a Loaf on Taxes?




By Roy C. Smith

The Trump $1.5 trillion tax plan is really two-bills-in-one. A good one and a bad one.

The first is a legitimate effort at long overdue reform of the method and effect of collecting taxes from businesses. It would repeal a long out-of-date system of taxing income wherever earned around the world, after deducting local taxes paid, but allowing tax payments to be deferred until the income was brought back into the US. In a time of global business integration and competition, the present system is inefficient because (a) it applies a 35% tax rate to all income, the highest tax rate of any large, developed country, (b) but that tax rate is reduced by the deferment provisions to an average effect rate of about 26%, which happens to be the average corporate rate for OECD countries, (c) however, only a few hundred large global corporations get the benefit of deferral, so the vast majority of America’s 5.5 million corporations pay an exceptionally high rate, which clearly impedes their growth and development.  A rate cut to 25% for smaller and midsized businesses would benefit them a lot.  

By the way, the argument that the cash reflecting the deferred taxes, some $2.5 trillion or so, is “trapped” outside the country and cannot be used to fund domestic investment is phony. Corporations can and do lend money between subsidiaries, or borrow from banks with the deferred cash as collateral.

Two solid reasons for adopting these Trump corporate tax reforms are that it harmonizes the US tax system with those of our global competitors and levels the playing field. And, it will add sufficiently to after-tax cash flows from all `businesses and raise their returns-on-equity to enable more economic growth, a major objective of the Trump plan.

Another reform element of the Trump plan is the abolishment of the estate tax on inherited wealth. This tax is now only paid on wealth greater than $5.45 million ($10.9 million for married couples), but it is then taxed at the rate of 40%. Abolishing the tax would be a huge benefit for the very rich (just 0.2% of taxpayers), which, of course, attracts a lot of political heat. Yes, the heirs of Mr. Trump and much of his cabinet would prosper greatly from such a change, but the numbers are not big on a national scale, as the estate tax represents less than 1% of annual tax revenues. The estate tax was installed in 1916 and has endured since, largely because of the argument that without such a tax a permanent class of enriched “nobility” would emerge that would weaken our democracy. The counter argument to this was the America is the land of opportunity in which wealth could be created from very little, but an estate tax confiscated the fruit of such efforts – constitutionally protected private property on which federal, state and local income and property taxes had already been paid. The present estate tax law, enacted in 2016, is a trade-off between these points of view. There is not much appetite to bring estate taxes up again so soon after the last effort to reform it and eliminating, and, in any case, it won’t affect the economy much

The rest of the Trump tax plan is essentially bad because it will increase the fiscal deficit and probably won’t create much growth. It is a hodgepodge of business and personal tax cuts designed to satisfy traditional republican demands for lower taxes to stimulate growth. Mr. Mnunchin says the plan will pay for itself by increased tax revenues from added growth. Despite the popularity of the “Laffer Curve” that predicted such an outcome from the Reagan era tax cuts, it didn’t happen then and very few economists believe it will this time.

About 47% of tax filers don’t pay federal income taxes, so they won’t be affected.  Analyses to date suggest that the tax cuts for middle income people will be offset by the loss of deductions that leave the average taxpayer about where he or she was. Lower rates on higher income people won’t matter that much, as most wealthy Americans pay much lower effective tax rates than the 39.6% maximum because of allowable deductions and so much of their income is from capital gains that are taxed at 22.8%. Reducing the maximum rate to 35% won’t result in much additional consumption on which incremental growth depends.  The rich don’t spend their tax savings, but instead invest it in (already high-priced) securities. But at very low unemployment (4.2%) and inflation (1.5%), the odds are that whatever new spending there may be from the tax cuts will end up increasing wage inflation more than growth.

One feature of the Trump plan, however, could make a big, if unintended, difference. This is the provision that would allow corporations or individuals to utilize “pass-through” vehicles (limited liability corporations or partnerships) to benefit from a maximum rate of 25%. Pass through vehicles are entities that don’t pay taxes but pass income (and losses) on to shareholders to pay (or deduct) at individual rates. A small business owner can often lower taxes considerably by passing through, but some of the biggest users of these entities are hedge fund and private equity investors and real estate operators like Mr. Trump. If the 25% rate were adopted for pass-throughs, these types of investors would be major beneficiaries along with many wealthy lawyers, doctors, and others who would set up their own entities to channel income to get lower rates. But if the corporate rate is to be lowered to 25%, this provision really is unnecessary.

Certainly, the Trump tax plan has its share of political problems. To get passed, it will have to be presented to the Senate as a “budget reconciliation” measure that can be approved by a simple majority of 51 votes. For this to happen, the Senate must first pass a budget resolution based on the Trump budget submitted earlier this year (the House passed such a resolution last week). According to the bi-partisan Tax Policy Center, the budget will produce a deficit of $2.4 trillion over 10-years, or $240 billion per year (1.2% of today’s GDP, to be added to the existing fiscal deficit of 3.1%). This deficit will then have to be financed by additional government borrowings, which may upset the deficit hawks among Republicans (they have been quiet so far), the future debt ceiling bill that will have to be passed to accommodate it, and raise serious questions as to whether the $2.4 trillion estimate, or the Treasury’s of net deficit reduction is reliable.  The Treasury forecast is based on “dynamic scoring” which assumes incremental tax revenues from a 3%+ annual growth that it says the tax plan will generate. In the past, dynamic scoring forecasts have been very inaccurate -- the amount of derived growth has been less than promised, and the deficits have been greater. Continually missing these forecasts partly explains why the US government’s debt to GDP ratio (107%) has grown to be the highest since WWII. This has been very worrying to many finance experts, debt rating agencies and those fearful of a debasing of the currency, and it should put some serious loyalty stresses on Republican senators who properly understand these issues.

The tax plan is unlikely to attract any support from Democrats, who are in lock-step that the whole thing is a give-away to the rich. It might get through the Republicans, but it will be tough on those Congressmen running for reelection in high-tax states that would lose the deductibility of state and local income and property taxes. The loss of this deduction is one of the last surviving means (after abandonment of the “border tax”) to gather new revenues to pay for the other cuts and increased defense spending.

The best outcome might be for Congress to pass only the good bill, the corporate tax reforms, and let the rest (like health care repeal) go for another time. Doing this could add to growth without growing the deficit. Middle class tax cuts may have been promised, but what would be delivered won’t be that much. Pass-throughs and an aggressive program of accelerated depreciation create distortions and unintended economic consequences that are more trouble than they are worth. Even the rich are resigned to paying some form of estate tax, so its repeal won’t really be missed.

Doing this, of course, would be an example of a half a loaf being better than none, something our present all-or-nothing Congress has been unable to accept as a working principle of governance.



Friday, September 15, 2017

The Troubled Future of Global Banks, Revisited



by Roy C. Smith


In different articles last year, Brad Hintz and I argued that the world’s largest capital market banks faced a troubled future, burdened chiefly by vastly increased regulatory requirements, heavy litigation costs, pressure on margins, and changes in the trading markets.  These burdens resulted in lowered returns on equity, and higher costs of equity capital, such that the net economic valued added (EVA) of these firms was negative and had been for several years.  Our conclusion was that the banks would have to substantially restructure their business models to regain economic viability. The data we used to form our opinion has been consistent since 2009, but the most recent set was as of Dec. 30, 2015. 

Since then, many things have happened. After the election of Donald Trump as President of the US the S&P 500 stock index rose 17.5%, As they continually surpassed record levels, stock markets hummed with speculation about improved economic growth rates, a strong dollar, and a sizeable reduction in US financial and other regulation.  The banking sector was to be a major beneficiary of these positive expectations.

Seven of the top ten capital market banks’ stock prices have gained more than 20% since January 1, 2017, though three (Barclays, Deutsche Bank, and Credit Suisse) posted declines of 20% or more.  The average price-to-book ratio for the top ten banks in Dec. 2015 was 0.75, at the end of the second quarter of 2017 it was 0.99; in 2015, the average EVA (the spread between the banks’ returns on equity and their cost of equity capital) was -8.90%; now it is -2.16%. Though five of the ten banks were in positive EVA territory, two, Deutsche Bank and Credit Suisse posted EVAs of -10.3% and -13.4%, respectively).

Banks have benefitted (in their EVA calculations) from the lowering of their average “beta” (a volatility measure used to calculate cost of equity capital under the Capital Asset Pricing Method) from 1.72 to 1.38. Lowered betas are a direct result of reduction in the risk levels of the banks, which was the main purpose of the increased regulation.

Average returns on equity also improved from 5.36% to 6.64%. Most of this appears to be due to cost cutting, asset sales, and reengineering products and trading platforms. Revenues for the top banks were up 4% for the first two quarters of 2017, but still down 13% from five years ago.

Overall, these data indicate things are getting better for most of the banks. And, the enormous storm of litigation from financial crisis misdeeds that weakened returns and book values for the last several years has apparently run its course. US banks have also done better on the stress tests and been permitted large increases in dividend payouts and stock repurchases.

However, expectations for an economic boost by reforming taxes, infrastructure spending and deregulation have diminished significantly – Republicans are divided and Mr. Trump seems helpless to do much about it. Whatever does happen will be less impactful, and later in arriving, than was thought six months ago. Deregulation is limited to executive orders not requiring Congressional approval, and this, too, has amounted to less than expected. The SEC produced a report in August that said it was unable to tell whether the Volcker rule limiting proprietary trading was effective or not, suggesting it might not be changed. Earlier, a Treasury Department report required by an earlier executive order only recommended five regulatory reforms of the most general nature. When and how these might be produced and become effective is unknown. The Financial Choice Act, meant to neutralize the Dodd Frank Wall Street Reform and Consumer Protection Act, was passed by the House of Representatives in June, but has little chance for passage by the Senate this year. Still, most observers believe that something will happen in the next year or two to soften Dodd Frank, but probably not anything very meaningful to capital market banks.

Dodd Frank is vast and very expensive to comply with, but it is not the chief source of the capital market banks’ regulatory burden.  These come from Basel III (a minimum bank capital adequacy agreement) and the new form of qualitative stress tests that central banks now impose on their global systemically important banks. Most of these measures were adopted by the G-20 group of countries with strong US support.

Basel III effectively doubled the capital adequacy requirement while halving leverage and requiring capital buffers to insure adequate liquidity in a time of crisis. This made trading inventories expensive when trading volumes were soft and margins were under competitive pressure as they still are. Basel III constraints seriously limited the operating field-of-play available to banks.

The stress tests were designed to be impossible to “game,” and the consequences for not meeting them were potentially so severe (in terms of limiting payment of dividends and stock buybacks) that none of the banks tried to do so.  However, the rules of the stress tests change without notice, so the banks’ operating areas were limited further.  Even so, some banks (JP Morgan, Goldman Sachs, and Wells Fargo) , have adapted and been able to generate minimally satisfactory EVAs under this regime (JP Morgan’s is +3.2%, modest but acceptable), but others (Credit Suisse, Deutsche Bank, Barclays, and Citigroup) continue to be unable to do so, despite years of tinkering with their balance sheets and business models.

One thing that hasn’t changed since Dec. 30, 2015 is the unwillingness of the struggling banks to break themselves up. That is, into investment banks or commercial banks in order to specialize in trading and fee businesses, or deposit taking and lending, two very dissimilar businesses.

We presented a case for such breakups last year – when many banks were trading well below book value – as a way of recovering shareholder value. None followed our advice, and now that some banks have seen major increases in their share prices, it is unlikely they will be interested in doing so now. But half of the industry is still in big trouble, still trading below book and earning far less that it costs their investors to hold their stock.

So, despite some signs to the contrary, nothing really has changed, or is likely to soon.  But our original argument still seems valid, so there is still a good argument for breaking up at least some of the worst performing banks.  Institutional and activist investors ought to encourage them to do so.

Published Sept. 13, 2017 in Financial News

Friday, August 25, 2017

Is Brexit another Dunkirk?

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By Roy C. Smith

The stunning events depicted in the movie Dunkirk, one of the summer’s top sellers, was short on context so possibly not everyone understood that it was Britain’s worst military defeat in its long history, however heroic the effort to recover the soldiers from the French beaches on which they had been suddenly pushed by the German army in 1940. The British were unprepared for the war, despite plenty of evidence that one was coming.

Brexit is another effort by Britain to pull its troops out of Europe, despite plenty of evidence that it could trigger an economic disaster for the UK and probably the rest of Europe. The UK and the EU are mutually bound together in important (if troublesome) ways; breaking this link is a political failure by the Conservative government of David Cameron that threatens to strand Britain on the beaches again.

Brexit was the outcome of a public referendum last year on whether to remain in or to exit the European Union. Turnout was 33 million (72% of the electorate), with 51.9% voting to leave. Conservative politicians (including Donald Trump) acclaimed the result as creating new opportunities for Britain to separate itself from an expensive, low-performing economic club they would be better off without. Most observers believe that the voters (and Mr. Trump) had little understanding of what was really at stake.

Some of the troubling effects of Brexit are just starting to come into focus: About 50% of the UK’s $700 billion two-way trade in goods and services will be subject to new tariffs, Northern Ireland’s politically and economically essential open border with Ireland will be closed, and the City of London (Britain’s – and Europe’s - financial center which exports more than $20 billion to the EU) will be weakened and some of its functions and personnel will be forced to relocate within the EU. Britain, which has received nearly half of all EU foreign direct investment to date, will attract much less of it in the future.

The EU has insisted that before negotiations on “transitional” and “final” relations between the UK and EU can be started, the UK must agree to a “divorce” settlement in which the UK pays it share of all outstanding EU liabilities, which some have estimated to be as much as $100 billion. Further, the already weakened Pound, which has dropped 17% relative to the Euro since the vote, will likely slump further.

Britons will no longer have free access to, or employment opportunities in the 27 remaining member countries of the EU where 1 million Britons now work, and EU residents of the UK will leave, as many have already begun to do. Indeed, Brexit will deprive Britain of a modest but necessary immigration of willing workers from other EU countries, many of them skilled, which the UK needs to maintain its labor force and growth rate. The birth rate in the UK is 1.8, higher than many EU counties but still well less than the natural population replenishment rate of 2.1. It is true that open immigration was one of the more controversial things that UK voters disliked about EU membership, but most voters did not understand that the annual net immigration, though having risen slowly since 1993 to 248,000 persons in 2016, is only 0.4% of the UK’s population of 65 million. 

Britain’s departure will weaken the rest of the EU. The UK is the EU’s second largest trade partner (just behind the US), generating a net trade surplus for the EU of $135 billion. The UK, fortified by its long traditions of liberal economic policies, was always the free market champion of the EU, without which Europe may slide back to becoming the over-regulated, under-performing “Eurosclerotic” economy it was before 1986 when, with help from Margaret Thatcher, it adopted the Single Market Act that made the EU into the world’s largest free trade zone of 500 million people and a GDP today of $16.5 trillion. The Single Market Act (1987) was followed a few years later by the Maastricht Treaty (1992) that created the ultimate in unification, a common currency and monetary policy, even though each member was free to conduct its own fiscal policy. The UK, with Sweden and Denmark, opted out of the Euro to preserve its independent monetary policy.

The Single Market and the Euro were significant achievements that Europeans hoped would return the world’s economic center of gravity to Europe. However, despite twenty-years of initial success, the financial crisis of 2008 caused serious economic trouble within both the broader EU and the narrower Eurozone. Countries such as Greece, Ireland, and Portugal received significant (though reluctant) bailout assistance; having to assist larger countries like Italy and Spain would be hugely expensive and cut deeply into the resources of other member countries experiencing their own difficulties. Intra EU infighting and dissent blossomed. Economic growth dropped and unemployment rose.

Popular support for the EU and its principles were fading fast, but then really collapsed with the appearance of 1.3 million Syrian and other refugees finding their way into the EU through weak external borders in Greece and Italy. Once inside the EU, passports were not required to travel within it. Until, that is, individual countries began objecting to the unwanted flow of refugees and closed borders anyway. (The UK agreed to accept 20,000 Syrians, far lest than most of the larger EU members, but so far has only admitted 4,400).

About this time everyone of voting age in the UK was invited to vote for the UK to remain or exit the EU.

The Cameron government that called for the referendum to appease backbenchers always assumed that the voters would elect to remain in the EU; they lost largely because the voters did not really understand what they were voting for, seeing it, some observers said, as an opportunity to show their dissatisfaction with the government in place, which opened up opportunities to express dislike of immigrants, their distrust of globalization, and their longstanding grumpiness about giving up British sovereignty by letting a bunch of “foreigners tell us what to do.”

Since the vote in June 2016, the Cameron government has been replaced by one led by Teresa May, who officially began the two-year negotiation process with the EU in March 2017. She then called a snap election in June 2017 to fortify her majority, only to lose it. May’s government is now part of a coalition with the Democratic Unionist Party of Northern Ireland whose 10 seats in Parliament provide a very slender majority.

During the past year, the British economy has performed about the same as it had been before the vote. Growth in 2017 is expected to be about 1.5%, versus 2.0% for the EU as a whole. This is down from 1.6% in 2016. Some forecasts through 2020 show growth remaining at about this level. UK unemployment, however, is 4.4%, much lower than the EU average of 9.1%. The FTSE stock market index is up 8%. 

But the UK is still in the EU and will be for another two years. The real impact of Brexit won’t happen until then. Richard Portes, a prominent economist from London Business school, says both the EU and the UK will be worse off than before Brexit, but the impact on the UK will be greater than that on the EU. Fears are beginning to develop that in anticipation of Brexit, consumers will hold back and corporations will invest less and relocate facilities and personnel to the EU, which will slow growth in the UK further.

The May government, having committed itself originally to a hard-line “Brexit means Brexit” position, has argued for the past year that no deal was better than a bad one. Negotiations have now begun and many obstacles have emerged, but if no agreement is reached by March 2019, the UK “falls off the cliff” as all the benefits of EU membership are suddenly lost, tariffs are imposed, and hundreds of rules affecting Britons’ ongoing relationships with the 27 individual EU countries will have to be sorted out one at a time. 

Businesses with global supply chains and customers in the EU, and the Mayor of the City of London are among those lobbying hard for a less rigid approach. So, Mrs. May is now allowing talk about a “softer Brexit,” which would hang on to a “customs union” (access to the EU markets without tariffs) but avoid some of the other regulations imposed by Brussels. Norway is not a EU member but it was granted custom union status in exchange for adopting the EU’s principle of free movement of people across borders.  For the UK to do the same would require it to give up its resistance to the EUs free immigration rules.

The best thing might be to admit that the Brexit vote was taken without voters having a good understanding of it, as former prime minister Tony Blair has claimed, and have another one after an educational period in which credible and knowledgeable people debate the pros and cons. But that would be a very heavy lift for the May government, so it seems unlikely. The opposition parties, of course, probably will try to defeat a weakened Mrs. May in a vote of no confidence in Parliament, to bring on another election before 2019.  If that happened and the Conservatives were defeated, a second referendum or some other way out might be achieved.

In the meantime, the British people are hostages to the results of their ill-considered and poorly managed referendum.  Being cut off from Europe and stranded on their little island will bring unnecessary hardship to the UK, but there is still time to minimize it, or better yet, to have another vote that at least would enable people to know what they are in for.  Otherwise, the old British “bash on regardless” approach begun by Mrs. May is likely to end up having fallen off the cliff, which would be the worse of the possible outcomes.

Well, they survived Dunkirk, and they will survive Brexit too, but at what cost?
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Thursday, August 17, 2017

Democrats Need to Learn to Love Business More


by Roy C. Smith  

November 2016 was disastrous for Democratic Party office holders nationwide. Not only was the presidency lost to a person most democrats thought was horribly unqualified, so was control of both house of Congress.  And, according to the National Council of State Legislatures, over the past decade Republicans have gained control of 68% of state legislatures, the highest proportion ever. Some polls suggest that only 25% of voters identify themselves as “liberals” and two-thirds think “big government” is the main threat to the future.

This has occurred despite evidence that wage rates had been stagnant for years, US levels of income inequality have reached peak levels for modern times, and several years of blaming Wall Street and big business for the sufferings of the American “middle class.”  

Rescuing the middle class from all this was a strategy Barack Obama devised. But what the middle class was, was unclear. According the Urban Institute, the middle class represented 78% of the US population in 2016, of which the “upper middle class” was 29% (up from 13% in 1979), and the “lower middle class” was 17% of the population (down from 24% in 1979). “Working Class” Americans that account for approximately a third of the population, according to some sociologists, are sometimes defined as those without college degrees who are part of the lower and middle sectors of the middle class.

Democratic Party supporters over the years have come from the working class, minorities, women and an assortment of intellectuals and entertainers. It has relied heavily on support from labor unions, though union membership dropped to 11.3% of the workforce in 2013, down from 20.1% in 1983. The percentage of union members in the private sector was only 6.7% of the workforce, while those in the public sector represented 35.3%.

In 2016 the Democratic Party, represented by its centrist standard bearer Hillary Clinton, was splintered by assaults from two different directions: socialist Bernie Sanders, who promised a more radical platform, and by Donald Trump, who appealed to some deep-seated concerns of working class people angry with the way things had turned out for them.

The thumping Democrats took at the polls has called for a rethink of what the party considers to be its basic principles. Democratic Party strategists Mark Penn and Andrew Stein recently published an OpEd in The New York Times (“Back to the Center, Democrats”) calling for a shift to the center, but others have insisted that it move further to the left instead. Senator Elizabeth Warren, a likely candidate for the Democratic nomination for president in 2020, said in a recent speech, “Liberals (i.e., the far left) are not a ‘wing’ of today’s Democratic Party, we are its heart and soul.” She went on to indict a “rigged system,” that imposed basic inequities on women, African-Americans, undocumented immigrants, and LBGTs.   

The election revealed that many middle class Americans feel that both Republicans and Democrats have done a poor job running the country over the past two eight-year administrations. During that time, economic growth has averaged just 2% per year (as compared to 3.5% for the prior 50-years), despite government stimulus plans and steady increases in public entitlements (health care and social security now account for 60% of the federal budget) that have raised the federal debt level to 106% of GDP, the highest since WWII.

The dilemma for Democrats is that Keynesian policies don’t work well when unemployment is low (4.3%) and the debt level is at its limit, and to decrease income inequality it would have to increase entitlements, and/or raise taxes on the upper middle class and the affluent, something Barack Obama was unable to do.

Further, many in the middle class may not be suffering as much as advertised. For example, most of the country’s $89 trillion of “household net worth” reported by the Federal Reserve in 2016 is owned by middle class Americans.  This is the sum of families’ savings, pensions, real estate and other investments at market values, less mortgages and other debts, after taxes, tuitions and other essential payouts. Household net worth has grown by a third since 2006, despite the financial crisis and recession, indicating that average American families have not been missing out on prosperity improvements over the past decade, and may indeed be more concerned by higher taxes, more entitlements and increased federal debt.

So, perhaps not all of the 250 million Americans classified as middle class want to be rescued by policies that might hurt them elsewhere. Most of America’s 5.5 million small businesses are owned and operated by middle class people wanting to preserve and expand what they have worked hard to create.

American has long had a love affair with its small business community that produces 46% of US GDP and much of its growth. But the love affair has not extended to larger enterprises, even though about 50% of all private sector employees work for the 12,000 or so “large enterprises” that are publicly owned (of which only about 5,000 are traded on the NYSE or NASDAQ). This is partly because of innate distrust of Big Business in America, but also because of criticism, litigation and general disparagement of it by Democrats during the Obama years. Large enterprises, however, are essential to US economic growth, make most of the investment in research that provides the technology innovations that sustain the economy, and pay most of the taxes of the private sector.  Large and small corporations together employ 85% of working Americans. It makes little sense to turn them into enemies.

When it is explained to them, most Americans seem ready to believe that the governing principal of the American enterprise system, the world’s most successful for 200 years, has been free-market capitalism. But this particular form of capitalism operates within an active and robust democracy, which through its legislatures and courts imposes rules and regulations that limit the role and influence of corporations. And, the system has evolved significantly over the years to institutionalize rights of workers, women, and minorities and to check abuses of size and power.  Most Americans know how important the free enterprise system is to the country’s future prosperity and don’t want to risk damaging it.

Democrats today seem convinced that Donald Trump’s personal behavior and inexperience will cause him to stumble, and they will slide back into power. But there is no evidence as yet that anyone else, Democrat or Republican, has a level of support equal to Mr. Trump’s 40% approval rating, however low that may seem to some.  If the only thing going for Democrats is that they are not Trump, then they may be much weaker than they think. Voters have kept them from office for a reason – they don’t have confidence in their ability to govern, especially if the party moves further left.

Democrats need to pay attention to Messrs. Penn and Stein and move the other way, back to the center. At a recent conference for Democrat bigwigs in Aspen, Jon Cowan, president of Third Way, a research group, echoed their sentiments and added “income inequality is severe,” and some parts of the system are unfair, but these are not central concerns to most Americans and many of the approaches to addressing them interfere with their own aspirations. There was plenty of pushback to the idea, of course, but no consensus emerged as to how the party’s message or policies ought to change.

When asked what the main concern of voters was in 1990, Bill Clinton said “it’s the economy, stupid,” emphasizing how obvious this was. The economy is in worse shape today, and it is still the main concern, but there are fewer government resources available to try to fix it.

Rather than attempt big programs to address unfairness in the system, which Congress is unlikely to approve, Democrats should realize that being more business-friendly, less litigious and regulatory-minded might enable the free enterprise system to catch its breath and get back to its job of improving the growth rate.  That is something voters did like in the Clinton years.