Wednesday, September 24, 2008

Galileo's Quick Take: Capping Pay Is Un-American

As for the denunciations of greed by John McCain, Wall Street trader Jim Cramer, and so many others, it is just so... un-American! America was founded on the principle of "life, liberty, and the pursuit of happiness." That means that each of us is free to live good, happy, and prosperous lives, to the extent of our abilities. It is no skin off anyone else's back if you or I make a lot of money. In fact, it helps other people because it means I am producing goods and services that other people want to buy.

Well, Congress wants to cap that, literally, by capping the salaries of Wall Street executives. Where does it end?

Thursday, September 18, 2008

The One Minute Case for Stock Shorting

I originally wrote this for the website "The One Minute Case" here. Given that short sellers are once again a scapegoat for a declining stock market, I have decided to re-publish it:

What is stock shorting?

Stock shorting is a method of profiting from a decline in a stock’s price. It is the opposite of investing long, where the investor profits from a rise in the stock’s price. “Going long” or hoping for a gain in the stock’s price is the more familiar method of investing. However, “going short” and profiting from a decline in a stock’s price is an equally valid method of investing.

How does stock shorting work?

Shorting a stock is a little more complicated than going long where a stock is simply bought and then sold later for either a gain or loss. Shorting stock first involves borrowing it from an existing owner. The short seller pays a fee to the owner to borrow his shares. Upon borrowing it, the stock is immediately sold and the proceeds are kept in the short seller’s brokerage account. When the short seller wants to close out his position (or the shares’ owner wants them back), he buys equivalent stock in the marketplace and returns the shares he borrowed back to the owner.

If the stock has fallen in value, he makes a profit that is the difference between the price at which he borrowed the stock and the price at which he bought it back. Conversely, if the stock has risen in value, he suffers a loss since he has to buy back the stock at a higher price than he borrowed it for.

Short sellers fulfill a crucial and productive role in financial markets:

Short sellers bring to light valuable information about poorly run companies.

Short sellers have a strong incentive to uncover poorly run companies. If a short seller successfully discovers ahead of others that a company is destroying value through incompetence, bad luck or even criminal activity, he profits by shorting the stock and publicizing the information. Short sellers are similar to good investigative journalists. They make more money if they can “scoop” others with information that will drive the stock down.

It is this aspect of short selling that many company managers, regulators and others find discomforting. Yet these same managers and regulators have no problem when an investor uncovers a successful company. Why should they be opposed to someone who does the opposite, and uncovers the overvalued, incompetent, lazy or even fraudulently managed companies?

Short sellers help capital go to the best companies.

By taking financial capital away from poorly run companies, short sellers free up money that can go to the best-run companies. Short sellers are the other half of the value-creating process of financial markets whereby capital is continually re-directed to those who can put it to the most valuable use. The existence of short sellers means that capital will more quickly flee the poorly run companies and thereby become available that much faster for the better-run companies. The profit that a short seller makes is his reward for aggressively uncovering the poorly run companies.

Short selling is challenging.

Short selling is not for everyone for the simple reason that stocks generally tend to go up. During the 20th century, stocks gained 9% a year on average, although there was significant yearly variation. Stocks do not decline in value across the board for long periods of time. Because of this, short sellers must time their moves well, and attempt to short at the top of a stock’s move and then close out the position when it has hit bottom. If the short seller mis-times his moves, he will lose money. Such precision in timing is less important for long investors because stocks generally go up.

It is a misconception that short sellers can unfairly cause stock prices to go down.

This is the most common misconception about short sellers. However, short selling is only likely to be successful if companies truly have problems. If a seller shorts a strong or improving company, he will lose money. It is a misconception to think that short sellers (or long investors) can cause stock prices to deviate for meaningful time periods from their true values.

The only power a short or long investor has comes from being right. When he is right, he is rewarded for helping to bring true information to the marketplace. When he is wrong, his wealth is dissipated and his ability to invest further is diminished. If he is wrong often enough, all of his wealth will be dissipated and his ability to influence stocks will be nullified.

Conclusion: Short selling is moral and should be permitted.

Short selling creates value by making the capital markets work more efficiently. Short sellers help bring negative information about companies to the market. By doing so, short sellers provide liquidity to the market and help capital to flow away from the worst companies and toward the best companies. Without short sellers, markets would be less liquid and more volatile. Long investors would have more difficulty buying and selling their positions, and the lack of liquidity would make it more difficult for companies to raise funds in public offerings.

To restrict short selling not only harms the efficiency of the markets, but it violates the right of stock owners to freely dispose of their shares as they see fit. Because their shares belong to them, it is their property, they have the right to do what they want with them, including loan out their shares to short sellers. Conversely, short sellers have the right to borrow those shares.

A proper understanding of short selling demonstrates the valuable and productive role it plays in the financial markets.


9/25/08 clarification:
Added "buying and" to last sentence, third paragraph from bottom. It now reads: "Long investors would have more difficulty buying and selling their positions, and the lack of liquidity would make it more difficult for companies to raise funds in public offerings." For the reason, see my answer to J. Henry's question in the comments below.

Monday, September 08, 2008

From De Facto to De Jure: The Nationalization of Fannie Mae and Freddie Mac

The weekend nationalization of Fannie Mae and Freddie Mac is nothing new. From their creation in the 1930s, these entities were government controlled. Whether government controlled them outright or had partially privatized them, government always called the shots. Government set terms on what types of mortgages they could offer, to whom, and in what amount. Most importantly, government provided a widely understood “implicit” guarantee of the debt issued by these entities. Unlike other financial institutions, Fannie Mae and Freddie Mac could issue debt (which was then lent out to mortgage borrowers) with the backing of the U.S. Treasury and Federal Reserve. That gave Fannie and Freddie an edge over private banks in making mortgage loans, by design. Reportedly, 50% of all outstanding mortgages are guaranteed by Fannie and Freddie, and as much as 75% of all new mortgages in recent years were issued by these agencies.

The government’s purpose in forming these entities was to make mortgages more widely available. Absent Fannie and Freddie, the other way to get mortgages has always been from private, profit-seeking banks, banks that had to safeguard their credit by striving to lend their money only to creditworthy borrowers. The only way Fannie and Freddie could out-compete these banks was by doing the one thing its government backing enabled it to do: lend to less creditworthy borrowers. This is a case of the bad credit driving out the good credit. In the space of 70 years, millions of uncreditworthy borrowers got mortgages as these government agencies pushed out the more prudent private banks and gained the largest market share in the mortgage market.

Now the loans are being called. The credit and stock markets are calling these loans en masse. The sheer weight of thousands of deadbeat borrowers has created a crisis that even the implicit guarantee of Fannie and Freddie’s debt by the U.S. government cannot ameliorate. So, this weekend the implicit guarantee has been made explicit.

That should make it fully clear to everyone, if it wasn’t during the past 70 years of the “implicit” guarantee. The lender to all these deadbeat borrowers, borrowers who didn’t qualify to get loans from private banks, is you, me, and everyone else in this country. We are all on the hook for the bad loans to our neighbors. That is socialism, and now it has been made explicit.

Sunday, September 07, 2008

It Doesn't Matter Who Is President

It is nearly impossible to know what a politician will do in office. I blame pragmatism for that difficulty. Nearly every politician succumbs to pragmatism, and pragmatism means that his ideas are divorced from his actions. Ideas are floating, unreal constructs to him, and actions are taken in response to range-of-the-moment considerations. As a result, any politician who proclaims certain ideals will not take those ideals seriously when he is in office. Instead, when he arrives in office, he responds to the day-to-day pressures that buffet him.

The question then becomes, what kind of pressures buffet him? When Jimmy Carter was president in the 1970s, an intellectual rebellion against regulation had arisen, led by figures such as Milton Friedman. Given the country’s economic malaise that Carter’s and his predecessors’ policies had produced and the need to “do something” new, Carter acquiesced to the de-regulationary proposals of Alfred Kahn and others. As a result, it was under Jimmy Carter’s administration, a left-wing Democrat, that airlines, trucking, and railroads were deregulated in the United States.

Consider also the example of Bill Clinton. Faced with the “swing to the Right” embodied in the 1994 elections, Bill Clinton, a conventional left-winger, relented and inaugurated partial welfare reform that reduced the future growth of welfare spending by billions of dollars.

Then consider the examples of Bush Sr. & Jr. Each Bush claimed to be for free markets. We “read the lips” of Bush Sr. on “no new taxes.” We also heard the claims of Bush Jr. to be for free markets. Yet Bush Sr. raised taxes when he was confronted by the pressure of Democrats and fellow Republicans complaining about a large budget deficit. For his part, despite his avowed “free market” stance, Bush Jr. could not resist the cries for protection from steel producers, most of whom, undoubtedly, donated large amounts of money to his election campaign. Therefore, he raised steel tariffs.

The examples I have cited show that party affiliation is a poor predictor of what a candidate will do in office. Also, his stated views have little bearing on what he will do. Rather, because of pragmatism, each candidate responded in a range-of-the-moment fashion to the general pressures around him. Carter and Clinton, although ostensibly anti-business Democrats, partially reduced regulation and the growth rate of welfare. Bush Sr. & Bush Jr., two ostensibly free market Republicans, presided over tax increases and protectionist policies, among other statist measures.

All four presidents were pragmatically responding to the “pressures of the day,” not the dictates of party or conscience.

I suggest that we try to understand what will be the “pressures of the day” tomorrow that will bear on McBama, when he is elected. I posit that those pressures will determine the policies, not the man. Moreover, I will venture that there are two sets of strong pressures that will influence him: (1) environmentalism, and (2) fear of intransigence vis-à-vis Islam. Thus, the next President, whoever he may be, will continue to enact alternative energy and anti-carbon policies, and will continue to take half-measures against the Islamists. I do not think it matters which man is President.


Note: This post first appeared as a response to Burgess Laughlin's comment on my prior post.

Friday, September 05, 2008

"Country First, Country First, Country First"

These words championed on Republican banners during John McCain’s acceptance speech last night mark a dangerous inversion of the moral principles America was founded upon. Consider the principles as stated in the Declaration of Independence:

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable rights, that among these are life, liberty and the pursuit of happiness. That to secure these rights, governments are instituted among men, deriving their just powers from the consent of the governed.
Man has certain inalienable rights, and to secure these rights governments are instituted among men. The individual is paramount in the Founders’ vision. The individual’s right to pursue his own happiness and the rights to life, liberty and property, which are his means of achieving it, is the purpose of government. Governments exist solely as the means to secure these rights.

McCain and the new Republican principles reverse that order. For them, it is country first. Service to the state is the ideal. John McCain himself represents that ideal, the patriotic soldier who re-discovered this principle while being tortured for six years in a Hanoi dungeon. In that dungeon, he says that he learned to stop saying “me first,” and learned to say “country first.”

McCain’s new discovery is actually very old. From his earliest days, man has been sacrificing himself to the state. Whether it was embodied in the tribe and king, or the shaman and witch doctor, or the collective, man’s fate was to suffer for others, until the first free country ever clearly enunciated a different moral principle.

The American Revolution was fought to overturn the principle of individual subservience to the state, to overturn the tyranny of kings and their ilk. In America, men could proudly claim their own happiness first. Their patriotism was based on the knowledge that the government existed to protect them from the tyranny of the state and the forceful violations of their rights by their fellow men.

McCain’s old vision is not patriotic, properly understood. Carried to its logical extreme, it will reduce our status to the level of serfs. Man will return to his traditional relationship with the state, that of subservience. Men will be put back in the dungeon.

While McCain himself does not represent that sort of tyrant yet in degree, he does represent it in principle. One of McCain’s heroes is Teddy Roosevelt. Teddy Roosevelt gave us “authoritarianism lite.” Like McCain, he bashed big business. Roosevelt busted up the big trusts, including Big Oil, which McCain also despises. Roosevelt was also an environmentalist, championing the establishment of the massive Parks system.

Expect more of the same from McCain and the new-old Republican Party, for now. For a vision of our longer-term future, study the history of every society that proclaimed the state first. The party of the state is not the ally of each of us who wants to pursue his own happiness. With country first, the individual is subservient.