Carneades'  Instablog

 

The National Association of Realtors released data on Existing Home Sales this morning which showed existing home sales declining 2.7% from July to a (SAAR) rate of 5,100,000 dwellings per year. The one year chart of existing home sales (blue line) above shows that we've spent the latter half of the past 12 months witnessing a rise in sales of existing homes. In fact, August's decrease was the first decline in activity since the March numbers were released; ironically, March also marked a low for US equity markets.

If you're looking for the silver lining, the number of months worth of housing inventory on the market is down 19.8% year over year. At 8.5 months of available housing inventory, we are still above the 6 month level which normally constitutes a "healthy" housing market. However, the inventory trend is headed in the right direction.

The risk I see going forward is that a) existing home sales moderate, or stagnate, around their current levels, and b) new housing starts continue to rise, possibly as a function of stimulus funds making their way into the economy. The government has already displayed a willingness to use stimulus funds to revive construction of politically advantageous housing projects; this sort of activity may be beneficial in the short term from a pure employment perspective, but it ultimately exacerbates the single largest fundamental drag on the US economy, i.e the anemic housing market. Housing starts and existing sales either need to both be trending positive, or starts need to be falling while sales are rising. The August trend - rising starts and falling sales - is a recipe for a continuation of housing's woes. Obviously, there is no use in over-analyzing each new data point; I'm merely pointing out the disadvantages the market faces if the current month's trend were to continue.

*no positions

Many commentators have, in the aftermath of the destruction wrought by reckless financial industry behavior, promulgated the view that restrictions should be placed on bankers' pay. The theory goes that there is a direct correlation between excessive risk taking and the expected monetary compensation derived from said risk taking. Most problematic is the reality that, contrary to the concept of risk - i.e it correlates with reward to the upside and loss to the downside - it appears that a downside never actually existed for some folks. Couple this perversion with the fact that Wall Streeter's annual compensation has reached a multiple of average US pay rivaled only by professional athletes, and it's easy to see why a lot of folks are outraged.

Watching ESPN last night, it occurred to me that professional sports has done a far superior job in structuring compensation for it's highest value added contributors - the actual athletes - than Wall Street has managed to do for it's upper echelons. A professional sports team is in fact a self-contained business, employing a wide range of individuals who are mostly paid standard, competitive salaries. The same holds true in the banking industry; a teller working at the deposit window is earning a modest wage, despite the handsome rewards that are doled out to those running the organization. The difference between the two industries however - besides the obvious variations in core business, is that professional sports leagues in America were able to foresee the adverse effects of ballooning salaries at the top of their member organizations, and implemented effective regulation of those salaries. Interestingly, each of the top three professional sports leagues in the US - NFL, NBA and MLB - have implemented differing strategies for tackling this problem. The three approaches can be likened to the respective league acting as the State, with varying degrees of interference. A brief description of each league's salary regulations follows:

National Football League
The most recent Collective Bargaining Agreement (CBA) between the League and the NFL Player's Association sets a salary cap for each team that is based upon the League's Projected Total Revenues (PTR). For 2008, the formula which determined the maximum amount each team could spend on player salaries was (PTR X 0.575 - League wide projected Benefits) / n , where n= the number of NFL teams for that year. Keep in mind that the CBA is a 361 page document, so in addition to knowing that attorneys had a field day with this one, we can infer that there are some exceptions to the above formula that can result in a higher or lower annual salary cap than the formula would imply. The point is though, each team has the exact same amount of money to spend on player's salaries each year.

National Basketball Association
The NBA's collective bargaining agreement is similar to the NFL's in that it's based upon a percentage of the League's annual revenue, and is allocated evenly across all teams. The NBA's system is more flexible however, evidenced by the fact that many teams "live" above the salary cap. There are specific portions of the CBA which allow for salary cap violations, most notably when a team wishes to re-sign a veteran player who has already spent at least 3 years with the team. There are also salary cap "taxes", meaning that for instance, if a team's salaries exceed a pre-specified amount, that team will be taxed by the league for it's excesses. By the way, those taxes are distributed evenly amongst those teams which did not disobey the salary cap.

Major League Baseball
MLB's Collective Bargaining agreement, the most free-market-like in professional sports, states that a player's salary is an amount to be determined between the player and the owner of the baseball team. There is no annual limit to the amount that a baseball team may spend on it's players salaries. There is however, a stipulation known as the Competitive Balance Tax; without getting into details, the Competitive Balance Tax is the theoretical equivalent of the progressive income tax system in the United States.

The three models above provide what I see as a relatively reasonable framework for the proper structuring of high level Wall Street pay. Salaries for each financial institution could be collectively based upon the trailing year's revenue. A substantial portion of that designated pay should be placed into an escrow account for around 5 years, and will be distributed accordingly assuming that certain performance measures have been met for the subsequent half-decade. In the event that the financial institution has significant losses for a given year, the escrow account will be used to shore up the bank's capital position. In the event of any sort of accounting scandal, the funds will immediately be distributed - in their entirety - to shareholders.

Could such a compensation model have prevented many of the problems we face today? My bet is yes.

Disclosure: no positions

The US Census Bureau released August housing starts data this morning which showed a 598,000 (seasonally adjusted annualized rate) rate of starts. The August rate was 1.5% higher than July's 589,000 figure, but still 29.6% below the August 2008 rate of 849,000.

The current recession has decimated housing starts far more than has ever been witnessed during the modern era of data recording. Prior to the current state of malaise, analysts had viewed the 1,000,000/year rate as the level at which new starts could not remain below for any extended period of time. After all, history has shown that whenever starts slip below 1 million, they do not remain so for long, and quickly spring upwards. With US starts below that threshold for the past 13 months however, that conventional wisdom has been shattered.

In order for a sustainable recovery in housing to occur, starts must remain at these depressed levels for at least another year. Unless builder's plan on selling all newly constructed homes below their cost, they will not be able to compete with the massive foreclosure inventory that is bleeding onto the market.

The August numbers do not indicate that starts have raced ahead of a level conducive of a recovery, however, further "improvements" in the starts area will serve to hinder, rather than promote, a housing market recovery.

Disclosure: no positions

InfoNgen was used to research this article

After falling victim to conventional wisdom last week, and speculating whether the FDIC had weeks or days remaining before it would need a Deposit Insurance Fund restoration bailout, I determined that the prudent course of action was to dig a little deeper into the issue. Specifically, I wanted to know the basics behind whatever accounting procedures took place at the FDIC in order to generate the headline "balance" of the Deposit Insurance Fund. In doing so, I came across several dissenting opinions (including an especially well-written article in American Banker) which, through a more precise look at the DIF, determined that the Fund has actually remained relatively stable despite there being nearly 100 bank failures in 2009 alone. Furthermore, I would argue that the Deposit Insurance Fund is not only far from depletion, but also unlikely to come under any considerable stress throughout the forthcoming year.

Most media representations of the DIF involve the reporting of the final line of the Deposit Insurance Fund's balance sheet, which is labeled "Fund Balance". While this may seem like the logical thing for journalists to do, the truth is that it is an inaccurate measure of the FDIC's funds available to absorb depositor losses.

Basically, the DIF's balance sheet is arranged much like any other corporation's would be, although the underlying "accounting equation" carries one distinct label; Assets = Liabilities + Fund Balance. To assume that the line labeled "Fund Balance" is inclusive of the FDIC's total deposit insurance resources at the moment is to ignore a line in the liabilities section labeled "Contingent Liabilities: future failures". This line item represents the FDIC's best estimation of the next four quarter's worth of failure related DIF losses, and is adjusted based upon the FDIC's assessment of troubled bank's balance sheets/loan losses/deposits etc. At the end of Q2'09, the FDIC had set aside $31.968B to cover losses it expects to occur over the next year. For the 12 months ended June '09, the DIF's headline "balance" has declined by $34.849B; however, Contingent Liabilities have risen by $21.378B. In other words, although the Fund's balance has declined 77% year over year, the FDIC's loss absorbing resources have only declined by 24% over the same period of time.

When you consider the substantial rise in Contingent Liabilities, along with the fact that the DIF has guaranteed revenue in the form of FDIC "assessments" on the banking industry, it becomes clear that the Deposit Insurance Fund is in a lot better shape than many give it credit.

Disclosure: no positions

InfoNgen was used to research this article

The corporate graveyard is littered with companies that were either unable to adapt to structural changes within an industry, or were - in the saddest of situations - unaware that these changes were even happening. Blockbuster Inc. (BBI) currently suffers from a combination of those two factors, a predicament exacerbated by the emergence of aggressive competition to it's core video rental business. This competition has intensified to the point that Blockbuster could be forced into either bankruptcy or irrelevancy within the next 12 to 18 months.

Most of us have stepped inside one of Blockbuster's brick and mortar video rental locations; at one time, getting in the car and heading to Blockbuster was actually an exciting event. Then Netflix (NFLX) came along, offering customers video rentals by mail, immediately siphoning sales from Blockbuster. Presently, subscription based video-by-mail services account for 36% of all videos rented by consumers, compared with a 45% share for rentals purchased at physical store locations. Blockbuster has also attempted to offer a Netflix-like service, however, it has clearly been unable to compete in this arena. The Company's total revenue was nearly $700MM less in 2008 than in 2003; a sign that it has been woefully incapable of replacing lost brick and mortar sales with online and mail alternatives. As a comparison, Netflix logged 2008 revenue that was over $1B more than it recorded in 2003.

Recently, video rental kiosks have made an enormous splash by offering cheap $1/day rentals, in prime locations (WalMart, grocery stores). DVD's rented at these kiosk locations now account for 19% of all video rental activity. More importantly however, is the marketing research firm NPD Group's prediction that, in the year 2010, 30% of all video rental transactions will take place at kiosks! A market share shift of that magnitude, in such a short period of time, will likely destroy Blockbusters brick and mortar sales. The Company appears to understand the dying nature of a DVD rental physical storefront, and has plans to charge headfirst into the kiosk rental business. Blockbuster only has 500 such machines right now, but expects to roll out 7000 in the year 2010 alone. Alas, this effort may be a textbook example of "too little, too late"; the leading player in the kiosk game - Redbox - already has machines in over 15,000 locations. The traditional real-estate cliche - location, location, location - has distinct parallels in kiosk site selection; a kiosk must be located in a venue that is convenient for the consumer. With a 14,500 machine disadvantage, it's likely that Blockbuster will struggle to compete with Redbox in the battle to place kiosks in the most convenient spots. Over the next year, the largest threat to the kiosk distribution model will be licensing disputes with change-averse Hollywood studios. As far as Blockbuster is concerned however, the question of whether or not studios will succeed in stymieing kiosk sales is effectively the difference between a bad or worse outcome for the Company; they will either continue to make a push into the market - from an extremely disadvantaged position - or their only chance of survival will be squashed by the studios.

This rapid shift in the video rental business is occurring at a horrible time for Blockbuster. The Company's revenues are on pace to decline $1B, or almost 20%, in 2009 compared to 2008. Assuming that NPD Group's projections regarding kiosk market share are correct, Blockbuster's second half numbers will deteriorate even further from already depressed current levels. I wouldn't be surprised if the Company logs less than $4B in revenue for 2009, a greater than 33% decline in annual revenue since 2004's $6B year. Unfortunately for Blockbuster, that isn't even the bad news; the Company has $415MM worth of debt obligations due between now and the end of 2010. So how does a Company with less than $100MM in cash, rapidly declining sales, and  gruesomely negative cash flow meet such an obligation? Well, Blockbuster's strategy is to do the only thing they can: slash G&A as rapidly and as deeply as possible, and sell assets like there's no tomorrow (because there might not be). This was a borderline-achievable goal prior to the rapid ascent of kiosk rentals; under present conditions however, it may be impossible. Simply put, sales may be declining faster than Blockbuster's ability to preserve cash via cost cuts and asset sales.

Many people still visit Blockbuster's physical locations, and may be disheartened in the event the Company is unable to meet it's looming debt obligations. My movie viewing habits will not be disrupted though; I've been streaming Netflix video content, on-demand, through my XBox for several months now.

Disclosure: no positions