Charles Lieberman's  Instablog

Strong consideration is being given to disassembling large financial institutions because they are too big to fail based on the experience of the past two years. It has been argued that a financial conglomerate like Citigroup is also too large and complicated to manage, but this self-evident claim may be incorrect. If we fail to understand exactly how the crisis was allowed to occur, we risk implementing the wrong solutions that cold weaken or undermine our financial institutions.

 

It is utterly simplistic to argue that the credit crisis was caused by banks that were too big to fail. Neither AIG nor Fannie Mae or Freddie Mac nor Merrill Lynch nor CIT were banks. Being small did not prevent the savings and loan crisis a couple of decades ago. Being large, by itself, did not cause the credit crisis. However, a failing large institution can cause huge systemic problems, so the real question is how did some of our largest financial institutions manage to fail?

 

Buffett’s decision to buy the rest of Burlington Northern at a significant premium to the stock’s price is representative of purchases by astute investors to take advantage of the decline in equity prices in the wake of the credit crisis. Investment titans become rich by scooping up bargains when others do not see them. Thus, Buffett’s purchase is another signal that stock prices are cheap and investors should be buyers, just like Buffett. Plus, it is a sign that Buffet is seeing the economy bottom/turn. On June 24^th, 2009, Buffet was quoted on CNBC saying the “US economy is in shambles.” Now, 131 days later, Buffet is making an “all-in wager on the economic future of the United States.”

 

Warren Buffett’s investment acumen has never been in doubt, so when he steps up to make a major purchase, investors should pay attention. Why now and why Burlington Northern? The now part is very straightforward. Despite their dramatic rebound off the March 9 lows, stock prices remain very cheap and remain below pre-Lehman bankruptcy levels. From a longer term perspective—the only perspective used by Buffett—an economic recovery will buoy the profits and value of an industrial stalwart like Burlington. Unambiguously, buying Burlington is a play on the recovery of the domestic economy.

The Federal Reserve Bank of Boston conference held on Cape Cod this past week focused on bank regulation, not on current policy. As former Fed Vice Chairman Alan Blinder put it so well, “It’s broke and we need to fix it.” In fact, there appeared to be unanimous agreement that the existing supervisory and regulatory structure failed and a major overhaul is a necessity. But while Blinder’s principles and framework for the overhaul were well received, there is little doubt that conference attendees, mostly economists, differed considerably over the nature of the new structure. Moreover, it is doubtful that the changes that emerge after Congress and lobbyists finish will reflect the well conceived principles that garnered solid support.

 

Even so, much of the discussion away from the sessions and papers kept coming back to current policy. The timing of the Fed’s “exit strategy” came up repeatedly. No one expressed an impending need for the Fed to begin withdrawing the liquidity it had injected into the financial system. Maybe I spoke to the wrong people. However, many attendees questioned why anyone would give serious consideration that the Fed withdraw liquidity before the economy had generated its first quarterly gain in GDP or even its first increase in monthly payroll employment. 

We are still in the early stages of earnings reporting season for the third quarter, but the preliminary indications suggest that corporate profits will exceed expectations for the third consecutive time, as we have been expecting. Q3 should not be a total surprise. The real surprise came in Q1, when economic growth contracted at a horrific 6% annual rate, yet profit margins increased. Now, profits are growing in response to the first signs of economic expansion. Companies have sharply reduced costs and operations are very lean. Even small increases in sales translate into solid increases in earnings, yet expectations are low. We expect more of this going forward, helping justify the sharp rally in the equities market that began in March.

 

The credit crisis that followed Lehman’s failure sparked a sharp retrenchment in consumer spending, but also a massive increase in corporate layoffs. Firms were very aggressive in their efforts to reduce costs to preserve their businesses. Companies reduced employment significantly more than sales declined, as documented by the record liquidation of inventories in the first half of the year. It is now evident that these cuts are unsustainable. Businesses must rehire just to prevent inventories from falling even more. But before they resume hiring, it is critical that they experience some rise in sales, so they can project an economic recovery. As recovery prospects improve, hiring will pick up at a more meaningful rate.

“This time, it is different” is recognized as one of the most dangerous ideas in the investment business. So it is somewhat surprising that so many people believe that economic growth will be disappointingly weak, no more than 2% in real terms, for an extended period into the future, as poor credit market conditions, troubled housing markets, and assorted other problems are resolved gradually. So we’re supposed to prepare ourselves for this weak growth that is the “new normal”. But does it make any sense? While it sounds plausible that some adverse conditions might hold back growth until underlying conditions improve, it is neither grounded in economic theory, nor does it make any sense that growth would be limited so severely. And with policy so expansion oriented, anything less than a solid expansion ought to be a disappointment.