Harry Long's  Instablog

In the folk tale Hansel and Gretel, the children's stepmother convinces their father the woodcutter to abandon them deep in the forest so they cannot find their way back home.

Hansel can only leave a trail of breadcrumbs from the bread he has for lunch. Unfortunately, the birds of the forest eat his trail of breadcrumbs, causing Hansel and Gretel to become lost and eventually at the mercy of an evil witch who plans to fatten up the children, then eat them.

Unfortunately, U.S. politicians have left the citizenry in a similar predicament. In the folk tale, the stepmother wants to abandon the children, because she fears starvation. In the past year, low equity to asset ratios at U.S. banks have caused bankers to fear insolvency.

Bankers' response to insolvency has been to lobby for policies which increase the money supply and impoverish ordinary Americans. Quite literally, much of the public has been abandoned in an economic sense by the very elected representatives who are supposed to look out for their interests.

The breadcrumbs are a basic knowledge of economics, and the birds of the forest are the forces of ignorance and propaganda. Like Hansel, perhaps we can plant a trail in stone.

The classic Monetarist view is that all inflation is a monetary phenomenon, related to increases or decreases in the quantity of money.

Intuitively, this makes sense. For instance, in a simple example, if we have a family with a budget constraint (income) of $50,000 and a spike in energy prices causes expenditures related to energy to go from $3,000 to $6,000 a year over a period of 2 years:

In year 1, the family had $47,000 to spend on all goods other than energy ($50,000 - $3,000).

In year 2, the family only has $44,000 to spend on all goods other than energy ($50,000 - $6,000).

It is impossible for the average price level of all goods other than energy to increase, when there is less money to spend on such goods. Therefore, the average price level of all goods must stay the same. The energy price spike is actually deflationary to the prices and quantity demanded of goods other than energy. We can see this in retail sales figures, etc during energy price spikes.

Therefore, the only real way to get the average price level for all goods to increase is to increase the supply of money.

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A simplified economic Monetarist framework is:
 

M x V = P x Q

M is the quantity of money
V is the velocity of money (which is assumed to be constant).
P is the price level during the period.
Q is real output (which is assumed to be constant).
 

With some simple math, we see that:
 

P = M x V / Q

Since Velocity and Real Output are assumed to be constant, when the government increases the money supply, it only leads to an increase in prices.
 

In other words, the government can seriously affect prices, but it cannot affect output by increasing the money supply.

Q = M x V / P

Since Velocity stays constant, Money Supply (M) and Prices (P) increase together, so Q (Real Output) does not change.

What are we left with? Not economic growth, or increases in Real Output (Q), but instead, inflation.

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Of course, like Hansel and Gretel being fattened for slaughter by the witch, the rapid in increase in money supply initially looks like a demand increase to business people of all stripes. But then, as input costs rise, the reality that prices are increasing (rather then real demand increasing) eventually sets in. Input prices increase, and profits do not.

Of course, the above is a coarse, simplified equation, with many built in assumptions. However, the stagflation of the 1970's has empirically proven the point that many of the equation's assumptions are roughly accurate. As Lord Keynes said, “It is better to be roughly right, than precisely wrong.”

Indeed, the 1970's proved furthermore, that in the real world, when prices increase, people (especially the unemployed) can afford less quantity of goods and services, and the economy is actually dramatically hurt.

When the Fed increases the asset side of its balance sheet by buying up toxic debt, the liability side of its balance sheet automatically increases. What are these liabilities? Dollars. However, without a gold standard, there is effectively no true liability, per se, merely an automatic increase in the money supply of dollars.

Intuitively, if the amount of real goods and services stays constant in the short term, there are now more dollars “chasing” the same goods and services and prices rise. Since there are more dollars, each dollar is less valuable. No new value has been created in the real economy of supply and demand for real goods and services.. The price level has merely risen.

Why do bankers like inflation? What are they thinking (I use the term liberally)? First, they needed more capital. What's the abstract (for most people) promise of higher inflation in the future next to their need for capital now? Remember, the government basically handed the banks capital. Who cares if the creation of more money hurts everyone else's savings, increases the general price level, and hurts the standard of living of those on fixed incomes? Second, accounting in the U.S., unlike in some South American countries such as Chile, is done in nominal terms, not adjusted for inflation. If house prices reflate, bankers do not have to write-off as many loans. Inflation covers all manner of banking sins.

But what we have, make no mistake, is the phenomenon of replacing financial expertise with political “expertise”. The average bank may not have diligent banking practices, but it does have the ability to buy votes. Since most Americans' wealth is held in dollars, banks are quite literally lobbying (in effect) to make the average taxpayer's dollars, and hence wealth, decrease in value.

Why are we socializing the cost of stupidity with affirmative action for the formerly rich and stupid? Why are we putting our society at the mercy of the witch of inflation? Why have we given politicians the power to dramatically affect the value of money—a power which recent events have proven they are prone to abuse under the influence of banking lobbyists?

If the goal of certain less competent market actors (Bank of America, Citigroup, etc) is to gain access to the public purse in order to secure their prosperity, the answer is to shrink the public purse, moving the scope of government action to the private domain.

Without government handouts, banks would be forced to raise capital in the private markets, or get taken over by the FDIC and have their deposits moved to less leveraged, more responsible banks.

Banking lobbyists have painted the false choice as one between governments bailouts to shore up equity capital and financial collapse. Multiple firms, such as Indymac, have had their deposits sold off to more responsible banks under the auspices of the FDIC, without any loss of depositor funds. The FDIC did lose almost $11 billion on insuring Indymac's deposits, but this pales in comparison to the cost the government would have incurred to increase Indymac's equity capital. Even large FDIC-led solutions are possible. Washington Mutual, with over $307 billion in assets was acquired by J.P Morgan Chase, in the year's largest deal arranged by the FDIC. These transactions have a clear track record of success vs. government handouts which keep problem banks in business.

The government can still accomplish the essential function of safeguarding depositor funds, without handouts to problem banks. These handouts don't safeguard our financial system--they safeguard bankers' jobs and hurt the rest of us with the resulting inflation. There is no net gain to society from these bailout. There is a net loss to society as the incompetent are rewarded with taxpayer funds, inflation takes hold, and deficits increase the interest paid to foreigners on ballooning government debt.

Nothing good will come of it. If we continue to prosper, it will be in spite of dumb decisions surrounding the money supply, not because of them.

DIsclosure:
No positions in any companies mentioned. That may change at any time.
 

"[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical."

The test of such a statement would be a country which is raising interest rates, while the rest of the world keeps them low. This week, Australia has provided us with such a test (http://finance.yahoo.com/news/Australia-rate-hike-a-good-apf-2390114046.html?x=0). Their central bank has raised interest rates, and so far, Australian equity markets have moved higher

I would argue that their central bank's decision to raise rates will incentivize capital to move from countries with anemic interest rates to Australia, which will (everything else being equal) benefit their economy and equity markets. Currently, central banks around the world operate under the erroneous assumption that anemic interest rates are stimulative. I have argued that ultra low interest rates increase asset prices rather than stimulate the real economy. Australia should benefit from its rate increase. Of course, only time will prove the point.

Hopefully, the world's central bankers and economists are taking note.

Disclosure: Long EFA. Positions may change at any time.

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

This past year, many of us have asked ourselves how corporations could practice such lax risk control. Often, in order to understand a board's effectiveness at risk control, it is wise to examine a board's makeup and the structure of incentives between board members. While corporate strategy is often complex, board members' incentives are often quite obvious after a thorough analysis of footnotes in company filings, such as 10-Ks and Proxy Statements.

Indeed, while many boards meet stock exchange and legal standards of independence, that does not mean that they are free from management influence.

Fremont Michigan Insuracorp is an interesting case study in the structure of board incentives.

1. There are familial relationships between board members and company officers. Michael Dekuiper, a board member, is the father-in-law of CFO Kevin Kaastra. I do not believe that familial relationships are conducive to board independence.

2. Three board members (including Michael Dekuiper) are independent agents of the company, receiving hundreds of thousand of dollars, in aggregate, from the company in commissions. I am confident these payments are proper. However, in my opinion, these payments may create incentives that make it hard for directors to be truly independent. If I were an agent on Fremont's board, I would not want to do anything that would upset executives, since I would be afraid that would jeopardize my business and commissions from the company. Therefore, no independent agent of the company should be sitting on its board. I feel that their presence entrenches management.

For example:

"Three nonemployee directors of the Company are also owners of independent insurance agencies. These individuals are currently appointed as agents with and write insurance for the Company. The terms and conditions of the agency agreements between these agencies and the Company are similar in all material respects to agency agreements with other agents of the Company. The Company pays all agencies commissions on business produced. All agencies are also able to earn profit sharing commissions based on the profit margins of the business produced. Total regular and profit sharing commissions earned by these agencies approximated $545,000, $526,000 and $484,000 in 2008, 2007 and 2006, respectively. The commission rates, including profit sharing commission opportunity, are the same as other agents of the Company. The agencies are independent agents and also write with regional and national insurers that may be competitors of the Company."(quoted from Fremont's latest 10-K, page 80)

3. In order to assure shareholders and agents that business is being placed with agents on the basis of merit, not familial relationships, or membership on the company's board, the company should publicly disclose the loss ratio of business generated by board members who serve as independent agents in relation to the average loss ratio for the company, broken out by each of the company's business lines, not only each year, but on average for the past 5 years.

    

4. One board member, Jack A. Siebers, is employed as a principal of Siebers Mohney PLC, a law firm that receives legal fees from the company. I would argue that such legal fees might incentivize him not to jeopardize business for his firm. Similarly to the three agents on the board, I believe his presence entrenches management. Whether or not board members pass stock exchange definitions of independence, the most important thing is that they are independent of any conflicts of interest or incentives which would run counter to their representing shareholders' interests.

For example:

"A nonemployee director of the Company is a partner in a law firm. The Company has retained this law firm for certain legal matters in the past and plans to continue to do so in the future. Legal fees paid by the Company to the law firm were approximately $69,000 in 2008, $74,000 in 2007 and $35,000 in 2006."

(quoted from Fremont's latest 10-K, page 80)

5. The board is staggered. This prevents shareholders from being able to elect a majority of board members in any individual year. A non-staggered board is shareholders' best check on management. As we have seen in America, we need stronger board oversight, not weaker oversight of management, to prevent breaches in corporate governance and irresponsible risk-taking. Being able to replace the entire board at one annual meeting is an excellent check on management.

6. The company needs to be far more diligent in its public filings. For instance, in its 2008 proxy statement, it stated the wrong deadline for the nomination of directors. The deadline in the proxy, disturbingly, contradicted the date stated in its Articles of Incorporation.

    

7. Fremont's personal lines have gone from a 2006 underwriting gain of $4,129,003 to a 2008 loss of $806,725. Simultaneously, net premiums earned in personal lines have grown tremendously. This growth has continued in the latest quarter reported at a high rate. Why is management growing a line with profitability that has declined for years and has now gone negative? If management and directors really understand that this is a grave problem, why haven't they stopped and indeed contracted the growth in premiums in this line until the issue of losses has been shown to be successfully remedied for at least two years?

    

8. Management must be open to suggestions on how to improve the situation and publicly articulate a plan to ALL shareholders. This plan must include a provision not to grow personal lines until the underwriting situation is fully remedied, with a strong combined ratio in the line of below 95, for at least 2 years. I believe that management's failure to do so already violates the tenets of conservative underwriting. In addition, I believe that the board's failure to insist on such a plan is clear evidence that the board is not overseeing risk properly.

    

   As we have seen in America, at financial institutions, board oversight of risk control is a key function of good corporate governance, and indeed, corporate survival. Board members with incentives which are potentially not aligned with shareholders must resign.
   
   

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   Disclosure: Harry Long owns FMMH shares directly, through partnerships, and through trusts. To the best of his knowledge, certain of his family members own FMMH shares through partnerships and trusts. Such ownership may change at any time.