From a small northwestern observatory…

Finance and economics generally focused on real estate

Archive for April 2009

4/27/09 — The Death of Efficiency?

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I was trying to explain to a lawyer why AIG was “too big to fail”.

While I let that sink in, I’ll tell you a little story. Back when I was an academic, every summer our Finance department would have a little private, in-house, self-edification symposium we jokingly called “Finance Camp”. Usually running 4 to 6 weeks, it would consist mainly of a weekly, afternoon session of 1 – 2 hours, in which each of us would take turns making a presentation on some aspect of that summer’s theme. One summer it was bond portfolio duration. Etc. You get the picture?

Anyway, one summer, we decided that the theme would be “bankruptcy”. While planning for the sessions, we realized that the Law School also taught “bankruptcy”, so we should invite the 3 or 4 law professors who taught that subject. We planned for a big “round robin” intro meeting, followed by alternating weeks of presentations from finance and law. Good idea, right?

Sigh… as it happened, not only were we talking about two different SUBJECTS, we were frankly talking about two different LANGUAGES. Case in point — from a finance perspective, if bankruptcy is properly priced ex ante, then the event of bankruptcy is irrelevant. From a legal perspective, the very concept of such irrelevance is inconceivable.

So, back to AIG. Everyone, I guess, seems to bemoan the fact that we have (or had) companies in America that were “too big to fail”. Because what they do is so clouded in mystery, it’s hard for the person on the street to grasp how badly the economic machinery would suffer if AIG failed. Imagine, instead, if Boeing and Airbus were one company, and they suddently went out of business, taking with them all the expertise not only to build new planes but also all the expertise to repair, maintain, and service all the existing airplanes. In short, air-transport in the world would grind to a halt by 8am t. Yeah… THAT big.

So, why are Boeing and Airbus so big? After all, these companies are fairly new to the game — Boeing didn’t even get into commercial aviation until the jetliner days, and Airbus is a fairly recent amalgamation. What ever happened to venerable names, like Douglas, de Havilland, and Lockheed?

In short, they were victims of efficiency. Monopoly theory suggests that as firms become more-and-more efficient, the “also-rans” drop out. One big mistake and a firm ceases to exist. Think about automobiles — the U.S. alone used to have dozens of auto manufacturers. Today, we’re down to three domestic producers (not counting off-shore headquartered labels which are actually made here). Indeed, world-wide, the number of profitable auto makers may be just a hand-full after this recession is over.

It might surprise the lay person to read that financial services is actually a fairly low-profit business, compared to making automobiles or airplanes. Car makers can easily knock a few thousand dollars off the list price and still make money. Boeing is currently making millions of dollars in concessions on airplanes. On the other hand, margins on financial instruments are extraordinarly thin. If so, then how are the AIGs and Merrill Lynchs of the world able to pay seven- and eight-figure salaries? Simple — a one percent margin on a billion dollars worth of business is still $10 million.

In a world like that, where financial houses constantly trade with other financial houses, we end up with razor-thin margins, which leads inexorably to monopolies. Add to it the fact that these financial houses are massively intertwined, and we end up with houses of cards that could completely collapse if a major, key-stone player falls down.

How do we fix it? The first question is should we fix it? Is the cost of having to pick up all of Humpty-Dumpty’s pieces every few years greater than the cost of inefficiency? Of course, this question probably doesn’t matter, since the regulators in the U.S. and most everywhere else seem inexorably headed toward new rules which will add significant inefficiency to the process. Is that a bad thing? Probably not — it would be nice to go back to the day when there were 10,000 mortgage lenders in the U.S. rather than just a hand full, when there were dozens of major stock brokerage firms rather than just a few, and when AIG didn’t completely own the insurance business (and a few other businesses that may surprise you, like airplane leasing). The price of this — and let’s call it an insurance premium — will be significant inefficiencies in the financial marketplace.

Written by johnkilpatrick

April 27, 2009 at 11:35 am

Posted in Economy

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4/21/09 — From a Seattle Perspective

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Ironically, I’m writing this sitting in a hotel room in Baltimore.

As many of you know, the Seattle Post-Intelligencer newspaper is one of this year’s recession casualties. However, many of their staff, with much help from their loyal followers, have created a very good on-line news source for Seattle-ites. We wish it well, along with many more like it around the world.

My good friend, Chuck Wolfe, contributed an editorial today. Whether you’re from Seattle or not, I encourage you to read it here. His comments can be generalized to any community facing a changing development dynamic.

Written by johnkilpatrick

April 21, 2009 at 5:11 pm

4/19/09 — Anyone Reading Krugman?

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Some Nobel Prize winners do great things, then it gets misused. Options theory comes to mind — Fisher Black (who died before the Nobel was awarded) and Myron Scholes gave us some wonderful tools for understanding how complex instruments should be priced, but I doubt they ever predicted the wild-and-crazy derivatives market that would result from their elegant math.

Others do great things, then misuse their fame themselves. Case in point — Paul Krugman. Now, I personally agree with most of the rest of the economic world that Krugman’s work in international trade was brilliant. On the other hand, I disagree with a lot of his politics. Don’t get me wrong — I read him all the time, and encourage others to do so as well. Note the link to his New York Times blog over on the right hand side of this page.

None-the-less, his April 17, 2009 column, titled Green Shoots and Glimmers, is Krugman wearing his “glass is half empty” hat, which he loves so very much. His column stands on its own, and I encourage you to read it. I don’t disagree with his facts. What I disagree with are his interpretations.

I would concur that unemployment probably hasn’t hit bottom. My own touchstone, based on the Philadelphia FED’s latest survey, is that we’ll see unemployment bottom out sometime in early 2010 and somewhere shy of 10%. I think we’ve seen the stock market bottom, and I think we’re close to seeing the bottom on housing prices.

Krugman would say this is all bad news — signs that the economy isn’t recovering and the Obama administration isn’t spending enough money. I would counter that the best ANY administration can do is to arrest the downward spiral (which the administration has apparently done), clean up the mess (which they are doing), and get out of the economy’s way so the free markets can go back to work (which is precisely the opposite of what Krugman would have them to do).

Do I agree with everything Obama is doing? No, but he’s doing SOMETHING, and it appears, at least in the long telescope, to be working. I don’t think we should all be cheerleaders, and a good, loyal opposition is a healthy thing for a democracy. However, the biggest danger for Obama’s administration doesn’t come from the right, but from the left, as evidenced by Krugman’s column.

Written by johnkilpatrick

April 19, 2009 at 2:28 pm

Posted in Economy

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4/17/09 — GGP Files for Bankruptcy

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Argus, on their blog, have a well-written report on the General Growth Properties Chapter 11 filing. I have more than a passing bit of interest in GGP — my Ph.D. dissertation was on REITs, and GGP was one of the companies I analyzed. More importantly, what implications does GGP’s filing have for retail real estate in general?

Is this a passing phenomenon, emblematic of the trough of a recession, or are we facing a structural shift in the American economy away from retail consumption? The former has some implications for GGP’s management (why did you leverage-up so much when you know that consumer recessions are cyclical realities?) as well as for their lenders and bondholders (why did you loan them so much?). The latter potentiality has much deeper, longer-term implications for both GGP as well as their competitors.

Only time will tell, but there is a lot of sentiment among both economists and other public policy types that a return to pre-2008 consumption patterns isn’t necessarily the best thing for America. Naturally, our global trading partners are apoplectic over such an idea — for example, if we quit “consuming” all of China’s stuff, many of their workers are either going to have to go back to farming or their economy is going to have to be more internally self sufficient. In either of those scenarios, China starts looking a lot like the next Japan, only much bigger.

Written by johnkilpatrick

April 17, 2009 at 8:58 am

4/16/09 –This USED to be weekly

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A surprisingly large number of entrepreneurs are sitting on the sidelines waiting to see what the Fed’s toxic asset solution will look like. In the spirit of “deja vu all over again”, this look a heck of a lot like 1989/91, when the RTC was coming into existence and a significant number of private firms helped with the workout of bad assets from the Savings and Loan crisis. It was terrifically clear back then — and it’s clear to me now — that this was/is not the sort of thing that can be done internally at a Federal agency (then, the FDIC, now the Treasury). An agency simply doesn’t have the people-power or the entrepreneural expertise to put these assets back to work.

Fortunately, it appears that Geitner “gets it” and the early indications are that they will want to bring some serious players (the Blackstones, Blackrocks, and Goldman Sachs of the world) to the table. From there, it’s anyone’s guess, but my bet is a thousand small private equity firms will get involved to buy, repackage, and redeploy the bad assets.

Written by johnkilpatrick

April 16, 2009 at 12:11 pm

4/14/09 — We’re all Hicksians Now

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What we call “Keynesianism” or “Keynesian Economics” really owes more of a tip-of-the-hat to a fellow named John Hicks, who in 1937 wrote “Mr. Keynes and the Classics” which, in effect, put Keynes’ somewhat theoretical constructs, his General Theory, into more practical terms. Hicks followed up with his own classic textbook, Value and Capital, which should be must-reading for all advanced economics students.

I say should, but, sadly, it really isn’t. Even when it was prescribed by elderly professors, a whole generation of younger students tended to gloss over both Hicks and Keynes in favor of more “practical” economic topics. After all, who was going to write a dissertation on the IS-LM curve?

Now that we’re all “Keynesians” again (or more properly “Hicksians”), it’s helpful to go back to basics, and I’m specifically referring to that frequently discounted IS-LM curve. A few days ago, I was struck by how little I remembered about these things. With some chagrin, I started doing some research, and found out I’m not the only one — even the best economists in the world are starting to dust off old advanced macro texts and re-remember just how an economy is supposed to work. For a great and relatively brief exposition on this oft-abused topic, I’d refer you to some class notes written by Paul Krugman a few years ago when he was “stuck” by his department at MIT to teach a quarter of Macro Econ Theory to grad students and also had to dust off these concepts. Thanks to the internet, nothing you ever write (particularly if you’re a future Nobel Prize winner) is totally forgotten, and you can read it on-line here. For a little extra commentary, I’d refer you to a 2006 entry from Greg Mankiw’s blog here.

Written by johnkilpatrick

April 13, 2009 at 6:55 pm

4/6/09 — Back in the Office

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Was in New Orleans and Baton Rouge last week. The Louisiana economy, which has never been wonderful, none-the-less seems to be handling the current recession better than most. Of course, the whole of the Gulf Coast is still recovering from the disasterous 2005 hurricane season that saw Katrina and Rita — both Category 3 storms at the time of landfall — hit the Louisiana coast within a month of each other. For a synopsis of the real estate research implications of these storms, see my 2007 Journal of Real Estate Literature article with Dr. Sofia Dermisi. You can also get a great synopsis of the economic impacts of these two storms from Louisiana State University’s Geographic Information Center.

According to LSU, about $25 Billion in Federal redevelopment funds have come into that state in the past 3 years, with the bulk of that flowing into the New Orleans area as a result of Katrina. Of course that doesn’t include substantial private settlements, such as the $330 milllion Murphy Oil settlement which Greenfield assisted in negotiating. The accounting for all of these pivate dollar flows will probably never be totalled.

Does that mean Louisiana has recovered from these disasters? Far from it. The state is still in economic turmoil, and current state budget cuts have the potential to eviscerate higher education, further increasing the “brain drain” that Governor Jindal pledged to stop in his campaign.

But, given where Louisiana was, economically, as of about a year ago, one would have expected that the recession would have simply shut down the economy there. Instead, there’s still a wonderful vibrancy in the state. Crops got planted this year, refineries are still in operation, and tourists still flock to the state. Anecdotal reports indicate that building construction has slowed, but not as badly as in some other parts of the country. Louisiana still has economic problems, and like the rest of the country, many of these problems are beyond their direct control. However, they seem to be slowly pulling themselves together.

Written by johnkilpatrick

April 6, 2009 at 12:09 pm