Welcome to America, Home of “The Speculation Economy”
With the financial world still in relative chaos, it’s time to take stock of some basic questions. Here are a couple: Is Wall Street doing more harm than good right now? How did it get to be such an integral part of the economy in the first place?
To answer that, we spent some time with Lawrence E. Mitchell, a George Washington University law professor who authored a new book called “The Speculation Economy: How Finance Triumphed Over Industry” (Berrett-Koehler Publishers Inc.)
Deal Journal: It’s so easy not to even ask how things got to be a certain way. You tracked the roots of the modern corporation. What did you find?
Lawrence Mitchell: Before 1889, for the most part, a company couldn’t buy stock in another company. In 1893, New Jersey came up with a law that allowed companies to buy stock in other companies. The most important part is that New Jersey said boards of directors had the final say on the value of the property. Now they had a way to combine and take over a corporation by printing stock. You could print as much stock as you needed to buy these companies.
In 1896, we came out of a huge depression. There was all this surplus capital around. Financiers and promoters, and later J.P. Morgan, said ‘wow, look at this. We can buy these companies for little or no cash. We can make bundles of money.’ For example, when Morgan put together U.S. Steel in 1901, it was capitalized at $1.4 billion, and Morgan took $62.5 million in stock. In 2007 dollars, that was a $1.4 billion fee, which was then dumped on the market. They were printing huge amounts of stock, compensating sellers with it, and all the stock got dumped on the market.
DJ: Then came the huge explosion in the stock market.
LM: Trading volume in 1897 was 77 million shares on the NYSE, almost all railroads. By 1901, that was 265 million shares. During this time, and depending whose numbers you use, anywhere from $8 billion to $20 billion of capitalization got shoved into the U.S. economy, almost all of it stock.
DJ: So what’s the matter with that? This capital was helping build new businesses and the economy at large.
LM: In most of these offerings they raised some working capital. But most of it was secondary sales. Industrial jobs grew no faster than they did previously. It was speculative.
DJ: And that’s the legacy you describe in your book.
LM: It transformed the entire financing of American business. Prior to this time, businesses were financed with retained earnings, founder savings, maybe some local debt and equity kicked in by friends. Common stock has an unlimited upside. And so the market began to demand that corporations focus not so much on the steady production of goods and services, but on shoving dividends out the door.
Today, 20% of GDP comes from manufacturing and 32% comes from finance. It kind of makes you wonder what finance was financing.
DJ: But part of the success of America has been its ability to innovate with finance.
LM: A tiny, tiny fraction, less than 3%, is for new offerings. The rest is secondary trading. If we’re not financing productivity, what are we financing? You start to see this sort of second-order level of remove from production and industry, of finance taking on its own independent logic, where money is moving from one pocket to another but not landing any place where it’s making any difference.
DJ: So we’re in danger of falling down the rabbit hole of finance?
LM: I’m deeply worried that unless we pay attention to restoring a basic balance to our economy, and redirecting finance to its original goal – which was to finance productivity – then we’re going to find ourselves in the long term in very bad shape.
DJ: How can we fix the problem as you see it?
LM: My favorite is that we revisit long-term capital gains taxation. You could take it industry by industry, one year versus 10 years, creating a sliding scale capital gains tax. For day traders, if they trade within a month, tax 90% of the gains, and over 10 years, extend tax forgiveness.
DJ: Seems like a pretty tough mission to get it changed.
LM: Thorsten Veblen said in 1903 that ‘industry and finance are two different things. The well being of the nation depends on it.’
Industry and Finance are indeed, two very different things, but our esteemed Congress doesn't get it:
The proposal by Bernanke and Congress to up the lending limit on Fannie Mae and Freddie Mac will not solve a thing if both are capital impaired and cannot make new loans. That seems to be the situation as Freddie Mac Loses $2 Billion and Seeks New Capital.
Freddie Mac, the nation's No. 2 buyer and guarantor of home loans, lost $2 billion in the third quarter and said Tuesday it must raise fresh capital to meet regulatory requirements. Its shares fell more than 26 percent.
The mortgage financier said it is "seriously considering" cutting in half its dividend in the fourth quarter and has hired Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. as financial advisers to help it examine possible new ways of raising capital in the near future.
My Comment: After listening to its latest conference call I questioned Fannie Mae's cure rates and capitalization in Fannie Mae's Credit Loss: What's The Real Story?
In the call Fannie repeatedly dodged questions over capital concerns. In response, I wrote "Fannie Mae is way undercapitalized and a systemic threat. Oddly enough this was the opinion of the Fed before they abruptly changed their minds in reaction to the credit crunch."
It did not take long to prove that assertion, and so much for the alleged transparency from this Fed.
Expect a disaster in Fannie Mae's next quarterly statement as well.
Freddie Mac said it set aside $1.2 billion in the turbulent July-September period to account for bad home loans, reflecting "the significant deterioration of mortgage credit."
My Comment: It is now clear that Fannie Mae is way too optimistic about what cure rates will be. This will restrict the ability of both Fannie and Freddie to take back more loans as well as issue new loans.
The $2 billion third-quarter loss for McLean, Va.-based Freddie Mac worked out to $3.29 a share, compared with $1.17 a share in the third quarter of 2006.
Freddie Mac's regulatory core capital was estimated to be just $600 million in excess of the 30 percent mandatory target capital surplus directed by the Office of Federal Housing Enterprise Oversight.
My Comment: In the next bubble blowing gimmick, expect the amount of regulatory capital required to be lowered. The Fed , Congress, and oversight committees will do damn near anything to keep the bubble alive. However, nothing will work. The system is broke. It's time for a new one.
"We have begun raising prices, tightened our credit standards and enhanced our risk management practices," Piszel said. "We also continue to improve our internal controls."
My Comment: Raising prices huh? We finally have explicit confirmation of what I have been saying for a long time: Mortgage rates are going to disconnect from 10-year treasuries over default concerns. We can now add capital impairment as a reason for further disconnect.
"We were getting thin" in terms of excess capital, and Freddie Mac decided it needed to bolster its capital "to manage through this credit cycle," Piszel said in a telephone interview. That cycle isn't expected to improve until 2009, he said, with home prices projected to register a 5 percent to 6 percent decline nationwide.
My Comment: Notice how 2007 became 2008 became 2009. I expect it will be more like 2012 at the earliest. My reasons were outlined in When Will Housing Bottom? Now we have more reasons to add to the list.
And, Peregrine Financial Group, the serial undercapitalized Investment "Experts", provides more reasons, to realize that finance and industry are not our greatest export, either:
Notice to public: Settlement hearing in the matter of Peregrine Financial Group (Canada) Inc. TORONTO, Nov. 16 /CNW/ - The Investment Dealers Association of Canada
(IDA) announced today that a hearing will be held before a Hearing Panel
appointed pursuant to By-law 20 for the presentation, review and consideration
of a Settlement Agreement.
The Settlement Agreement is between IDA staff and Peregrine Financial
Group (Canada) Inc., which was at all material times a Member of the IDA, and
relates to matters for which it may be disciplined. The conduct which is the
subject of the hearing occurred during the time period from December 2005 to
March 2006. The charges against Peregrine Financial Group (Canada) Inc.
include that it failed to maintain a risk adjusted capital at a level greater
than zero calculated in accordance with Form 1, contrary to By-law 17.1.
The hearing is scheduled to commence at 10:00 a.m. on Wednesday, November
28, 2007, at Legal Transcript Services, 111 Richmond Street West, Suite 1500,
Toronto, Ontario. The hearing is not open to the public unless and until the
Settlement Agreement has been accepted by the Hearing Panel. Copies of the
decision of the Hearing Panel and the Settlement Agreement will be made
available if and when the Settlement Agreement is accepted by the Hearing
Panel.Oh yeah, they seem to have "been there done that" in Canada previously.Welcome to America, Home of “The Speculation Economy”