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Wednesday, June 3, 2015

How to Grow a Financial Business: Bubbles vs the Long Haul

I've been struck by the correlation between large shifts in the flow of funds and bubbles, but haven't found data other than for the US and Japan, and those metrics aren't directly comparable. So let me go from the macro(prodential) to the micro behavioral: how can you grow a financial business? There are three ways:

  1. provide better service
  2. price below competitors
  3. take on more risk than competitors

The first provides a sustainable model, exemplified by relationship banking. Because a relationship adds value, at least when backed by comptence, you can charge a premium. As long as you're not greedy, you can also hold onto customers, because there's a sunk cost to a relationship, and creating a new one takes costly time & effort. It's hard to do with large firms, because they need too much money and have too varied of needs. But a good investment bank – think boutiques – can still pull that off. The real niche where this strategy works are community banks, whose customers are too small to play one lender off another, and whose owners/managers have too little time for financial games: they've a business to run. The downside is that a community bank following such a strategy can neither grow quickly nor become too large. That's because from the bank side there's also a resource cost to building and maintaining relationships, and managers need discretion. The first works against growth, while a bank that grows too large needs to systematize lending standards. The really good managers can leave to start their own small banks.

The second strategy is obvious: buying business. That's not so bad when conditions are tight, but that's when bad paper comes to the surface and there are pressures to not grow. So it's really only relevant in an upswing, when volumes are rising but margins are also falling. So to keep growing you have to give money away, and sooner rather than later.

The third aspect, lowering standards, is probably not what a manager pitches to the executive committee, but is a corollary to the second: in order to preserve yields in a business-buying environment, you have to take on greater risk. It helps that in an up cycle risks blur: poorly managed firms do well, or at least well enough. The standard consumer credit rating, their FICO score, just keeps getting better and better as not-very-reliable workers who in a downturn had unsteady income hold onto jobs longer and improve their payment record. You don't need a deliberate game of shading the rating, you just need naivete and optimism on the part of those relying on credit analysis. It helps that those at the working level in finance tend to be young, and don't remember the last down cycle.

My personal experience as a banker was in an up cycle, as the gopher in a team working on eurodollar syndicate loans to Latin America in the late 1970s. Brazil was going to be the next Japan, commodity prices were strong as well, and no one had any experience – the last period of robust international lending ended in 1914. On the surface we were lending to companies for explicit projects, but everything carried a government guarantee, and the Brazilian financiers all came across as competent and experienced, unlike their counterparts in certain other countries.

Margins kept falling, LIBOR + 2%, then LIBOR + 1%, then LIBOR + 0.5%....but we got a management fee, and had funding costs below LIBOR, so that was all right. About the time I was making the decision on whether to head to graduate school I was tasked with calling around to peer institutions to find out the size of their Brazil book and credit ceiling; I had the details for my own bank's position to horse trade. It quickly became clear that all the big players had Brazil paper coming out of every orifice, and were finding it hard to syndicate (unload) onto regional "correspondent" banks, back in the era before interstate banking was allowed. [The only way regional banks could diversify their loan portfolio beyond their local geography was by buying paper from us and our peers.]

Then came Paul Volcker, reflecting Jimmy Carter's determination to tackle inflation. Suddenly commodity prices were falling, Brazil's industrialization strategy hit a wall, and LIBOR peaked at over 20%. On some loans Brazil needed to pay 22% at a time when dollar revenue was plummeting. The big banks managed to tidy over the gap for a couple years, but in effect by mid-1979 the loans that underlay the Latin American debt crisis had already built past the point of no return. My bank managed to survive another decade, but was fatally weakened. Oh, and as ought to be obvious, I decided to head to grad school. Among other things, I'd been the representative for Japanese banks to the IMF-led debt restructuring for Jamaica (also here), an immensely sad experience, and didn't want to do that full-time for Brazil and others.

Meanwhile ... other parts of my bank were making a big push into national accounts (Fortune 100), with similar bad results, while other parts of the US financial system were building up real estate loans, from the entire Savings & Loan sector to big banks like Citi. Had I started elsewhere, I would surely have built up an equally impressive resume printable in red ink. Since then I've been in Japan at the height of their real estate bubble studying urban economics [with hindsight, economics doesn't help much in explaining differential behavior during bubbles], and then was around a couple dot.com executives leading up to the 2000 debacle (on paper I lost a lot of money, but only bought into the market after prices were well below peak). Then there's the more recent real estate cycle, thanks to which I "own" [am beholden to] two houses.

To summarize, growing a financial business quickly is a losing proposition. That such is occurring can perhaps be inferred from the pace of change from old to new sectors in flow-of-funds data. [Still true, in that contingent liabilities are likely underestimated?] If you're looking at a career in finance, and aren't comfortable with making a living forever searching for greater fools, then look for a relationship business. Don't look however to become wealthy.

Monday, May 11, 2015

Employment: tortoise slow, tortoise steady?


Summer 2011 job growth has generally outpaced population growth, adjusting for the retirement of the baby boomers. However, it's a small mountain that we need to climb, given the severity of the Great Recession. As a result, the economy remains several years away from normal levels – an optimistic projection shows we might be back to normal as early as summer 2017. More realistically, we're looking at late 2018 or early 2019, given headwinds to the economy. These include slowing global growth and a strong dollar, and the end of the oil boom, which is hurting investment faster than lower gasoline prices are adding to consumption. In any case, the economy remains 6 million jobs shy of where we need to be. That's reflected in many things, large and small. To give one example, I sit on the board of the local United Way of Rockbridge. We hear that local non-profits that attempt to meet emergency needs for utilities, food and rent see more rather than less need, with more working poor showing up than two years ago: jobs are failing to provide income sufficient to keep up with long-run needs.

Let me reiterate that the economy continues to improve, bit by bit. One indicator that I follow (which underlies the "normal job" level calculation) is the employment to population ratio. This avoids the challenge of counting discouraged workers, which over the past 8 years has swayed the unemployment rate in ways that make it a weak indicator of the job market. Now this participation rate likewise is imperfect as a measure, as it doesn't allow a distinction between part-time and full-time work, and one feature of the Great Recession was a large increase in those put on short hours. The BLS began collecting that data in 1994, and while it peaked at 6% during the depths of the recession, the current 4% rate remains higher than at any point during 1994-late 2008. The third graph provides that data for younger workers. Employment fell by 6% for prime-age workers during the Great Recession. Given noise in the data, it was unclear in spring 2013 that that rate had improved.

During the past two years, however, the share working has clearly been recovering, though it is still 3% below normal levels. The exception is among the young. Some 8% of those age 20-24 have yet to start their work-lives, relative to the stable rate prior to the Great Recession. While according to annual data from the BLS the majority of the difference appears to be accounted for by an increase of those in school, from 8-9% prior to the Great Recession to 13% in 2014. It's unclear to me as an economist what change in the economy would suddenly lead to education becoming more valuable. Instead, it's the opportunity cost that's changed: if (good) jobs aren't available, and in particular if career-oriented entry-level jobs aren't available, there's much less downside to remaining in school. (For those age 16-20 the shift is more dramatic: labor force participation among this group of young Americans fell from roughly 50% to 40%, which is a drop of 10 percentage points (or a 20% decline). Almost all of this appears offset by an increase in schooling. (See the table at the bottom.)

One component of slow growth is the lack of recovery in the housing sector. Now the rate of new housing starts shows a long-run decline, reflecting a decline in the birthrate, the aging of the population and a consequent decrease in the rate of new household formation. I've not tried to model that, and a quick search did not find any papers doing quite what I wanted. It is clear that household formation falls during recessions. For example, FT Alphaville notes the rise in children living with parents; there's no reason to think this is other than a response to the recession. (Kwan Ok Lee & Gary Painter (2013) "What happens to household formation in a recession? Journal of Urban Economics 76:1, 93-109 model this statistically.) What is clear is that housing starts remain very low and for the last year have shown no tendency to rise. So not only construction jobs but housing-related consumer durables suffer.

Will this component of our economy rebound, and offset the headwinds? Theory is unclear, as there are many margins of adjustment, tied to incomes of the young but also the age composition of the population, shifts in the nature of rental housing, and the price of owner-occupied housing. The empirical record is one of volatility. So there's no grounds that I can see for projecting change.

Finally, all this ties into interest rate policy. There's a 6 month lag between a change in interest rates and the start of the impact of higher rates on the economy, and the full impact is not felt for 12-18 months. If the economy will normalize in 24 months, then the Fed needs to start gradually raising interest rates later this year. Given the tendency of the Fed to move in increments of 25 basis points and FOMC meetings generating roughly 8 decision points per year, a 2016 start could lead to short-term rates of 2.5% by sometime in 2017. But if my analysis is accurate, we are still 3-4 years out, and there's no rush. Since it's easier to use monetary policy quell inflation than to spur growth, that reinforces the argument for delay: if you have to make a mistake, it's better to be too late than too early.

  Age 16-20 Age 21-25
Year Labor Force Participation Rate In School or Training Either Work or School Labor Force Participation Rate In School or Training Either Work or School
1998 56.2 31.0 87.3 80.3 7.6 87.7
1999 55.6 31.8 87.4 79.8 7.8 87.6
2000 56.0 32.1 88.1 80.0 7.5 87.5
2001 54.0 34.0 88.0 79.4 7.9 87.3
2002 51.8 35.9 87.7 79.1 8.3 87.4
2003 49.4 38.7 88.1 77.8 9.0 86.9
2004 48.7 39.3 88.0 77.4 9.4 86.8
2005 48.6 39.2 87.8 77.1 9.1 86.3
2006 48.5 40.1 88.5 77.4 9.5 87.0
2007 46.3 42.1 88.4 77.5 9.6 87.1
2008 45.5 43.0 88.5 77.2 10.0 87.2
2009 42.8 44.9 87.7 76.3 10.4 86.6
2010 40.7 46.9 87.6 75.1 11.4 86.5
2011 40.1 47.8 87.9 74.7 11.9 86.6
2012 39.9 47.8 87.7 74.3 12.2 86.5
2013 39.8 48.1 87.9 74.0 12.1 86.2
2014 36.0 53.2 89.2 73.2 13.3 86.5

Friday, May 1, 2015

Lambo: A Rampage of Conspicuous Consumption

mike smitka

If vehicles were purely practical devices to get from point A to point B then car enthusiasts would not exist. Colors? – everything would be gray, easier than white but cooler and less prone to showing dirt than black. Acceleration? – why? Comfort, yes, critical for the commuter, and autonomous cruise control would be part of every vehicle, overriding any attempt at aggressive driving while eliminating rear-end collisions. Perhaps seats could be customized for those unusually tall or short, or for the minority with trim physiques. Sizes, well, there surely would need to be a range, from 2-seat commuters to soccer mom SUVs. And cost! – without superfluous variety, engineering and tooling would be spread across production runs of a few million, while advertising would be unnecessary. There'd be no need to maintain much inventory in the system, either -- in contrast to the 60+ days of inventory in the system today, and the megadealer with 300 vehicles on their and hundreds more off-site. Repairs would be cheaper, and so would insurance, so depreciation aside, the cost of ownership would be lower. Used cars would likewise be a commodity, carrying a minimal markup, and easy to sell.

Elephants in the Room! Startling New Studies Revealed!


Two important automotive conferences were held in New York City recently in conjunction with the New York International Auto Show. The first conference was the J. D. Power Automotive Forum, followed the next day by the Driving Sales President's Club Event. The conferences had at least one thing in common. They both were launching points for two new surveys regarding what consumers supposedly want in their retail shopping experience, based on consumers answering questions to survey questions. AutoTrader released its new survey at the Power conference while Driving Sales revealed its own survey the next day at their own conference. The presentations of these survey results were rife with anecdotes. Both "studies" "proved" what some people have been trying to prove for decades, that consumers prefer not to negotiate and don't like the sales process.

...the continuation of attempts to predict auto buying behavior by asking survey questions instead of observing actions...

Notes from the International Car Rental Show April 2015

Ruggles/Wards/Bobit Media

I was recently privileged to attend the International Car Rental Show, held at Bally’s Las Vegas. I have attended this show in previous years and always came away with something noteworthy. This year, for the first time, the show included a break out track for auto dealers. While my primary interest was keeping up with all things car rental as they impact residual values going forward, I felt compelled to attend the car dealer sessions. And was I in for a shock.

Pardon the Sarcasm


I am astonished that the new “hot trend” in auto retail is thinking that a car deal should be accomplished in an hour or so. Hell, it takes almost that long to explain how the infotainment system works, let alone the other gadgets in a new vehicle.

How long does it take to go over all of the forms demanded by government regulation, or do we just have the customer sign them without reading them? After all, we want our customers to be happy, right?

The 6 Fluids

As a car owner, the best thing that you can do for your vehicle is to keep it properly maintained. You don’t need a mechanic to check the fluids in your engine, nor do you need a degree to be able to top them off when necessary. By taking a few simple measures and making sure that these six fluids are within proper levels, you can prolong the life of your car. Your owner’s manual will have everything you need to know about maintenance schedules and recommended fluids. For a great running vehicle, here are the six automotive fluids you shouldn’t forget to check.

Friday, April 17, 2015

The PACE of Automotive Innovation

Suppliers are integral to new technology in the auto industry to an extent not true since the early years of the 20th century, when ventures such as Ford began as mere assemblers, not manufacturers. That will be highlighted on Monday, at the 21st PACE "academy awards" for supplier innovation. (For those not in the know, Monday's the opening night of the SAE [Society of Automotive Engineers] in Detroit.)

Wednesday, April 15, 2015

China's Pending Depreciation

As I prepare to begin grading final exams from my course on China's economy, let me start a series of posts stemming from my teaching this term, and from a lecture (ppt here) that I prepared for the Asian Studies program at James Madison University to my north, in Harrisonburg VA. (It's also my son's alma mater.) Here I focus on China's exchange rate.

Sunday, March 8, 2015

96 month car loans and risks in the auto finance sector

With loan maturities of 96 months no longer uncommon, the downside from a recession – that is, higher than anticipated defaults – looms larger. Longer maturies likewise amplify the downside from the return of interest rates to historic averages. If your footprint is auto finance, you can't ignore this: even if you yourself don't directly handle, hold or insure paper, your customers do. So what are the prospects for the next year or two?

Thursday, February 26, 2015

tis the season -- or this year, not -- but keep it out of our data

As yet more snow falls, we're reminded ... that it's the start of spring? While this year is colder than any I remember, though not so bad in terms of total snow, it does raise the question of how to interpret economic data. Of course housing starts are down, but they're always down this time of year. Some prices are up and others down, again as in the past. Since it was the most recently updated series -- the new data were released at 8:30 am this morning -- I use the Consumer Price Index as an example.

Thursday, February 12, 2015

Promises versus Deliverables: Jeb Bush and 4% Growth

Jeb Bush has set the presidential race pace with a promise of 4% growth. Other contenders, Democratic and Republic, will make similar promises, or perhaps already have – I've not looked. My intent here is to examine the issue, not the man.

In the medium and long run growth rates are about the supply side. Now in the short run demand factors matter, and since we're still in recovery from our Great Recession, we can hopefully have a few years of above-normal growth. My own estimation, taking into account the retirement of the baby boomers, is that we're about 7 million jobs short of where we need to be. Of course the next Administration won't take office until early 2017, and realistically their policies won't kick in until 2018. We're adding jobs at a 2 million per year pace. So if we keep that up, by then we'll be pretty close to normal. Looking at the supply side is thus sensible.

4.0% growth isn't going to happen

Tuesday, February 10, 2015

Reflections on NADA Week 2015, San Francisco

Ruggles based on a column in Wards
minor additions by Smitka

There was a lot going on in San Francisco in January. The week began with the American Financial Services Association (AFSA) conference. Following that, J. D. Power and Automotive News held conferences on the same day, while at the same time, NADA workshops were in session. There was simply no way to take it all in so I’ll only comment on the high points of sessions I attended.


Notably absent from the AFSA conference was the Consumer Financial Protection Bureau. I got the impression they weren’t invited and wouldn’t have come anyway. Last year, CFPB’s Patrice Ficklin addressed a packed room. Since last year’s event, AFSA commissioned a scholarly study, conducted by the highly regarded Charles River Associates, that isn’t kind to CFPB’s suspect methodology called Bayesian Improved Surname Geocoding (BISG) which CFPB uses to “prove” unintentional “disparate impact” discrimination. One gets the impression that zealots at CFPB see discrimination behind every tree and will stop at nothing to “prove” it. According to the Charles River study as summed up in an AFSA bulletin, “BISG estimates race and ethnicity based on an applicant’s name and census data. AFSA’s study calculated BISG probabilities against a test population of mortgage data, where race and ethnicity are known. Among the findings:

The Current State of Leasing and Residual Based Financing

Ruggles, February 2015

According to the most recent Manheim Market Report, “Lease originations exceeded 3.5 million for the first time since 1999. It will take only a slight increase in 2015 to push new leases above the all-time high reached in 1999.” This is largely the result of Auto OEMs attempting to counteract the negative impact of long term financing, which is also reaching new highs. Both initiatives are efforts by the OEMs to maintain volume and production in the face of rising MSRPs and transaction prices. Increasing finance terms take consumers out of the market for extended periods of time and dramatically decreases the chance the consumer will return to the same dealer and/or manufacturer for their next vehicle.

Saturday, January 17, 2015

US Inflation

Here are 4 graphs that give an overview of inflation from the perspective of both producers and consumers. Data are percent change from the same month of the previous year.

On the left is the overall movement, on the right data that excludes food and energy. In other words, if we ignore the recent drop in commodity prices, which is a one-time event rather than a trend, what does inflation look like? (Click on the graphs to enlarge them.)