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My perspectives as an investor and consumer

Stressing out the banks

juliedavidow_stress01

One of the programs created under the TARP is the Capital Assistance Program (CAP).  The CAP was designed to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  A stress test, called the Supervisory Capital Assessment Program (SCAP),  was crafted and implemented by the Federal Reserve and the Treasury to aid them in assessing said capital cushion.  Details of the stress test were released to the public by the Federal Reserve on April 24th, through a 21-page white paper.  I present here a synopsis of the white paper.

All domestic bank holding companies (BHCs) with year-end 2008 assets exceeding $100 billion were required to participate in the SCAP.  According to ProPublica, 19 firms fell under this requirement.  They are listed in the second table below.  These 19 firms hold 66% of the assets and 50% of the loans in the US banking system.  They were asked to project their losses, and available resources for absorbing these losses, for 2009 and 2010 based on two economic scenarios — a baseline scenario and an adverse alternative.  The table below lists the components of the economic scenarios and the effect of the baseline and adverse conditions on each of them.  The supervisors, then, assessed whether their capital was adequate for them to function during this period.

fedeconomicscenariosfor2009_2010

Step 1: Loss Projections. BHCs were asked to project losses for 2009 and 2010 for 12 separate categories of loans held in the accrual book, for loans and securities held in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios, and in some cases for positions held in the trading account.  The losses were to be consistent with the economic outlooks in the baseline and more adverse scenarios.  The BHCs were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (“cash flow losses”) rather than discounts related to mark‐to‐market values.  The required assessments were broadly classified as:
19largestbanksbyassets20091

  • First and Second Lien Mortgages: institutions provided detailed descriptions of their residential mortgage portfolio risk characteristics – type of product, loan-to-value (LTV) ratio, FICO score, geography, level of documentation, year of origination, etc.
  • Credit Cards and Other Consumer Loans (e.g., auto, personal, student): portfolio information included FICO scores, payment rates, utilization rates, and geographic concentrations.
  • Commercial and Industrial Loans: based on the distribution of exposures by industry
  • Commercial Real Estate Loans: included loans for construction and land development, multi-family property, and non-farm non-residential projects.  Information such as property type, loan-to-value ratios, debt service coverage ratios, geography, and loan maturities was provided.
  • Other Loans: farmland lending, loans to depository institutions, loans to governments, etc.
  • Securities in AFS and HTM Portfolios: majority are public-sector securities such as Treasury securities, government agency securities, sovereign debt, and high-grade municipal securities. Private-sector securities include corporate bonds, equities, asset-backed securities, commercial mortgage-backed securities (CMBS), and non-agency residential mortgage-backed securities (RMBS).  Supervisors focused on evaluating the private-sector securities.  Loss estimates were based on an examination of 100,000 of these securities.  Loss estimate, and subsequent “write-down” to fair value, for each security was determined based on credit loss rates on the underlying assets, consistent with loss rates for unsecuritized loans listed above.
  • Trading Portfolio Losses: estimated by applying market stress factors to the firm’s trading portfolio based on actual market movements that occurred between June 30 and December 31, 2008.
  • Counterparty Credit Risk: the risk that an organization is unable to pay out on a credit-related contract when it is supposed to, which directly impacts a firm’s earnings and the value of its assets.  The action taken by the firm to account for this risk is referred to as credit valuation adjustment (CVA).  Supervisors focused specifically on a firm’s loss estimates for mark-to-market losses stemming from CVA associated with market shocks applied to assets in trading books.

Step 2: Resources to Absorb Losses. Institutions were also instructed to provide projections of resources available to absorb losses under the two economic scenarios.  These include the pre-provision net revenue (PPNR) and the allowance for loan losses over the two-year horizon.

  • PPNR is the income after non-credit-related expenses that would flow into the firms before they take provisions or other write-downs or losses.
  • BHCs supposedly had some allowance for loan and lease losses at the end of 2008.  They were required to estimate what portion of this allowance would be required to absorb potential future credit losses on their loan portfolio under each economic scenario.  This calculation could either result in depletion of the year-end 2008 reserves (if there is adequate allowance) or indicate the need for building the reserves (if the allowance is inadequate).

Step 3: Determination of Necessary Capital Buffer. Supervisors examined two main elements as indicators of capital adequacy – pro forma equity capital and Tier 1 capital.

  • Pro forma equity capital was estimated by rolling tax-adjusted net income (PPNR minus credit losses minus reserve builds) for the two-year horizon through equity capital.
  • Tier 1 capital is composed of common and non-common equity, with the dominant component being common stockholder’s equity.

The initial assessment of the capital adequacy, or lack thereof, was conveyed to the BHCs in late April and is expected to be released to the public on May 4th, 2009.  As yet it is uncertain whether the publicized results will reveal much about the banks.

Filed under: Business, Economy, Government, , , , ,

Understanding the PPIP

davidellis-flow1-07sOn March 23, 2009, the Treasury Department released details of the Public-Private Investment Program (PPIP), which is one of the programs under the TARP aimed at restoring financial stability.

The details of the program were complicated enough to elicit a standalone post.

The Problem. According to the Treasury, one of the problems plaguing the financial system is that of legacy assets – real estate loans held directly by the banks (“legacy loans”) and securities, or tradable financial instruments, backed by loan portfolios (“legacy securities”).  The true value of these assets has been brought to question. As a result, there is uncertainty surrounding the balance sheets of the institutions holding these assets.  Markets don’t like uncertainty as is evident from their performance, especially that of bank stocks, over the last 12 months.

Proposed Solution. The program’s intent is to repair the balance sheets of these institutions by moving the legacy assets off the hands of banking institutions and into the hands of investors.  Cleaner balance sheets could make it easier for banks to raise capital and increase their willingness to lend.

Principles of the Proposal. Treasury will use $75 – $100 billion in TARP money to become co-investors with the private sector, with backing provided by the FDIC and the Federal Reserve.  The “investment partnership” will, thus, be able to purchase $500 billion to $1 trillion of toxic mortgage assets (both residential and commercial) from banking institutions that currently carry them.

There are two separate approaches, one for legacy loans and the other for legacy securities.  Initially, Treasury will share its $75 – $100 billion equity stake equally between the two programs with the option of shifting the allocation towards the option with the greater promise of success with market participants.

  1. Legacy Loans Program: Suppose a bank has a pool of mortgages with $100 face value that it wants off its hands.  It approaches the FDIC, which determines whether it wants to leverage the pool at a 6-to1 debt-to-equity ratio.  If it decides to go ahead, the pool is auctioned by the FDIC.  Several private sector investors are hoped will bid.  The private sector bidder with the highest bid would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.  Let’s say the highest bid is $84.  Of this purchase price, the FDIC would guarantee $6 of every $7 in investment, or in this example, $72.  This is debt financing.  The remaining $12 is equity financing, which is shared equally by the private investor ($6) and the Treasury ($6).  The private investor would then manage the servicing of the pool of purchased assets.  The private investor and the Treasury would each be able to purchase $14 worth of assets for every $1 of their own money (14-to-1 leverage).
  2. Legacy Securities Program: Treasury will approve up to five fund managers for this program.  A fund manager, for example, submits a proposal and is pre-qualified to raise private capital.  The Treasury plans on being a joint-venture partner.  Let’s say a fund manager is able to raise $100 of private capital for the fund.  The Treasury will co-invest $100 in equity financing along side the private investor and will provide an additional loan of $100 (debt financing) to the “partnership” fund.  Additional requests for loans up to $100 will also be considered by the Treasury.  As a result, the fund manager has $300 – $400 in total capital for purchase of securities.  The fund manager has full discretion in investment decisions.  This program will be incorporated into the previously announced Term Asset-Backed Securities Loan Facility (TALF) whose original goal was to provide debt financing (non-recourse loans) to buyers of newly created consumer and small business loans.

The PPIP program has thus far met with lukewarm reception from the private sector, which is noteworthy given the necessity of their participation.  On a conference call to analysts and investors last Thursday, Jamie Dimon, the CEO of JP Morgan and, currently, the go-to guy for the US government on financial mergers/takeovers, said that they will not take part in the PPIP.  “We’re certainly not going to borrow from the federal government because we’ve learned our lesson about that,” said the Chief Executive.  Wells Fargo and US Bancorp are noncommittal.

It remains to be seen whether the Public-Private Investment Program will succeed in getting credit flowing again or further reveal corporate fear of business decisions driven a government that’s looking solely in the rearview mirror.

Filed under: Business, Economy, Government, , , ,

Take a look under that TARP

barsness_bigbluemountainIntimidated and confused by all the programs initiated by the government within the past 12 months?  Don’t beat yourself up.  We are in the majority.  Let’s try and shed some light on these programs and gain some understanding into the allocation of our taxpayer dollars.

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law amidst a tailspin in the financial markets.  The Troubled Assets Relief Program (TARP) was established under the EESA with the goal of stabilizing the financial system of the country and, hopefully, preventing a systemic collapse.  Under this law, the Treasury was granted authorization to spend up to $700 billion towards the purchase of troubled assets and the injection of capital into banking institutions.

The TARP has several programs under it:

  • Capital Assistance Program (CAP): to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  Financial institutions have to undergo a supervised stress test to be deemed eligible.  The stress test requires these institutions to make some assumptions. The banks would have to assume that the economy shrinks by 3.3 percent in 2009 and remains flat in 2010.  Assumptions will also have to include a decline in house prices by 22 percent this yearUnemployment should rise to 8.9 percent this year and reach 10.3 percent in 2010.  Big banks – those with consolidated assets greater than $100 billion – are required to carry out the test by the end of April.  If regulators assess that an institution does not have enough capital under these assumptions, they would have to raise the required capital either in the private markets or from the government.
  • Consumer and Business Lending Initiative (CBLI): a joint initiative with the Federal Reserve.  The goal of this program is to unfreeze consumer and business credit markets by providing financing to private investors willing to purchase assets backed by auto, student, small business, and credit card loans.  Under this plan the Federal Reserve will provide $200 billion in lending and the Treasury will support it with $20 billion in credit protection.
  • Making Home Affordable Program: an effort to stem the tide of foreclosures and declining home values through the employment of three initiatives:
    1. A refinance for 4 to 5 million people who took out loans owned or guaranteed by Freddie Mac and Fannie Mae
    2. A $75 billion loan modification program aimed at preventing foreclosures by targeting 3 to 4 million at-risk homeowners
    3. Support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac through increased funding commitments to the two entities
  • Public-Private Investment Program (PPIP): to repair balance sheets throughout the financial system through the Legacy Loan Program and the Legacy Securities Program.  The loan program will facilitate the purchase of troubled loans from banks while the securities program will attempt to move the highly illiquid securities (such as mortgage-backed securities and collateralized debt obligations) off the balance sheets of banks and into the hands of investors.  The PPIP is conducted in conjunction with the FDIC and the Federal Reserve.  $75 to $100 billion in TARP capital is combined with private capital.  FDIC and the Federal Reserve will provide leverage for the private capital thereby increasing purchasing power to $500 billion-$1 trillion.  Remember how excessive leverage was our financial system’s undoing?  Looks like we’re going back to the same well in order to rescue the selfsame.  I may have to post another article just on the intricacies of the PPIP.
  • Capital Purchase Program (CPP): created in October 2008 to provide immediate capital to stabilize the financial and banking system, and to support the economy.  It is a voluntary program in which the US Government, through the Department of Treasury, invests in preferred equity securities issued by qualified financial institutions.  The goal is to invest up to $250 billion.  As of the April 10th report by the Treasury, $198.8 billion has been invested.
  • Asset Guarantee Program (AGP): under this program, Treasury will guarantee certain assets held by systemically significant financial institutions. Assets to be insured are selected by the Treasury and must have been originated before March 14, 2008.  In return for this assurance, the government collects a premium from the financial institution, the value of which is determined through actuarial analysis.  Citigroup seems to be the only institution so far to have qualified, and tapped into, this program or forced to do so.  It has received a guarantee on up to $5 billion of its assets to date.
  • Targeted Investment Program (TIP): the goal here is to stabilize the financial system by reducing the chance that one firm’s distress will threaten other financially sound businesses, institutions, and municipalities.  The program is implemented through investments in these unstable institutions.  Citigroup and Bank of America are the lucky ones chosen for this program, each receiving $20 billion through investments in preferred stock with warrants.
  • Automotive Industry Financing Program (AIFP): instituted to prevent a significant disruption of the American auto industry.  Most of the aid has been through the issue of loans, which have so far totaled $24.7 billion.  $5.5 billion has gone to Chrysler Holding and Chrysler Financial.  $19.2 billion has gone to General Motors and GMAC.  The notable exception is Ford Motor, which stayed away from government support and has taken this opportunity to separate itself from the other two.  New York Times has an article on how this company managed to stay independent.
  • Systemically Significant Failing Institution Program (SSFI): to prevent disruptions to financial markets from the failure of institutions that are critical to the functioning of the nation’s financial system.  This domain is reserved for those rarest of institutions – ones that made the worst business decisions of, at least, the past decade, and threaten to cut us all off at our knees.  The lone inhabitant of this realm is American International Group, Inc. or fondly referred to as AIG.  The taxpayers have used $40 billion from this program to prop up this company.  This is in addition to the ~$90 billion it has drawn from the credit-liquidity facility created for it by the Federal Reserve.

Now that you’ve taken a look under the TARP what impressions are you left with?

Filed under: Economy, Government, , , , , ,

Redefining the paradox of thrift

cycleschange41There is a story in The Scriptures about a man named Joseph, who had the gift of interpreting dreams.  One unfortunate event after another led him to the king’s prison where he had served for two years.  One night, Pharaoh, the king of Egypt, had two dreams both of which troubled him inordinately.  In one dream, seven healthy cows, standing by the river Nile, were devoured by seven sickly ones, which were none the better for it.  In the other dream, seven plump ears of grain were consumed by seven thin and blighted ones.

Of all the wise men in Pharaoh’s court, Joseph turned out to be the only one who could interpret the dreams.  He explained that both dreams referred to the same thing – two consecutive time periods, each seven years in duration.  The first seven years would be ones of plenty but they would be followed by seven years of hunger and famine.

Not only did Joseph have an interpretation, he also had a plan to address the inevitable downturn.  For the first seven years, the time of abundance, the Pharaoh was to collect 20% of the harvest throughout the land of Egypt and save them in storehouses.  These “savings” would be used to feed not just the people of Egypt, but also of neighboring lands who were going to be affected by the dearth during the subsequent seven years.

As the story goes, Joseph’s interpretation of the dream was accurate and the implementation of his strategy positioned Egypt to not only survive the famine but to provide for her neighbors.

I am reminded of this story every time I hear the phrase, “the paradox of thrift” in the media.  Paradox of thrift is also referred to as the “paradox of saving” and was presented by the economist, John Maynard Keynes.  According to this paradox, if everyone saves more during times of recession, then aggregate demand will fall resulting in reduced savings by the population as a whole because of decreased consumption and economic growth.

Here is an example of the paradox in microcosm.  When you save more now than you did last year (as a percentage of your income), you do so by reducing spending because the chances of one’s income rising in a recession are low.  One of the ways you reduce spending may involve cutting expenditure on dining out.  As a result, your local restaurant feels the pinch.  It responds to the altered environment by cutting pay for its employees, reducing work hours or laying some of them off.  Regardless of the nature of the restaurant’s response, the employees’ incomes are reduced.  They, in turn, spend less.  When taken in aggregate, this could lower economic growth as represented by Gross Domestic Product (GDP), because 70% of GDP is based on consumer spending.

Economists of the Keynesian vein believe that spending needs to come from somewhere to stimulate the economy during a recession.  If the consumer has decided to clamp down on spending, it’s the government’s responsibility to pick up the slack.  Herein lies the impetus for the American Recovery and Reinvestment Act of 2009.

I don’t dismiss the paradox outright as do economists that follow the Nobel Laureate, Milton Friedman.  However, the context seems to be turned on its head.  There are certain principles in the story that I recounted earlier that seem to have been abrogated by our society:

  • Always remembering that nothing continues in perpetuity i.e., there is a cycle or season to everything.
  • Times of recession follow periods of growth and vice versa.
  • Preparing for famine needs to be a part of living in abundance.
  • If you have prepared during good times, then you will be in a position to support your community during tough times.
  • If you are in a position to help others during the community’s or nation’s dearth, then you ought to do so.

To me, this is how the paradox should be played out during a recession.  The key is for us to act from a position of strength, not weakness.  A strong position would mean low or no debt and cash reserves sufficient not merely for ourselves but also to support others.  Unfortunately, most of us find ourselves in the contrasting position – that of minimal cash reserves and a mountain of debt.  Opportunities for investment, career advancement or change, societal impact, etc., are all presenting themselves, yet we feel impotent.

However, our story need not end there.  That is the beauty of cycles.  When one passes, another one arises.  What is required of us is a reaffirmation of the principles we once abrogated – to build towards a position of strength and then, operate from that position.

If you are operating from a position of weakness, don’t allow economists to guilt-trip you into spending under the guise of saving the rest of the population.  You can’t help anyone when you are withering.  If, however, you find yourself in a strong position these days, then use this opportunity to impact your community whether it be through investments, doing business with local establishments, or supporting your favorite charities.  Those of us who are not in your position will be inspired by you and aspire to join you in these efforts during the next cycle.

Filed under: Economy, Government, , , , , , ,

To the creditor go the spoils

spinning_into_debt_by_m0nk3y504Through my earlier post, “Do you know where your money is?”  you were made aware of the amount of federal debt our nation has accumulated ($10 trillion) and the alarming rate at which it is projected to grow over the next ten years (60%).  As you know, debt does not exist in a vacuum.  Every dollar of debt has to be financed by someone.  I can only get a mortgage if a creditor (bank, mortgage originator, etc.) is willing to  finance the desired amount.  Each dollar spent beyond my means has to be facilitated by a credit card company, a bank, a family member, etc.  The creditor or lender expects the borrowed amount (the principal) to be paid back with interest.  Such expectations are based on the creditor’s understanding of my credit worthiness or my ability to pay back the borrowed amount.   The creditor is taking a risk in lending me the money since there is always a possibility that I won’t be able to pay back.  This risk usually comes at a price for me and a reward for the lender.  The price/reward typically takes the form of interest.  Therefore, the more credit worthy I’m deemed, the lower the risk for the lender and lower the interest I’m charged (usually) for the benefit of credit.

Same is the case with the federal government.  The $10 trillion in debt has to be financed by someone1.  About $6 trillion of it is financed by the public and is referred to as public debt.  The public constitutes states, corporations, individuals, and foreign governments.  The rest (~$4 trillion) is in intragovernmental holdings, a vehicle by which the federal government borrows money from other governmental agencies.  The largest borrowing of this kind (56%) is from the Social Security Trust Fund.  I can see some eyebrows being raised as you read this.  However, the story gets even more interesting.

Public debt can be broadly classified as marketable and nonmarketable securities.  Marketable securities can be resold by whoever owns them.  These are made up of Treasury Bills, Treasury Notes, Treasury Bonds, and Treasury Inflation Protected Securities (TIPS).  Marketable securities represent 90% of public debt.  Nonmarketable securities cannot be resold and are primarily consisted of savings securities, special state and local government securities, and Government Account Series securities.

Majority of public debt (52%) is held by foreigners.  China is the largest of these creditors with $740 billion in US Treasury securities (as of January 2009).  The creditor always holds the upper hand in a relationship.  The more I owe someone, the more they are in a position to exert control over my decisions.  Such exhibition of control doesn’t always have to be overt.  Merely an unspoken threat will suffice.  China’s latest inferences to the quality of US credit is but one example of the poor ramifications of ever increasing federal debt in the hands of foreign governments.  Their negotiating leverage as a trading partner gains power with each passing year.

There is another issue to consider.  Additional debt will have to be issued in order to fund all the stimulus packages.  This debt will need financing from foreign creditors.  As I mentioned earlier, an entity’s credit worthiness plays a big part in the kind of financing deals it can garner.  Both Standard & Poor’s and Moody’s have raised concerns over the ability of the US to maintain its triple-A rating in the long run.  If the quality of US sovereign debt is in question, we may have to pay higher rates in interest to find enough buyers.  These buyers could also seek additional benefits, such as trade deals that are skewed in their favor, a bigger say in international policy, etc., in order to continue financing our debt.

So no matter what our government says about trying to exact trading concessions from partners like China, remember this – it’s the entity that holds the debt that always controls the board.

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1 GAO-08-168 Financial Audit: Bureau of the Public Debt’s Fiscal Years 2008 and 2007 Schedules of Federal Debt

Filed under: Economy, Government, , , , ,

Use leverage to transform health care in the US

ailing_healthcare_by_frantzwahWe all understand to some extent that our health care system is in dire need of reform.  Do we know what its condition really is?  Allow me to paint a picture.

What is the current and projected state of health care in the US?

National Health Expenditure (NHE) is defined as the total health care spending in the United States.  According to Centers for Medicare & Medicaid Services (CMMS), which quantifies health spending on an annual basis, the NHE grew 6.1% to $2.2 trillion in 2007, or $7,421 per person.  In comparison, this cost was $75 billion or $356 per person in 1970.  Health care spending currently accounts for 16% of our Gross Domestic Product (GDP) and is projected to grow by an average of 6.2% per year between 2008 and 2018.  At that rate the NHE will have reached $4.5 trillion in ten years and account for 20% of our GDP.  Healthcare spending has exceeded overall economic growth (GDP) annually by an average of 2.5 percentage points since 1970.

80% of health care spending goes to hospital care (37%), physician and other professional services (29%), and drugs (14%).  Many doctors complain that the system is now turned on its head where more and more of each healthcare dollar goes to cover administrative costs associated with the first two categories than to pay professional fees.  The facilitator of the doctor-patient relationship has become the principal entity.  Meanwhile, the doctor-patient relationship is now there to support the facilitator.

Private health insurance and out-of-pocket payments accounted for the largest part of health spending (55%) in 2007.  Public programs like Medicare, Medicaid, etc., comprised 45% of NHE.  While worker’s earnings and overall inflation has increased ~30% since 1999, health insurance premiums have grown 119% during the same period.  This usually means that workers have to spend more of their income each year on health care to maintain coverage.  These effects may either be direct – through increased worker contributions for premiums or reduced benefits, or indirect – such as when employers forgo wage increases to offset increases in premiums.  I gather you’ll agree with me that neither of these options is ideal.

Due to the influence of the recession and the leading edge of the Baby Boom generation becoming eligible for Medicare, average annual spending growth by public payers is expected to outpace that of private payers.  As a result, CMMS projects that public programs will overtake private insurance and reach 51% of NHE by 2018.  Not only will it be necessary for us to allocate greater portions of our income to employer-covered insurance premiums and Medicare, there is no guarantee that it will be sufficient to bear the imminent burden on our health care system.

How can this problem be addressed?

Victor Fuchs, Professor of Economics and of Health Research and Policy at Stanford University, proposes tackling health care reform around four essential principles: coverage for the uninsured, cost control, coordinated care, and choice1.  According to him, any reform which does not cover these essentials is doomed to fail.  In addition, any reform plan that is not controversial is certain to be inconsequential.

Dr. Benjamin Carson has one such controversial and ambitious plan.  Dr. Carson, who has served in a medical advisory role for both President Clinton and President Bush, suggests the idea of a medical endowment where ten percent of the cost of health care be set aside annually in an endowment fund2.  The interest from the endowment would be used initially to cover health care expenses for the uninsured and underinsured, the first C of Prof. Fuchs principles.  He envisions growing the fund to such a size in 15-20 years that it can cover most of the country.  He has initiated a pilot program at Johns Hopkins Medicine.  The fund, called the Benevolent Endowment Network fund, will be started off in pediatric neurosurgery, expanded to all of neurosurgery with the hope of eventually covering the entire hospital.

On the corporate side, Wal-Mart is slowly positioning itself to be a force in health care through a controversial plan for tackling the second C – cost control.  I call it controversial because Wal-Mart tends to elicit a visceral reaction from many people, who view the company as “pure evil.”  I merely present the company as one of the potential forces necessary for true health care reform to be accomplished.  In September 2006, the company introduced $4 30-day prescription pricing for 291 generics in the Tampa Bay, FL area, which was available to the uninsured.  It has since expanded the program to 49 states covering 350 generics and 1000 over-the-counter medications.  Pricing now includes an option for a 90-day prescription for $10.  Several pharmacy chains, including Target and K-Mart, were forced to follow suit.  Anecdotal evidence from my pharmacist friends, who work for other chains, suggests anger at this move.  Meanwhile, many consumers applauded the move.

The company is now looking to shake up Pharmacy Benefits Management (PBM).  It announced a pilot with Caterpillar to provide 2500 prescription drugs to 70,000 of its employees, spouses, and retirees.  If successful, it is sure to try expanding the deal with other employers.  This, in turn, could help employers cut their costs related to prescription drug coverage.

The third leg in Wal-Mart’s stool is electronic medical records (EMR).  According to an article in the New York Times, Wal-Mart has decided to team its Sam’s Club division with Dell and eClinicalWorks to market hardware, software, installation,maintenance, and training to physicians’ offices.  They will be mainly targeting small physician groups where 75% of the nation’s physicians practice.  Another initiative in the works for Wal-Mart is telemedicine in collaboration with NuPhysicia, LLC.

Michael Porter, University Professor at Harvard Business School and Director of the Institute for Strategy and Competitiveness, has a plan for tackling the third and fourth C’s – coordinated care and choice.  He proposes a value-based health care delivery system where players strive to create value for patients rather than capturing more revenue, shifting costs, and restricting services.  The centerpiece of this strategy involves bundled reimbursement for an entire care cycle instead of individual services like doctor visits, MRI scan, radiologist consultation, biopsies, etc.  He provides examples of institutions such as The Cleveland Clinic and MD Anderson Cancer Center where disease-based integrated practice is bearing fruit.

Despite the various forces working to address the four C’s, one important issue that I see missing is that of preventive medicine.  I proffer this as the most important piece for the long term viability of any health care reform that’s implemented.  Most reform ideas center around the reduction of current health care burden which are all remedial in nature.  In fact, our entire nation’s health care focus seems to be on treating the disease.  Even the preventive measures mainly target regular screenings.  The assumption here is that some type of disease is inevitable; so let’s try to nip it in the bud through screenings.  What about the notion that many diseases may be prevented if we actively engage in a lifestyle that’s healthier this year than it was the last?  A friend of mine (hat tip CJC) made a statement recently which I believe to be true:

No health care reform or plan in the world can bear the burden of overweight and obesity and the complications that arise from it.”

According to the National Institutes of Health, two-thirds of us are overweight and one-third are obese.  Overweight and obesity are known risk factors for several diseases.  Certain diseases can trigger other complications and multiply the cost associated with treating them all.  For example, people with diabetes spent $190 billion for health care in 2004, nearly seven times the $28 billion they spent specifically to treat diabetes.  A sizeable portion of the total spending for these people went to the treatment of conditions that are common complications of diabetes3.  So leverage, in this case, works against us and multiplies the burden on the health care system.

However, leverage may be employed to our advantage, as well.  What if we take personal responsibility for our long term health through healthier eating and more physical activity?  We may be able to reduce conditions of overweight, and obesity and diseases like diabetes, heart attack, stroke and other related disorders.  As a result, we will find ourselves making fewer doctor visits outside our regular check-ups.  Fewer complimentary services are ordered by our primary physician.  All of this reduces the burden on our health care system.  Health care providers can, in turn, focus on patients with diseases that are out of their control and provide better value.  Meanwhile, consumers may be willing to apply some of the savings from their reduced insurance premiums to cover the uninsured and underinsured.  The four C’s have a better chance of success in providing coverage for all of us because less strain is put on by each of us.  And the best part: this leverage monetarily costs us next to nothing.

All it requires is one question and small steps to answer it: How can I live healthier this year than I did last year?

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1 Health Reform: Getting the Essentials Right by Victor R. Fuchs

2 The vision of the Benevolent Endowment Network fund by Dr. Ben Carson

3 Roehrig C., et al. National Health Spending by Medical Condition, 1995-2005.  Health Affairs.  Volume 28, Number 2 (2009): pp 358-367.

Filed under: Business, Economy, Government, Health, , , , , , , , , ,

Do you know where your money is?

paper_money_macroOn February 26th, President Obama laid out his administration’s budget proposal for 2010.  The entire document, with a great marketing title of “A New Era of Responsibility,” contains 112 pages of words and an additional 21 pages of tables.  Believe it or not, this is actually a summary of the detailed version that will be released in April.  Ironically this administration makes it no easier to understand how our government is spending our money.  In fact, the US Government Accountability Office has complained about this ambiguity in budget proposals for the past twelve years.  I point this out to you because we should not confuse strategy with ineptitude.  I would probably employ ambiguity as well, if I were they.  In the chapter, “On Military Strategy,” the Huainanzi has this to say about the use of ambiguity:

“It is important that strategy be unfathomable, that form be concealed, and that movements be unexpected, so that preparedness against them is impossible.  What enables a good general to win without fail is always having unfathomable wisdom and a modus operandi that leaves no tracks.”

Unless someone knows clearly what you are up to, they cannot hold you accountable.  When it comes to the democratic process, an uninformed electorate is one that can be easily swayed.  Rhetoric is a politician’s friend, whereas clearly delineated items in a financial statement are not.  This is not to say that financial statements are immune to manipulation but the task is more cumbersome than the spin of a wordsmith.

I looked around the web to see if anyone had succinctly presented all the information contained in the budget proposal.  I could not find any that were comprehensive enough.  So I decided to undertake the task.  My goal was to distill everything down to two or three tables which can be understood by anyone within a few minutes.  I must confess that this task took me days to reasonably connect the dots.

The federal fiscal year starts on October 1st and runs through September 30th of the following year.  The budget has a spending side (outlays) and a tax revenue side (receipts).  There are two basic categories of spending: mandatory and discretionary.  Mandatory spending contains entitlement programs, such as Social Security and Medicare, which are provided by law.  This accounts for approximately 60% of annual outlays.  Discretionary spending is appropriated annually by Congress and can be split into defense and non-defense spending.  Defense spending typically absorbs 50-60% of the discretionary outlays.

Table 1 itemizes federal outlays by governmental agencies.  obamabudgetoutlays2009Click on the table to see it in detail.  The agencies are listed in decreasing order of the amount allocated to them annually.  Federal spending is projected to be $3.9 trillion in 2009, an increase of ~$1 trillion from 2008.  $497 billion of it is allocated to the Treasury Department for the Troubled Asset Relief Program (TARP) and a placeholder for potential financial stabilization.  Even after the one-time allocation to the Treasury expires, federal outlays only settle to the ~$3.6 trillion level for the remainder of President Obama’s current term.  The slack is going to be picked up by mandatory spending for the departments of Health and Human Services, Social Security Administration, and “Other Mandatory Programs,” which are conveniently not listed.  The Department of Defense will see spending levels drop from ~$700 billion (including the cost of Iraq and Afghanistan war) to $670 billion in 2010, a decrease of less than 1% of total federal spending.

Actual spending amounts for “Other Mandatory Programs” are not listed anywhere.  obamabudgetmandatory2009The best I could do was look at the contribution of mandatory spending by various agencies to the budget deficit.  Table 2 lists these contributions.  This is an example of the ambiguity that I am referring to.  You’ll notice several agencies with “No Significant Change.”  From a strategy perspective, this looks much better than listing the actual amounts of spending.  Spending cuts can be made to look rather large when actual spending amounts are not given.  For example, a $500 million spending cut seems large but is insignificant if the reduction comes from an agency that sees $500 billion in annual spending (0.1% spending cut).  The biggest contributor to the increase in 2009 deficit, from the mandatory spending category, is the Department of Treasury.  Notice how convoluted this statement sounds.  Ambiguity.  The less we know, the fewer questions we ask.

$250 billion is allocated to the Treasury in 2009 as a placeholder for the potential stabilization of financial markets.  The Department of Education will see some changes, as well.  Pell grants will be converted from the discretionary category to the mandatory.  Entitlements for financial intermediaries under the Family Federal Education Loan Program will be eliminated.

Health reform initiatives will begin in 2011 and be ramped up during the President’s second term (2013-2016).  During this period savings will be wrung to the tune of $75 billion annually through Health Savings and limiting tax liability from itemized deductions to 28 percent.

Table 3 summarizes the Federal Budget and compares it with the last two obamabudgetsummary2009years of the previous administration.  The revenue side of the budget (receipts) comes mainly from taxes of various forms.  Individual income taxes (45%), Social Insurance taxes like Social Security and Medicare (36%), and Corporate taxes (12%) contribute the bulk of receipts.  They are estimated to decrease this year and the next primarily due to job losses and shrinking of corporate profits.  Couple that with increased federal spending and deficits are projected to increase almost four fold to $1.7 trillion in 2009 and settle around $600 billion by 2012.  Even more shocking are the numbers associated with our federal debt, which is projected to increase by 60% from $10 trillion in 2008 to $16 trillion in 2012.

If I told you that my personal financial plan over the next four years is to live increasing below my means (greater deficits) and increasing my debt by 60% would you consider this era of mine as being responsible?  If a publicly traded corporation told you that it is going to be losing money on its operations at a greater rate and increasing its debt load by 60% over the next four years, would you consider this management to be responsible and the company to be a highly attractive investment?  Yet our government considers this to be “A New Era of Responsibility.”

My advise to you would be to pay NO ATTENTION to the words.  Follow the numbers instead and let them narrate the true story.  At least you will be in a position to decide whether you like the story or not.

Filed under: Economy, Government, , , , , , ,

As the pendulum swings…

the_pendulumThrough my experience as an investor, I’ve learned to look at the market as a collective expression of fear or greed. Webster’s dictionary defines greed as a selfish and excessive desire for more of something than is needed.  Fear, on the other hand, is an unpleasant often strong emotion caused by anticipation or awareness of danger.

The market tends to swing between these extremes in reaction to various factors.  What’s peculiar to me is the timing of these emotions.  We are most fearful when we should be aggressive and most greedy when we should be cautious.  I use the words “aggressive” and “cautious” purposefully because I don’t think we should ever be making decisions based on fear or greed.

Part of the reason for collective emotion is due to the human tendency for groupthink.  Groupthink is an exhibition of consensus without critical thought or analysis.  It requires minimal effort, is not caustic, and appeals to our desire for a comfortable buffer.  If an idea fails, at least we’re not the only ones failing.  There is a certain level of comfort in failing or being mediocre as a group.  Unfortunately a successful idea under groupthink does not bear a lot of fruit because the participants, by design, are too late to the game.

Independent thought, on the other hand, requires maximal effort.  You find yourself having to do most of the research and analysis, and drawing your own conclusions.  These ideas differ from the “group;” so criticism is inevitable, which over time, can wear emotions down.  Besides, there is always the danger of failing miserably with no one to fall along with you. Once we take these factors into account it’s no surprise that many of us unintentionally pursue the path of least resistance.

The emotional pendulum had swung to the side of greed during the historic housing boom:

  • as home values appreciated, the idea of quick and large profits gained momentum
  • our wrongful association of material wealth with happiness found new life
  • homes inappropriately became ATM’s due to easy access to home equity loans
  • financiers saw an opportunity to take advantage of groupthink participants to juice up their bottom lines
  • as our perceived “ATM’s” got bigger, we allowed ourselves to suspend the simple, yet profound, notion of spending less than we earn

Kyle Bass serves as an example of a person who resisted groupthink during the greed phase.  Mr. Bass runs a hedge fund out of Dallas, Texas.  In 2005 he started doing his own research into the mortgage-related securities that were being packaged by Wall Street and sold worldwide.  He asked the tough questions.  According to him, Wall Street was putting lipstick on a pig and selling it to people who did not understand what they were buying.  The lynchpin to the groupthink assumption was that home values would never come down.  Bass came to the conclusion that the trend was unsustainable and the unraveling would be vicious.  He and his partners predicted early on that the amount of troubled loans would hit $1 trillion.  He even shared his concerns with risk managers on Wall Street.  No one wanted to listen.  He then made the tough decision of putting a substantial portion of his own capital and that of his investors behind his conclusions even as the herd was thundering the other way.  His fund reported a return of 400 percent in 2007.

The pendulum now finds itself swinging to the other extreme — that of fear:

  • people are pulling out of the stock market after seeing half the value of their portfolios vanish into thin air
  • those nearing retirement are worried that they will have to work much longer to make up for the lost value in their retirement accounts
  • the housing-led recession is fully afoot
  • those who have lost jobs are wondering if they’ll find one soon
  • those who still have their jobs are fearful of losing it any day
  • the decline in home values hasn’t abated yet (remember the lynchpin?)
  • the foundations of many banks are crumbling leaving people wondering if their money will be safe
  • ……….

Fear seems to control our decisions these days.  Unfortunately, the economy will not see an improvement until this emotion subsides.  One thing I know for sure…this too shall pass.  As Solomon, the wise man, once said, “To every thing there is a season, and a time to every purpose under the heaven.”   There are enormous opportunities for people who recognize this, resist groupthink, make tough decisions, and take some risks.  As sure as Kyle Bass earned his profits working against the market’s greed, there will be those who reap great rewards working against the market’s fear.  Sadly, most of us will only hear about it after the fact.

Filed under: Business, Economy, Psychology, , , ,

House of Cards

3008220063_3399805fc0_medHave you had a chance to see the new CNBC documentary, “House of Cards,” by David Faber?  If not, I recommend catching one of the reruns.  Faber presents the various elements that contributed to the housing-induced credit crisis and recession.  It is evident that there is plenty of blame to go around.  Factors include, but are not limited to:

  • historically low interest rates
  • consumer desire to fulfill the dream of home ownership at any cost
  • congressional legislation to facilitate that desire
  • Wall Street salivating at the prospect of additional revenue streams through formulation of loosely regulated/unregulated structured products
  • rating agencies operating under conflict of interest
  • investors reaching for the holy grail of high yields and “no risk” which they thought were encapsulated in these structured products

One element which was not covered in the documentary but, in my opinion, should share responsibility is the National Association of Realtors, led by David Lereah, which kept trumpeting the “buyer’s market” mantra.  Such rhetoric only exacerbated renters’ fears that they were going to miss out on the greatest real estate boom in history.  Now, as a private consultant, he admits he was wrong.

As consumers, we need to develop the ability for critical thought.  We need to learn to ask the right questions:

  • Is this in my family’s and my best long term interest?
  • Can I truly afford this?
  • Do I really understand what’s in this document?
  • Can I trust someone who benefits from my signing the document when they tell me not to worry about the fine print?
  • Am I making this decision based on fear or greed?

The primary interest of publicly traded companies is not necessarily the consumer.  They are beholden, first and foremost, to the shareholders.  Consumers need to be cognizant of this fact and hold themselves and the counterparty accountable.  Otherwise, we will find ourselves exhibiting the same systemic problems down the road albeit in another form.  Alan Greenspan, the former Chairman of the Federal Reserve, even states this as a foregone conclusion:

There is no doubt that somewhere in the future we’re going to have this conversation again.  It will not be for quite a period of time.  But, it will occur because the flaws of human nature are such that we cannot change that.

Filed under: Economy, Real Estate, , ,