Wednesday, November 26, 2008

Credit Ratings

Many savers with a 401(k) or other investment account are probably familiar with the Standard & Poors, Moody’s or other credit rating firms. Monthly statements usually include their ratings alongside a list of assets.

Lately though the credit rating firms have admitted to Congress [Washington Post, Credit-Rating Firms Grilled Over Conflicts, October 23, 2008] their ratings have been tainted by conflict of interest. Moody’s and Standard & Poors are paid by the firms they rate. The article quoted a memo written at Standard & Poors by someone who said "Let’s hope we are all wealthy and retired by the time this house of cards falters."

Long before I read that anonymous statement I wondered about credit ratings and whether they are good guides for savers and investors. Credit rating firms use past performance to rate future risk.

Forecasting the conditions in markets years ahead is hard enough but the current wave of defaults on mortgage backed securities has spread to other firms in a domino effect. The good management and triple A rating at one firm can be affected by defaults at other firms. Ratings cannot be given in isolation from the solvency of the larger financial system.

Since a bond is an enforceable contract just like a home mortgage, it is worth asking whether a failure to pay interest and principal on time is the important financial risk. As long as a defaulting institution remains after a default, then late payments can be recovered later.

For example, corporate bond holders risk losing interest and principal in a default, but a corporation can literally disappear in a bankruptcy. Cities, counties and states do not disappear. Even if they go into default they continue to have taxing authority to meet their legal pledge of full faith and credit to pay their bond obligations.

Furthermore, city and county governments are created and governed by state legislation, which makes state government responsible for city and country bond payments in the event of their default.

Following this logic, even small municipalities should have higher credit ratings than private sector corporations. Size and name recognition should not matter in credit ratings and the difference of market interest rates between government and corporate bonds may not reflect actual differences of risk. Remember too non-federal government bonds and bond funds are not taxed as part of income.

The article did not tell readers if Congress wants to impose professional standards, or what if anything it intends to do about this newly reported conflict of interest. In the mean time, remember governments are likely to be around to pay their bills.

Wednesday, November 12, 2008

Circuit City Jobs

Circuit City is back in the news [Washington Post, November 6, 2008] with plans to close 155 stores and layoff thousands in bankruptcy reorganization. I say back in the news because there was an article about Circuit City in the Washington Post back on March 29, 2007 titled “Circuit City Cuts 3,400 ‘Overpaid’ Workers.”

The cuts came out of 40,000 in store jobs, or 9 percent of the company’s in store workforce. The firings were not related to job performance the company announced, but came as part of an effort to cut costs and improve the bottom line.

They were going to save on labor costs we learn later in the article by firing their “overpaid” staff and rehiring new sales people at lower wages. That may sound like a way to save money, but now, 18 months later, there is good reason to doubt they saved any money.

Circuit City is part of retail trade in a sector called Electronics and Appliance Stores where salesmanship is important. Circuit City buyers may need to learn about complicated electronic products and how they work before they make up their mind. Retail Salespersons do selling, which means explaining and demonstrating products, answering questions, knowing warranty terms or other product information.

In other retail sectors like gasoline stations and grocery stores, selling and salesmanship are not as important. People know if their gas tank is empty and they buy their pasta and potatoes from a cashier, not a salesperson. Explaining and selling takes time, skill and experience and so more and better paid retail sales jobs are needed at electronic and appliance stores than gasoline stations or grocery stores.

The need for salesmanship is partly reflected in staffing where retail salespersons and their supervisors make up more than 40 percent of retail jobs. Staffing at gasoline stations contrasts with electronics and appliance stores where more than 60 percent of jobs are cashier, but virtually none are retail salespersons.

The Washington Post article back in March 2007 informed readers that Circuit City dismissed their sales staff earning wages over of $15.50 an hour, or their most experienced and longest tenured sales staff.

We can be sure Circuit City management saved on wages, but wage savings are not cost savings unless they lower costs per dollar of sales. Ignoring productivity tells us that Circuit City management did not know the meaning of overpaid, or even how to save.

True, the economy is doing poorly now, which is probably part of Circuit City problems, but as the saying goes, “They were penny wise and pound foolish.”

Wednesday, November 5, 2008

Mr. Greenspan Talks

The caption in the Washington Post reads “Greenspan Says He Was Wrong on Regulation.” [WP, Oct. 24, 2008] The former Federal Reserve Board Chairman told Congressional Committee members the “… crisis has shaken his very understanding of how markets work, and agreed that certain financial derivatives should be regulated – an idea he long resisted.”

After his opening comments to the committee Mr. Greenspan argues against regulation and warns Congress that regulation is a threat to economic growth, despite the collapse of derivatives markets this fall.

Greenspan worships free markets so much he forgets that free markets and regulation work together all the time. Take physicians. Physicians are regulated because they have to go to medical school and get a license before they practice medicine. Across America biology students dissect frogs, but without that licensing regulation any one of them could decide they know anatomy so well they can be surgeons, ready to do surgery on you and me.

Regulating doctors lets us be confident they are competent to be physicians; without regulation many would suffer before word got out and free markets acted to eliminate incompetent physicians.

Free markets need equal opportunity and they operate best when we know what we are getting. Regulations requiring equal opportunity, disclosure, honesty and integrity aide and promote the smooth operation of financial markets just as they do in physicians markets.

Remember banks and all financial intermediaries operate with one purpose: to attract the funds of net savers so the savings can be returned to the spending stream by loans to net borrowers. For many years savings accounts, certificates of deposit, stocks, bonds and mutual funds have served the millions in America who save.

Unless Mr. Greenspan will explain what unregulated derivatives can do for America’s economy, which are beyond the established and regulated methods of saving and investing, then we can feel justified that he is arguing against disclosure, honesty, and integrity essential in financial markets.

After the collapse of derivatives markets, and then financial markets, further opposition to regulatory standards gets close to defending secrecy and deception. We would like to think better of Mr. Greenspan, but given his testimony he is making it hard.