The Audit

Debits and Credits

A valuable warning from the Times; Ben Stein’s not all bad; The Economist malls it in

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Editor’s note: This Debits and Credits holiday edition reviews the business press from the past two weeks

Two days before Christmas The New York Times unwrapped an excellent examination of how broadly the housing bust’s fallout is being felt in hard-hit areas.
Take a look at the havoc unfolding in Lee County in Southwest Florida:

In the county, a tidal wave of foreclosures is turning some neighborhoods into veritable ghost towns. The county school district recently scrapped plans to build seven new schools over the next two years. Real estate agents and construction workers are scrambling for other lines of work, and abandoning the area. As houses are relinquished to red ink and the elements, break-ins are skyrocketing, yet law enforcement is resigned to making do with existing staff.

The macroeconomic impact of the mortgage mess has proven difficult to predict. Will the economy tip into recession? While consumers nationwide are reining in their spending a bit, it’s in freefall in Lee County, Florida, and its economy is sinking. With foreclosures up fourfold from a year ago in the county, sales-tax receipts are down 14 percent and government and business spending is slowing. One in four houses in the county sits empty, and the unemployment rate has nearly doubled in a year. Burglaries are up more than 33 percent.

As the Times’ headline puts it, “This Is the Sound of a Bubble Bursting”:

Scanlon Auto Group, a luxury car dealer, says it has seen its sales dip significantly — the first time that’s happened in 25 years. Rumrunners, a popular Cape Coral restaurant with tables gazing out on a marina, says its business is down by a third, compared with last year.

Furniture dealers are folding. Hardware stores are suffering. At Taco Ardiente in Lehigh Acres, business is down by more than three-fourths, complains the owner, Hugo Lopez. His tables were once full of the Hispanic immigrants who filled the ranks of the construction trade. The work is gone, and so are the workers.

In Cape Coral, city hall is paying landscapers to mow the overgrown lawns of abandoned houses. One realtor has stopped printing lists of foreclosed and other troubled properties because “it’s too long.” Homeowners who cashed in their newfound equity now are under water on their loans and losing their homes.

“It was here that housing prices multiplied first and most exuberantly, and here that the deterioration has unfolded most rapidly. As troubles spill from real estate and construction into other areas of life, this region offers what may be a foretaste of the economic pain awaiting other parts of the country

If the Times’s supposition proves correct, look out below.

Also on the 23rd, the Times ran a Ben Stein column
on capitalism and trust. You can’t have the former without the latter, he notes, pointing out how major scandals have shaken market confidence from the junk-bond frauds in the ‘80s to the technology analysts’ cynical hype in the ‘90s. He addresses the latest case of breached trust:

The biggest of the big names were among the most aggressive in betraying their clients’ trust, as I see it. Some of the biggest names were selling securities that they — apparently — barely understood themselves. In so doing, they exposed their buyers, and their stockholders, to immense losses. (Think Merrill Lynch, Bear Stearns, Lehman Brothers and many others.) Other major players, including Goldman Sachs, were aggressively shorting the very same sort of products they were underwriting.

Now, Stein has come under attack lately, not always reasonably. Portfolio’s Felix Salmon validly but with some unneeded heat points out these investment banks have no fiduciary duty to people buying these securities unless they manage their money.

If an investment bank underwrites a sale of securities, then the bank’s client in that transaction is the issuer, not the investors. In an IPO, for instance, the issuer often pays the underwriter 7 percent of the proceeds. The investors, meanwhile, make their own decisions as to whether they think the stock is a good buy at the IPO price. If you want to get a good idea of who a bank is working for, just look to see who’s paying them.

It is true: Stein employs words like “fiduciary” and “client” carelessly. We wish he’d shape up because he’s got some valuable things to say.

The broader point is this: Investors trust that Goldman Sachs isn’t going to underwrite just any old trash, and yet, it did, didn’t it? That’s Stein’s essential point, and while not elegantly put, it’s clear enough. Stein believes Goldman’s short position is evidence that it knew the product was bad when it sold it, a position some have attacked as naive, foolish, even preposterous. In fact, it’s none of those things.

Now, Goldman can spin this as “risk management” and insist that it was doing it to protect its stockholders. (Remember, though, that Goldman’s lushly compensated traders and executives get a far larger share of the pie than we pitiful stockholders do.) But selling short the same securities or very similar ones that they were peddling to the clients is extremely hard to reconcile with basic fairness.

The erosion of fiduciary duties is one thing, but here he’s just talking about basic business integrity. It’s a good point and a simple one. Maybe too simple for some.

We also like how Stein traces the erosion of trust to Drexel’s rise in the early 1980s. So, markets weren’t always this way, after all, and booms and busts are not acts of nature that cannot be mitigated. Reading economics blogs, you’d never know it.

We would add that Drexel didn’t rise in a vacuum. Stein’s timeline of the decline in trust coincides with the ascendance of financial deregulation. Stein’s memory supports our view: Well-functioning markets can not only withstand oversight; they require it.

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Comments

Felix Salmon

Mon 31 Dec 2007 01:06 PM

When you say that "investors trust that Goldman Sachs isn’t going to underwrite just any old trash" I think you forget that we're talking about QIBs here, qualified institutional investors. Mortgage-backed bonds were not sold by Goldman Sachs or by anybody else to retail investors: this isn't a case like Blodget's where the ignorant masses were being duped by their stockbrokers.

I can assure you that the institutions which buy RMBSs did not do so because of the name of the underwriter, they did so because they wanted that extra yield. So I think it's a stretch to talk about a betrayal of trust here.

As for Stein's tracing the erosion of trust, it's all much simpler than that, as Yves Smith explains:

"Investment banking" meant something very different in those days than it does now. And the conflicts Stein wails about weren't possible in firms that weren't integrated. But in those supposed glory days, the firms also charged proportionally much greater fees and had a cozy oligopoly. You can afford to be genteel when you are making easy money...
Stein, in talking inaccurately about fiduciary duty (and much else) accesses a desire to turn the clock back to when customer relationships meant more, when a vendor would cut his customer some slack and might even be proactive to make sure he didn't stray. But in those days customers were faithful and margins were fatter. Is America willing to give up Wal-Mart, price comparisons on the Internet, and their Wall Street analogues, dirt cheap commissions, lower M&A fees, and (at least in plain vanilla products) competitive fees on money management products? What Stein is asking for is a return to a relationship-oriented approach, but it's a two-way street. Customers who shop for the finest prices, by definition, aren't loyal.