Those wonderful shops

I been looking at retailers lately – not something I know a lot about.  I know enough to know I can hurt myself if I get these wrong – as my post about being a fuddy-duddy old guy reveals.

However I have come across this retailer in relatively good categories with a very low valuation and acceptable looking – though economically cyclic - run of same store sales increases.  Here are the numbers:

Fiscal year	Same store sales
1992	1%
1993	7%
1994	8%
1995	15%
1996	5%
1997	-8%
1998	-1%
1999	8%
2000	8%
2001	-4%
2002	-10%
2003	4%
2004	-3%
2005	1%
2006	8%
2007	6%
2008	-8%

The same store sales were up 50 percent over the period 1992 to 2007 – not a great 15 years – but not diabolical.  They were down 8% in 2008 – which – given the economy looks bad – but again not pinch yourself bad.  

And this stock looks cheap.  Really cheap.  Breathtakingly cheap.

I am going to leave a few spaces before the rest of this post….

More space…

And more…

So it’s a bait-and-switch – the company is Circuit City – and whilst the same store sales look sort of acceptable they were anything but acceptable when compared to the competitor.  Here are Circuit City’s same store sales compared to Best Buy:

Fiscal year	Circuit City	Best Buy
1992	1%	14%
1993	7%	19%
1994	8%	27%
1995	15%	20%
1996	5%	6%
1997	-8%	-5%
1998	-1%	2%
1999	8%	13%
2000	8%	11%
2001	-4%	5%
2002	-10%	2%
2003	4%	2.4%
2004	-3%	7.1%
2005	1%	4.3%
2006	8%	4.9%
2007	6%	5.0%
2008	-8%	2.9%

And now you can see what happened.  Circuit City just got crushed.  Best Buy had superior sales per-square-foot or sales per unit of cost structure – and that difference got bigger and bigger and bigger.

As it did they could cut price – so whilst Circuit City’s same store sales sort of kept up with the costs their gross margin per unit of costs most certainly did not.

It is impossible to analyse the stock except in the context of its competition.  Circuit City’s problems are not it sales per-se – but its sales relative to its competitors.  Underperform by that much for that long and – despite your glorious past – there is nothing left.  Every investor should have emblazoned on their forehead that “competition is a wealth hazard” and anyone that tries to sell you a stock without analysing the competition should be sacked.  [Simple but blunt.]

I visited Circuit City headquarters once.  In those days it had a billion dollars of unencumbered cash on its balance sheet.  That cash represented past profits.  Past glories of which there were many.  Circuit City was a fantastic company once…

Circuit City it seemed tried many things to get the sales up (and match Best Buy).  The above mentioned cash disappeared when CC had a bad experiment in credit cards.  It should be easy enough to drive sales if you lent to people who had no intention of paying you back.  Given that, it is surprisingly hard to find the credit card boost in CC’s numbers.  

Also about just before I visited them they (finally) got rid of whitegoods – and tried to match the software (music, DVDs etc) offering at Best Buy.  They had to refurb all the shops.  Lots of cost – and only a few years of interesting same store sales growth.  

People seemed to be down on Circuit City sacking its expensive sales staff and rehiring cheap ones a few years before insolvency.  But the expensive sales staff hardly helped the sales keep up with Best Buy and would have been sacked anyway when the company was liquidated.  The problem lay elsewhere and being sacked two years ago was a relative blessing (the new hires will be hunting for work in this labour market).

Consider this an open thread.  What is it that Circuit City did worse than Best Buy?  I have my ideas – and will jot them in the comments where appropriate – but I really want yours.

Also – if anyone has a good memory – can they tell me why both companies had lousy sales in 1997?

John

Smashed up old fuddy-duddy guys

When I was about 22 my dream date and I ended making love on the balcony of a friend’s beach house on a balmy evening with a very high end stereo playing Van Morrison’s Astral Weeks at reasonable volume.

It even happened a few times.

My dream material goods were not fast cars (never been a rev-head) or an iphone (they didn’t exist) or even a mobile phone.  No – it was a high-end stereo – probably a beautiful Scottish turntable like a Linn - and a beautiful pair of Italian speakers (I still own my Sonus Fabers – and they cost a couple of thousand dollars then – probably five thousand in today’s money).  

That was a long time ago.  

Today’s 22 year old wants 5000 songs in his pocket (or 20 thousand), has probably never heard of Astral Weeks, can’t possibly afford a beach shack on the New South Wales coast (they used to be the playthings of the middle class – they now cost millions and are the play things for the super-rich) and wouldn’t give a damn about my Sonus Faber speakers.

Small, portable.  Who would have thought that Bob Dylan (of all people!) would wind up squealing about the declining sound quality of modern music.  He is right: the sound quality that made Astral Weeks so special is gone.  Even the sound of Bob Dylan howling out a pre-Animals version of House of the Rising Sun) is just missing on an iPod.  

Which leads me to how much you can stuff up an investment thesis.  

If you had told me in 1998 that (a) houses would get bigger, (b) the upper middle class would grow like topsy, (c) the middle class would borrow to finance houses and lifestyles like the upper middle class then I would have thought that high-end stereos would just have a great time.

I would have thought the middle class would continue to have such dreams – and that music – especially at high fidelity (and possibly high volume) would remain key to social lives (or even making love on the balcony).  

If I had known how the macroeconomic outcomes were going to look I would purchased Tweeter stock with glee.  Tweeter was a chain of big-box stores that sold at a price/quality point above Best-Buy or Circuit City.  It was a place where I could fantasize about my favourite consumer goods.  Ok – my Sonus Faber speakers might have been a step above Tweeter – but that was sort of the idea.

Well the world that I dreamed about has been smashed up – and I am just another smashed up fuddy-duddy middle aged guy.  (Get used to it John.) 

Tweeter is being liquidated.  John, say goodbye to your once dreams of material goods.

But for the moment I want to leave you with a promo from Tweeter’s liquidation sale.

I guess it tells you what to short.  All of this is so yesterday.  Like your blogger.

John

PS.  The Animals ruined House of the Rising Sun forever.  The first person in the song that Bob Dylan sung was a woman – and it wasn’t her father that was the gambling man – it was her sweetheart.  The pain in the lyrics is far more intense that way.  I gather the Dylan version is quite close to a version sung by Leadbelly – but I have never heard the Leadbelly version.

Anyway - even if you loathe Bob Dylan (and plenty of people do) listen to this gem.  Then buy the CD next time you see it in the discount bin - but only if you too are a fuddy-duddy like me.

PPS.  If you are really interested in the anticedents of the house of the rising sun - here is a Joan Baez version from 1960.  Obviously this pre-dates either Dylan or the Animals.  Baez has a truly stunning voice but Bob Dylan changes the lyrics for the better (much better).  If anyone can fine the version of the lyrics either Woodie Guthrie or Leadbelly sung I would be interested.  

I think the lyrics were refined to sheer elegance by Bob Dylan and stuffed by the animals.

John Paulson accuses his competitors of theft or fraud

I was reading Paulson Funds latest client letter (hat-tip Kedrosky).  It is an enviable list of the things he got right this year.  However one section jumped out at me – a hand grenade thrown at about 100 hedge funds:

Redemption policy

As a firm, we have not imposed any gates or other restrictions on clients withdrawing their assets.  While we recognize the difficulties of the current environment, we think it’s a manager responsibility to raise liquidity to meet the needs of their investors.  There is plenty of liquidity in the markets.  Even in opaque areas of the markets such as in bank debt, mortgage backed securities and other distressed securities, we see hundreds of millions of dollars trading every day.  We are especially surprised that many managers have restricted client withdrawas when: 1) the total redemptions are manageable (15-25% of AUM); 2) the managers have the cash; and 3) one of the stated reasons for restricting withdrawals is so the manager can continue to invest in new opportunities.  Emphasis added.  

I read this as John Paulson saying that there are funds which have easy enough to mark to market assets and where the assets are sufficiently liquid are refusing to give money back.  Theft or fraud.  Or maybe both.  Moreover the liquidity according to Paulson is sufficient that funds almost never should have stop withdrawals – even in opaque areas of the market.

Now I guess it is up to John Paulson to name names – or perhaps some enterprising WSJ reporter can do it for us.  Whatever – this is a big story.

John Hempton

Bad tax policy and bad government process – GM as a test case

The WSJ leads with a story about how GM wants to avoid a tax burden that comes from restructuring its liabilities – converting its debt to equity.

Bad idea – and if the Obama administration rolls over for this tickle I will rapidly lose faith.

Some background – debt forgiveness and taxation

I wrote a while ago on debt forgiveness and double counting of losses.  I wrote in an accounting sense – but it most important in a tax sense.  It works like this:  

If a tax system is poorly designed person A can lend to person B who can lend to person C etc.  If the person at the end of the chain (lets call him person Z) loses the $100 he legitimately gets a tax loss.  However if he fails to repay person Y then Y also legitimately has a tax loss.  The same $100 will if you are not careful produce two tax losses.  Indeed if the same thing happens along the whole chain the same $100 can produce 26 tax losses – and if that happens you rapidly have no tax system.

Every OECD tax system fixes this by assessing the gains from debt forgiveness.  A debt you don’t need to repay is a loss that you haven’t made (the person you have borrowed from has really made the loss).  In the US debt forgiveness is ordinary income.  In Australia it is income according to a special legislative provision.  Both ways the tax system corrects the double counting problem.  

Now GM is proposing a debt restructure – converting debt into equity.  The debt holders are not being repaid and they make a tax loss.  GM no longer has to repay the debt holders so they make a gain.  They will be assessed on that gain.  

Normally nobody would care much – because GM has plenty of tax losses that it has made and the gain will just reduce those losses.  But GM also plans to use those losses to get big refunds on past tax paid or by other means.

Now I am a fairly liberal sort of guy.  If the Obama administration wants to explicitly give $7 billion to GM then go ahead and get Congressional and Senate approval.  I gather they have the numbers.

But giving it in a non-transparent way – and a way that dismembers one of the rationally built parts of the tax system – is hardly a model of good government process.  

One thing the stimulus program (and hence the Obama administration) will need is a depth of process so that the waste and scandals that go with that much largesse can be controlled.

We had Paulson with his three page-no-process-just-trust-me plan.  GM is trying the same sort of crap on.  

Stop it now.

John

PS.  Disclosure: the early part of my career was in tax policy (both in Australia and New Zealand) – eventually becoming chief technical analyst tax policy at the New Zealand treasury.  I have a view – built from experience – that discipline on tax system design is almost the defining mark of sound government process.  

Governments who dish out money as cold hard cash are subject to (justified) public scrutiny.  Tax provisions for special interests are economically very similar but the scrutiny level is low.  Moreover – low tax conservatives should agree with me – in that tax cuts for special interest can often preclude general tax cuts for all interests.

Freshwater and Saltwater: macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molongolo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher long term interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays. I have detailed that mistake here. Bill Gross made a similar mistake declaring the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was in good company.

Now the subject of freshwater, salterwater and other macroeconomic elixirs is the thing in the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

Scandinavian bank collapse - not all the same

Do not bother reading this post unless you are directly interested in a history of Norwegian versus Swedish bank collapses...

It seems that some central bankers read this blog. I got an email from a senior Scandinavian central banker following the exchanges on this blog (see this exchange for an example).

Anyway he points me to a note by P Honohanen of the World Bank (written several years ago) and which I reproduce here. I think this should close some of the debate. Either way it is useful if you wish to know what actually went on...

For several years it has been fashionable to look to Sweden as offering a policy model for recovering from a banking crisis. And your editors have to admit that, along with most other commentators, they had been inclined to assume that the Swedish case was mirrored by the roughly contemporaneous crises in the rest of Scandinavia. But the Norwegian crisis actually predated that in Sweden and, as we have discovered by reading the comprehensive volume on the Norwegian case which has just been published by Norges Bank (“The Norwegian Banking Crisis”), containment and resolution policy was quite different. Certainly the two countries both made a good recovery: on some reckonings the Norwegian government, like that of Sweden, may have ended up with a small cash profit after selling back into the market bank shares that it had acquired in the crash. Though sometimes thought of as a classic macro boom-and-bust, the Norwegian crisis may be better classified as the result of inexperienced bankers trading in a newly liberalized market with recently lowered capital requirements and a sharply reduced frequency of on-site supervisory inspection. The crisis was a big one: the three largest banks (DNB, Fokus and Christiania) all failed along with many smaller banks including sizable regional banks. The privately owned and managed deposit protection schemes were overwhelmed and had to be nationalized – illustrating a weakness inherent in what is otherwise a good idea: distancing deposit protection from the government. Government took ownership of the major banks – and retains, for strategic or political reasons, a major stake in DNB. But, and this is the first important contrast with the policy stance adopted in Sweden, in no case were shareholders bailed out. (Yes, the authorities were sued by disappointed shareholders, but unsuccessfully.) Two other key points to notice: government did not issue a blanket deposit guarantee and they did not set up Asset Management Companies. These striking contrasts certainly argue for avoiding knee-jerk application of the Swedish policy approach in these three dimensions.

The perfect appointment

I have – framed above my desk – a $100,000,000 note – serial number AA23100220 and signed by Dr G Gono – the Governor of the Reserve Bank of Zimbabwe.

This – it seems – offers the solution to all our deflationary woes.

It seems that no matter how many dollars the Fed prints it can’t induce inflationary fears.  I suggested that the Fed rent a couple of hundred helicopters and (literally) push $2 billion out the window.  That I thought was irresponsible enough to raise inflationary expectations.

Alas real objections can be made – not the least that people might climb on rooftops looking for the booty – and slip and die.  I can’t morally justify the deaths.

But the Zimbabwe note has given me another solution – one that doesn’t require any helicopters or even the printing of any money.  It is more than sufficiently irresponsible – yet nobody will die.

Ben Bernanke should resign forthwith and Dr G Gono should be appointed as Chairman of the Fed Reserve.  

Nothing need change.  Monetary policy can remain in the effective hands of the other governors – but the appointment of Dr Gono will rapidly raise inflationary expectations – and the new inflationary expectations should induce the spending of the massive hoard of saved dollars – providing all the economic stimulus needed.

Dr Gono may be the wrong man for Zimbabwe – and the right hand man of a dictator.  But he is what America needs right now.  

Do you think we can get him confirmed?

John Hempton

What is a non-performing loan?

Once upon a time I saw loan restructurings as code for faking the accounts.  That was with good justification.

Conseco – before it blew up – had a habit of restructuring any loan that was delinquent.  After restructure it was no longer delinquent – and lo – the credit metrics seemed OK.

After Conseco finally went bankrupt the truth came out.  Loan performance went from sort-of-OK-if-you-ignored-the-fact-that-cash-actually-coming-back-in-payments-was-low to utterly desperate.  The AAA strips of Conseco securitisations failed widely.

These days restructuring loans is the stated objective of many powers that be – most notably Sheila Bair.  I never quite got that.  If you show too many non performing assets (NPAs) Sheila Bair will just confiscate your bank.  So the incentive is to restructure and restructure early.  If the borrower can perform to restructured spec then presumably they are no longer an NPA.  What Sheila Bair appeared to be advocating was government sanctioned account faking.

Then of course some banks tell it straight – and count the restructured loans amongst their NPAs.  Here is an extract from the recent Fifth Third conference call.  Fifth Third is a problematic bank and in WaMu fashion I own the subordinated debt – not the common – and in WaMu fashion I probably have reason to be nervous.  Anyway to quote:

Turning to the consumer portfolio, we also continued to be very aggressive in restructuring consumer loans, modifying over $200 million in the quarter. We believe restructuring loans where appropriate will result in significantly greater likelihood of payment and more value ultimately received by Fifth Third. These activities are beneficial not only to our shareholders, but are also consistent with the needs of our customers.  [Sheila Bair’s line precisely – are they pandering?]

As of year end, we had $574 million in troubled debt restructurings and NPAs, classified that way because they hadn't met the six-month consecutive performance threshold.  [Hey wow – they count restructured loans as non-performing – so they are not producing the Conseco fake numbers…  My cynicism is misplaced in this instance.]

Fifth Third has been among the most active of banks in the US in restructuring loans for consumer borrowers, a process we began over a year ago. We've been among the most active among our peers in these restructurings only one of the 15 largest US banks reports a higher dollar amount of restructured loans among its nonaccrual loans, according to regulatory filings.

Now this is very odd.  $574 million of restructured loans in the NPAs is about the highest in America!  But we know lots of banks are restructuring many loans – many billions worth.  Sheila Bair is telling them to do it.  But if you take Fifth Third at its word (and I think you should here) all the other banks are classifying most those restructured loans as performing.

In other words they are – Conseco like – faking their accounting.  And Sheila Bair is not only complicit – she is actively encouraging.

Welcome to modern banking.  

Cute

By far the best reaction to the helicopter post from one of my favourite bloggers.

See Cassandra.


John

Reaction to the Helicopter post

The helicopter post has had the most reaction of any post on this blog. I guess that is the territory when you suggest that the solution to the financial crisis is to literally throw money from helicopters. Nonetheless I wish I could get that sort of reaction to a more serious post.

The reaction to the helicopter post fell into three categories:

• those that didn’t get it
  
• those that got it but may have had ethical problems, and
  
• those that understood it all too well.
  

I got one comment – via email – which explained very simply why the helicopter proposal wouldn’t work. I think that commentator’s argument is accurate – so – at the end I will lay it out and (tentatively) withdraw the helicopter proposal.

Those that didn’t get it

There seemed to be several comments (email and on blog) which suggested that it would be better if we just gave everyone a tax holiday (payroll, income, death duties depending on where in the political spectrum the commentator was).

This does not cut it. The purpose of the proposal (throwing money out of helicopters) was not to distribute money (for which plenty of effective mechanisms exist). The purpose was much more radical – to remove trust in money itself.

The proposal I made was remarkably cheap (a $2 billion solution to a multi-trillion dollar problem) and if it works it works for purely psychological reasons – which is that it is so reckless and irresponsible that nobody could ignore the inflationary impacts of Federal Reserve policy. Reckless and irresponsible (and small) was the charm of this proposal.

Indeed I suggested in the comments that it would work even better if Bernanke continuously surrounded himself with buxom prostitutes paid out of freshly minted moolah, but that image was just too horrific – even for this purpose (although it may be effective).

Some that simply got it

There were a couple of posts that simply got it. The cutest came from someone calling themselves the German Trader who put it very simply (if in very poor English):

You only give something away when you think it is worthless and what you get is of greater worth. While seeing the riots after Bens helicopters came past I surely want buy a new car.

Kieren (who I do not know) pointed out that the trick was really to produce inflationary expectations (and hence to get people to spend) without producing inflation. That is why this might work. The amount of money involved is small ($2 billion versus over $2 trillion in money supply) so its effect should also be small – but the expectations effect could be enormous. That was – in theoretical terms – what I was trying to achieve.

Some who got it and raised ethical objections

There were a few ethical objections raised – firstly by people who thought I was right that this policy would cause riots and deaths and then promoted more responsible ways of doing the same trick. The people killed in riots are collateral damage of a deliberately irresponsible policy. I don’t know how to weigh one life versus another – but this financial crisis will kill hundreds of people before it is over – either suicides or more bluntly hunger in some countries badly hit. The ethical objection is real – and I have no solution. The policy proposed is deliberately irresponsible – and irresponsibility causes death in some instances.

The main ethical objection I expected was about property rights and theft. I wrote the post in Australian hours and it was seen by Australian/Asians then English/Europeans and finally by North Americans.

I had to wait until American waking hours for someone to point out the obvious - which is that the policy being advocated was the deliberate theft of property (deliberate inflation being theft). Europeans somehow seem less concerned than Americans about property rights.

I am usually very harsh on government policies which involve the removal of property rights simply because those policies are usually counter-productive. There are plenty of posts on this blog along those lines. However those posts are argued on a facts-and-circumstances basis – the abrogation of property rights is argued as a problem in this instance and property rights are not automatically given full moral status. That is my position generally – honouring property rights is a good thing to do because it generally leads to better outcomes. I understand that some people (almost all Americans and including many readers of this blog) have raised property rights to full ethical status (along with for instance the rights to liberty etc). Not my ethics – but I understand – and the outcomes are usually OK so I am generally happy to leave that form of right wing fundamentalism alone.

I prefer argue for property rights from an outcomes perspective (as incidentally did many Modern Scots - esp Hume - but later Smith with regard to some economic matters*). Your blogger does not really wish to comment on the property rights as a moral precept here – other than to note for some people this really is fundamental. Just leave it at that.

The commentators that got it all too well

The comment on the post which got the most comment from other commentators was someone that got it all too well. The comment was that – as a result of this policy – some right wing “nut” would load a truck with fertilizer and diesel and blow up the Federal Reserve.

Some people objected to calling that person a nut – but I have no other word for suicide bomber of any persuasion. More to the point – this person – and eventually many others – would realise what this policy was about – which is removing all trust from dollars – and hence theft of one ideal that they hold quite dear.

The question which was raised in emails was about how you would reintroduce trust after you have destroyed it. I think that is actually a key problem. Trust is essential for an economic system in general – but trust in money at the moment is quite destructive as people would prefer hold enormous quantities of money rather than build real assets and employ real people. However you can’t build real assets and employ real people without trust either. The helicopter proposal is targeted at getting rid of trust in one place and one time only (the trust in money in the rare instance of a liquidity trap). Whether you can conduct a strike that surgical with a helicopter full of rolls of money is open for question. Military strikes are nowhere near as precise as the pictures on CNN.

Finally – the real objection

This came in an email from one of the most astute commentators on my blog:

It won't work because immediately after the drop, Congress would arrest Bernanke along with the entire Fed board (probably replace it with a money czar)…. Politicians would be forced to promise responsibility and accountability in the face of the threat of civil unrest - don't forget, a lot of people own guns legally in this country. There will be new laws designed to keep the value of the dollar. In the end, the dollar would get stronger, not weaker…

In other words the whole idea won’t work because it is actually not possible to be that irresponsible – that the underlying US system is sufficiently strong – that if Bernanke were that irresponsible he would simply be replaced.

If Bernanke can’t plausibly be quite that irresponsible we might as well park the helicopters.

And if you can’t use monetary policy to solve this recession then alas we are left with what appears to be two inferior choices (a) a fiscal expansion of gargantuan proportions or (b) letting the system burn and winding up in a great depression type scenario. Both are unpalatable – but I would vote for the fiscal expansion.

It would be much better to just load up that helicopter. Alas...

John

*There is a serious edit to the this post because I have not read theory of moral sentiments for twenty years and then did not finish it. I have pulled out my copy and I was wrong. I wasn't about Hume (who I have always thought right). Smith it seems thought that moral laws within the economic sphere were made by man - but outside Man was not capable of such moralizing. The rights to property seem - from my quick skim fall into manmade lot - but... suggestion withdrawn...

J