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How to Invest $250 Billion
It is important to remember the difference between spending and investment. We are in our current financial mess because we have confused spending with investment. An investment is a capital allocation where you expect to earn a positive return and preserve the value of your original investment. For example, the global housing crunch was inevitable once buyers were willing to accept net yields lower than their cost of finance. Politicians are an essential part of our society. However, politicians are best at getting elected, then re-elected. They are not experts at effective capital allocation and they bear limited penalties for misallocating our capital. One of the main criticisms of the banking system is that profits were privatized, while losses are (potentially) being nationalized. How is political oversight going to be an improvement? Thain and O'Neal made some poor calls, but at least they had an incentive to make the right ones and were publicly humiliated by their errors. Obama is constitutionally prohibited from being in power at the time that the TARP chickens are going to come home to roost. Gordon Brown is unlikely to be around when the UK's investments mature. Politicians are focused on winning the next election, not on ensuring a positive return on deficit spending. Here are some ideas on how to allocate $250 Billion of capital in a way that has a good shot achieving a financial sector restructuring as well as generating a positive return for the investors (you, me and EVERY generation that follows us, forever). The basic structure is a public:private joint venture. Instead of a single Aggregator Bank, start five. Establish a framework so that we are able to move away from a nationalized banking industry as fast as possible. Build competition into the front end. So the $250 Billion is split five ways -- $50 Billion per company. Each new company (NewCo) has a total capitalization of $100 Billion. So the government's commitment is made in partnership with, and on the same terms as, the Private Sector. 50:50. The business, a new bank, starts with equity at 10% of total capitalization -- $10 Billion. 50% of that is committed by the government. The other 50% is committed/raised by the investment group that will be running NewCo. I would want to see $1 billion coming from the partners that will be running/overseeing NewCo. So you'd end up with a 50:40:10 shareholding structure between Government:Private:Management. $1 billion sounds like a lot for a management team to raise, and it is. However, the sort of people that you would want to run NewCo have access to that kind of money (and more). The $1 Billion should come from the personal side of their portfolios. This leaves $90 Billion of debt finance to complete the capital structure. $45 Billion would be new money (from the Treasury) and the other $45 Billion would be loans taken by the vendors of assets sold into NewCo. For example, if Citi wanted to sell $X Billion of assets to NewCo, they would have to take y% of their purchase consideration in the form of NewCo debt. So they get a mixture of cash and debt. I would keep the board small, four members. One appointed by the Central Bank/Fed; One Appointed by the Treasury and Two Representing Management. Shareholder and debtholder rights would be similar as for any private equity deal. The Treasury representative being the one that gets to report to Parliament/Congress (an enviable job!). If the board becomes deadlocked then the head of the Central Bank has a casting vote (not a politician). I would give a big equity incentive for return of government capital. I would also give a big share of the profits to the executive management team. However, I would lock it in over time. Here's an example how:
If I was Treasury Secretary then I'd hire Berkshire Hathaway; Permira; Alchemy Partners; and Goldman Sachs. Alchemy and Permira are listed because of Jon Moulton and Damon Buffini -- two men that have experience making difficult decisions and building investment businesses. Similar to Warren Buffett, they are beyond political influence. I wasn't able to come up with a fifth firm so put that out to tender and let a legislative sub-committee make the decision on who to back. I wouldn't place any special rules/restrictions on these new companies other than compliance with all existing laws/regulations for a privately held bank. I would leave their board of directors free to set their own investment policies. Personally, I think that would work a lot better than hiring unemployed finance guys to negotiate with former colleagues while being overseen by committees of politicians. While I respect the skills of the politicians, we are setting ourselves up for investment failure. More reasons why are included below. Back next week. gordo Other People’s Money What do the Congress, Citibank, AIG, the British Government, the US Federal Reserve and your financial advisor have in common? The all make decisions with Other People’s Money (OPM). The press has been writing about a “battle” between government/business; or capitalism/socialism. I don’t see any battle, or struggle. What I do see is a continuous movement towards ever increasing leverage – directly via personal debts and indirectly via government debts. The “problem” is leverage, rather than greedy bankers or lobbyists. These players are acting rationally given their incentives. To change behavior, we need to change incentives. Where I think we went wrong is giving too much leeway to people that control Other People’s Money. We have created a system that encourages ever increasing leverage – to fix that system we need to take the pain that results from the Great Unwinding, then place limits on the capacity to lever assets and income. Today, we are in the process of releasing a tremendous amount of personal freedom. Governments, bankers, CEOs, hedgefunders… all of these players are acting in their self interest. Writing multiple page articles on Who To Blame might sell newspapers but focusing on blame is a waste of time. These people were hailed and feted over the last decade – we ALL got it wrong. Let’s learn from that. Here in the US, the national debt is $10.7 trillion. I figure we’re looking at $16 trillion by the end of 2010 – that’s ~$50,000 for every person in America. I wasn’t able to get a handle on the precise size of the tax base in America but estimate there are currently 100 million tax returns where the filer has to pay Federal taxes. So that means an average debt of ~$160,000 per taxpayer – at 5% that’s $650 per month in interest for the rest of your life, before we pay taxes to cover our Federal, State and Local spending ($5 trillion per annum and rising). People are going to continue to act in their self-interest, which means the following is likely:
History tells us that tax increases are a lot more likely than spending cuts. So how will taxes increase? Obama’s spending programs remind me of Canadian or European policies so I suspect we’ll see similar taxation policies – a national value added tax is coming. What does this actually mean? A lot of writers are extremely bearish on the US – I’m not so sure. High taxes and debt service are going to be drag on economic growth but what really matters to people (and voters) is relative prosperity. The rest of the world is going to be in even worse shape, or at least as bad. If I had to choose a country to ride this out, then the US is a good place to be. The financial sector will continue to be decimated and I wonder if we are collectively insolvent right now. The banks made crappy loans when times were good. Now Washington, and Westminster, insist that banks increase lending into a falling economy? The total leverage in the system must come down, not increase. The goal of government support should be to limit the speed of the (inevitable) collapse rather than increase our collective debt burden. America’s “fundamental skills” remain excellent – our main challenge is leverage and the risk of deflation. My expectation is that we’ll meet that challenge through inflation – if we can. Inflating our way out of debt is politically expedient and the citizens that pay the penalty for inflation are in the minority. If I had to choose what’s best for the citizenry (not myself) then inflation would be the way to escape our debt trap. That said, as you saw in the chart from two weeks ago, we may not have the capacity to inflate the economy. The Great Unwinding may provide too large a headwind for the government to overcome.
So what does this actually mean? My main takeaway is one of expectations – I don’t think that it is reasonable to assume, or expect, that any government, company or individual is going to be able to ‘solve’ the current situation. We’re going to delever, it will be painful and then we’ll start building back up again. I see merit in spreading the word about extremely bad decisions by government and/or Wall Street. I ping the occasional ‘entertaining’ piece to my Facebook page. My recommendations, and current portfolio decisions:
I’m going to be late moving into an inflation-resistant portfolio – I think that we could be in for a very rough ride for the next two years and the benefit of being right is far outweighed by the pain of being wrong. If things implode then liquid capital will be highly valuable. Be highly cautious about the advice you receive from experts with a livelihood that depends on Other People’s Money – or anyone that speaks with confidence on what’s going to happen – we are DEEP in uncharted territory. Where you can, watch what people you respect are doing with their own money, not the money of their clients/constituents. If you leveraged yourself to the peak then know that you are not alone; learn from this recession and pass the lessons on to your kids. Human nature being what it is we’ll be back to euphoria sooner than any of us expect. gordo
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