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Perishable Pundit
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Boca Raton FL 33481

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Fax: 561-994-1610



Produce Business

Deli Business

American Food & Ag Exporter

Cheese Connoisseur

Despite Fresh & Easy Sales Growth,
Challenges Lie Ahead

Next week Tesco is due to announce financials, and it is expected we will get the first “hard numbers” on how the Fresh & Easy rollout here in the US is going.

There is little question that Tesco’s efforts to boost sales have been met with some real success. Our best information is that Fresh & Easy has seen sales growth between 6-12% month over month on a “same store sales” basis for the last six months or so.

The “pause” in Tesco’s Fresh & Easy rollout schedule earlier this year seemed to be used principally to shift away from the Every Day Low Price (EDLP) model and move to a much more ad-driven and promotionally priced model. All through the summer, one was greeted at the entry with large “grilling” specials all very attractively priced — often 50% off normal Fresh & Easy retail.

In some cases Tesco abandoned its initial insistence on selling repacked produce under its own brand and has just bought specials it can sell cheaply under the packer’s own label in a special promotionally priced produce section.

Combine this new emphasis on promotional pricing with its pre-existing policy of marking dated perishables down 50% the day before the expire date, and add in the heavy mailing and distribution of coupons good for $5 off each $20 purchase — freely accepted in multiples so $10 off a $40 purchase, $15 off a $60 purchase, etc. — and one sees a very compelling value proposition.

Although Fresh & Easy did poorly in the produce pricing study conducted by sister publication, PRODUCE BUSINESS, we suspect it would do better today and, if we included coupons — which seem ubiquitous and are often distributed at checkout — it might actually beat Wal-Mart.

As a short-term strategy, this heavy emphasis on promotion is probably a smart idea. One of the trade luminaries with a keen mind for retail put it this way:

No doubt Fresh & Easy is getting more promotional and now has ad/in-store specials versus their old EDLP ads. Keep in mind, once you have exposed your model to more people and more people like it, they will support it. It is the right decision to spend on deep promotional specials as the cheapest thing you have is the product, which usually accounts for 25% of the total sales and the rest is rent, payroll, utilities, transportation, and the ad man.

Indeed. Rather than struggling at $50,000 per store per week — which is what we and others, such as the Willard Bishop Group, saw as their sales levels — it is smart to heavily discount the product and build traffic.

The $64,000 question, though, is will these customers “like it”? Will they continue to “support it” when the promotional hook is pulled away? In other words, do the customers attracted by these great deals become loyal to a concept or are they just loyal to great deals? The day Fresh & Easy decides to start making money, will its customers move on to other opportunities, for example, working with a retailer who accepts manufacturer’s coupons?

It is impossible to know for certain and, surely, some of the customers attracted to try the store by bargains will stay for the quality, convenience, ambiance or unique products, etc. Yet our assessment just observing customers is that they are disproportionately elderly, students and others who are very focused on price. We suspect many will not stick around if the bargains become less frequent or substantial.

And the losses seem likely to continue for some time almost regardless of the individual store sales. At one point, Tesco was saying it would have 200 stores open by the end of 2008. Later it guided down to 150 stores open by the end of 2008. The company now has 83 stores open. Its first store to open after its “pause” was July 2, 2008, which was its 62nd store. This means it has opened roughly 1.75 stores per week since the pause.

If Fresh & Easy continues at this pace through the end of 2008, it will open another 15 or 16 stores by year’s end — but that would mean going through Thanksgiving, Christmas, etc., without a breath. In any case, Fresh & Easy may not even have a hundred stores open by yearend and certainly won’t meet its adjusted guidance level of 150 stores.

This is very significant because the large distribution center and heavy executive team is quite expensive, and Fresh & Easy needs to defray these costs against a substantial store base — otherwise it will just keep hemorrhaging money. And time is not on its side. A loss of $100 million today has to be made up, with interest, in the future for this investment to ever pay off. Besides, now that Tesco has its cards on the table, other retailers, including Safeway with its Market by Vons and, shortly, Wal-Mart with its Marketside concept, will turn up the heat.

In addition, as time has gone by Fresh & Easy will experience cost pressures. Although it likes to trumpet wages of $10 an hour — above the minimum wage — the truth is that Fresh & Easy pays significantly less than its unionized competitors, such as Kroger and Safeway, that have the bulk of the market share in the Fresh & Easy trading area. This makes it a juicy target for the United Food and Commercial Workers union, which surely will get full encouragement in this effort from the already unionized chains.

The ever vigilant Nancy Luna of The Orange County Registerwrote a piece when workers in an Orange County Fresh & Easy became the first to formally petition for union membership. The piece is entitled Fresh & Easy Workers in O.C. First To Demand Union Status:

Fresh & Easy employees in Huntington Beach have demanded that the British employer recognize them as a union — a move that could set the stage for the company’s other Southern California workers to follow suit, union officials said Wednesday.

“Obviously, they want fair wages and benefits that are equal to the other people working in the industry,” said Greg Conger, president of United Food and Commercial Workers Local 324.

The Buena Park union represents 23,000 grocery workers in Orange County. Since November, when U.K.-based Tesco launched its first United States markets, called Fresh & Easy, local unions and community watchdog groups have pushed the food giant to become a union employer.

The Orange County Fresh & Easy workers, who earn a starting wage of $10 an hour, are the first employees working for the small-format chain to formally request union status. Fresh & Easy plans to open more than 200 neighborhood markets in the U.S.…

Conger said he expects a response from Fresh & Easy within a week. If the chain approves the organization of a union in Huntington Beach, Conger expects other Fresh & Easy employees to make similar requests.

If Tesco rejects the workers initial move, the employees can force the issue with an election under the National Labor Relations Board. If 50 percent of the employees vote in favor of a union, Tesco must recognize them as a labor group, said Todd Conger, a spokesman for UFCW Local 324.

If that happens, the grocery union anticipates other Fresh & Easy workers to lobby for union status.

“Our ultimate goal is to get all Fresh & Easy employees into the union fold,” said Todd Conger, whose father is Greg Conger.

Helping organize Fresh & Easy workers in Huntington Beach is Graham Ozenbaugh.

The 19-year Vons employee started working at the store as a $10 an hour “customer assistant” in December with the specific goal of getting the workers to form a union.

Todd Conger said the use of undercover union lobbyists such as Ozenbaugh is typical in “major campaigns” waged by labor organizations.

Conger said these workers, who take a leave of absence from their union-grocery jobs, are given supplemental pay. Ozenbaugh earns $20.80 an hour as a Vons supervisor.

“I’ve lived in Orange County since I was 22 and there’s no way I could survive off the wages in that store,” he said of his Fresh & Easy wage.

Wal-Mart has managed to avoid unionization, but Fresh & Easy may not be as successful. Wal-Mart stores are large and so getting 50%-plus-one of the employees to agree is difficult. Most Fresh & Easy stores only employ 20 or 25 people, so it is easier for unions to stack the deck by simply taking jobs at the store as Mr. Ozenbaugh did. Also Fresh & Easy’s pledge to make 20 hours available to each employee and make them eligible for health insurance, etc., will tend to attract a more permanent employee as opposed to teenagers or senior citizens just looking for a little income supplement — this type of employee is more interested in unionization than a student who is just working for the summer or till the end of the semester.

Right now Fresh & Easy has the economy in its favor. With times tough, promotional pricing is a big draw and with the possibility of a recession, employees may want to shy away from unionization efforts fearing for their jobs. Whether this is enough to push Fresh & Easy into the black is very much an open question.

Wal-Mart’s Marketside Format
Opens In Fresh & Easy’s Back Yard

Simultaneously with Tesco’s release of financial results that will provide some hard numbers on its Fresh & Easy chain, Wal-Mart will open the doors on its first four Marketside stores in the Phoenix area.

Although British newspapers have portrayed the Marketside concept as a response to Tesco’s Fresh & Easy venture, we think that this point can be overstated.

Wal-Mart has many reasons to be interested in smaller stores. In its existing markets, they may serve to help keep fill-in business between trips to Supercenters in Wal-Mart’s hands. In big unionized cities where a combination of scarce real estate and political opposition have made it difficult for Wal-Mart to open supercenters, a new smaller concept may provide a point of entry. Wal-Mart also has plenty of worries regarding deep discounters such as Aldi, and this concept might be a tool to deal with these competitors.

We understand that Lee Scott, Wal-Mart’s CEO, is very interested in exporting the concept back to the UK. He is on record as saying that Wal-Mart’s ASDA group made a mistake in failing to seize the small store space that Tesco did with its Tesco Express model.

Certainly no one at Wal-Mart dismisses Tesco’s retail acumen. Indeed no less a figure than Lee Scott himself has said as much:

The success of Tesco’s fledgling US venture, Fresh & Easy, has been endorsed by the most unlikely of advocates — bitter rival Wal-Mart’s chief executive, Lee Scott.

Tesco’s push into the US — which has proved a graveyard for UK store groups’ ambitions in the past — is regarded by many observers as a high-risk enterprise.

However, Scott’s comments, which he made to an audience of investors at last week’s Goldman Sachs retail conference in New York, may well convince skeptics to revise their opinion.

Responding to a question, Scott said he had heard mixed reports about how Fresh & Easy was faring, but that he was convinced the business would perform well.

He said: “The thing that bothers me is Tesco is a very good retailer. I have a lot of faith that they will find their direction and it is something we need to pay attention to.”

Yet this is in a sense only a back–handed compliment. Mr. Scott points to no particular innovation or characteristic that makes Fresh & Easy great; he is only saying that Tesco is “a very good retailer” and that “they will find their direction.” Indeed, the great strength of Fresh & Easy since its opening has not been its concept — which is, at best, uncertain — not its distribution — which has been a mess — not its consumer appeal — which has been lukewarm — not its real estate department — which has secured many poor locations… What has been the salvation of Fresh & Easy was Sir Terry Leahy coming out and saying that Fresh & Easy was not a test, it was a rollout.

By putting his own and Tesco’s prestige behind the launch, Sir Terry Leahy allowed all sins to be forgiven because any failure could instantly be attributed to a learning curve. If Fresh & Easy was failing, it made little difference as version 2.0, 3.0 or 4.0 would surely be sterling.

In contrast, Wal-Mart’s new Marketside has received no such commitment from Wal-Mart’s CEO. Indeed Wal-Mart has made a point of emphasizing that this is most definitely a test, rather than a roll-out. Although there was hullabaloo over a newspaper help-wanted ad suggesting that Marketside was going to grow into a 1,000 store chain, and we talked about this here, that ad was more an expression of a wish than an actual plan.

Now with Wal-Mart’s Marketside stores about to open, we will find answers to key questions. What we know about the concept is that it will emphasize brands more heavily that Fresh & Easy does. There will not be all this needless repacking of fresh produce. There is some confusion regarding in-store services, however. At an earlier stage in its evolution, the concept was slated to have a service deli, but with the turn in the economy and, perhaps, with Fresh & Easy’s turn to a more promotional price structure, the focus seems to have moved a bit to providing a more economical product and, at least for the initial test stores, the service deli is out.

Despite this, we have been advised that precisely because these stores are tests, they have been designed with great flexibility including excess plumbing and electric so that they can be reconfigured quickly if the market should so indicate.

Although Wal-Mart has only announced these initial four stores in Arizona, it has also been signing leases in California, including downtown San Diego and Oceanside.

Key questions not yet answered: What will the pricing strategy be? Wal-Mart has kept prices at its Neighborhood Market concept identical to its Supercenters. What will it do in this new venue? How great will the assortment and quality of the prepared foods section be? Earlier in the process, each store was going to make its own prepared foods on site. It is unclear if this plan has survived. And if it has, how will each store deal with food safety and variety challenges?

But mostly, the question is how dedicated is Wal-Mart to the concept? Everyone has been speaking grandly about Tesco’s rollout on Fresh & Easy, but these are small stores. Wal-Mart has rolled out many multiples of the square footage of Fresh & Easy — even today all the Fresh & Easy stores open in the country could fit in five supercenters –so if Wal-Mart likes the concept, with its pre-existing distribution centers and large real estate team, it will quickly cover the country.

But in all likelihood, even if successful, such small stores won’t provide a return on investment adequate to encourage Wal-Mart to commit capital to such a rollout. We think the smart thing to do for Wal-Mart would be something similar to the Sav-a-Lot division of Supervalu. Wal-Mart should franchise out the stores, then it would have hard-working entrepreneurs and their families keeping the stores in great shape while Wal-Mart could use its real estate arm to develop and lease the stores as McDonald’s has and use its procurement and logistics abilities to supply the stores.

Basically with owner-operators, Marketside will get a quality and commitment from management that the small size of the stores will make difficult to afford in a hired employee. It will also get people who are expert in their local communities, often from the dominant ethnic or religious group, and thus likely to know what products to stock and what community organizations to support.

And what of the great battle between Wal-Mart and Tesco supposedly about to play out in the deserts of Arizona? It may be decided closer to Piccadilly Circus. Tesco’s real problem now is that in its core market, food price inflation — boosted by the fall of the British currency — is zooming and that is playing in the hands of the discounters. Wal-Mart’s ASDA division is a big beneficiary, but the real threat is Aldi, Lidl, Netto, Iceland — the so-called “hard discounters.” Tesco’s market share has been slipping despite substantial capital expenditures.

In the past, British retailers have withdrawn from America not so much because of problems in their American divisions but because of problems back home. Sainsbury’s sold Shaws, and Marks & Spencer sold Kings because attention was needed back home.

Now Tesco is a much more international company, but Fresh & Easy is also a less established concept, and it is losing large amounts of money in a way Shaw’s and Kings never did. It is true that Sir Terry Leahy has said this is a launch not a trial, but then again California does strange things to such commitments. California Governor Ronald Reagan once said that his “feet were set in concrete” in opposition to tax-withholding. When Governor Reagan announced that he would sign the bill back in 1971, he told reporters “That sound you hear is the concrete breaking up around my feet.”

Government Bailout
Requires Deeper Analysis

The government’s plan to “fix” the financial crisis is built on an incorrect premise and probably won’t work. In any case, it is either unnecessary or immoral.

The government identifies the problem as a lack of liquidity. So the government proposes to buy up to $700 billion of distressed assets, which supposedly will restore liquidity to the marketplace.

But this is an incorrect diagnosis of the problem because there is no absence of liquidity in the market. There are plenty of buyers for real estate, for mortgages, even complex paper after mortgages have been sliced and diced in tranches of different levels of risk — the problem is that sellers don’t like the price.

This past spring a real estate broker working with a professional auction house held an auction of properties near Pundit headquarters in South Florida. Out of 75 “lots” for sale, only two actually sold. Why? There were bids on every house but only two "lots" were sold. In fact, one of the “lots” for sale consisted of 50 condo units being sold individually. Ten units of the lot were sold at “absolute” auction — meaning no minimums and no reserves — and they sold easily. The other 40 units were not sold because they did not meet the seller’s secret reserve.

Ben Bernanke, chairman of the Federal Reserve, came under attack for saying on Tuesday that the government would pay more than “fire sale” prices for the assets it would buy. By the next day, he was backtracking saying, “I am not advocating the government intentionally overpay for these assets.”

But he can’t have it both ways. If the government is going to buy these assets at the same price the seller could realize by selling them into the market, then there is no point to having the government buy these assets. If, however, the government is going to pay more than the market price for these assets, then this is just a bail-out for people or companies that happened to invest in these particular assets.

In a sense, it is just a pay-off to powerful political interests.

Our opposition has little to do with ideological purity or an opposition to government intervention in the markets. We basically have six concerns:

  1. To the extent there is a problem with credit between financial institutions, it is a reflection of the difficulty potential buyers or lenders have in valuing the assets held by other financial institutions. The more the government buys these assets, bails people out so they don’t have to sell these assets, etc., the longer this period of evaluation difficulty continues. Had the government allowed Bear Stearns to go broke, its assets would have all been sold and this would have helped establish actual market values. With this information we could easily see if other financial institutions have a positive net worth or not.
  2. The case for bailing out Fannie Mae and Freddie Mac was the strongest because they have been portrayed as quasi-governmental entities. Yet we think, exactly for that reason, it would have been desirable to let them fail. There is no legitimate place in our constitutional system for “quasi-governmental entities.” If politicians want to subsidize mortgages, they should either have to tax or borrow the money to do that. There should not be an “off-budget” item with the implied guarantee of the US government.

    It would have been a very good thing for investors around the world to know that no President or Congress can bind the government of the future except via issuing debt backed by the “full faith and credit” of the United States. Every person, business or government that bought a Fannie Mae or Freddie Mac bond did so for one reason only — they wanted to get more interest than they could by buying a US Treasury bond. That is called speculation, and it would have been healthier for the system for such speculators to lose money. Thus the principle that the US government can be bound only by law, not by implication, would be clearly established for future lenders.
  3. The problem is not mortgages, nor liquidity; it is leverage. If Bear Stearns had $90 billion and bought $90 billion worth of mortgages and the paper dropped to 10 cents on the dollar, Bear Stearns would lose $81 billion. This would, of course, be sad for Bear Stearns’ shareholders. But people lose money all the time and it would not be a great threat to the financial system. The problem is that entities like Bear Stearns had $3 billion and were leveraging to buy $90 billion worth of mortgages. So if the mortgages go to 10 cents on the dollar, not only do these entities lose all of the $3 billion they started with, they can only pay back $9 billion of the $87 billion they borrowed.

    The reason the financial system was freezing is because of doubt that the bad paper could be sold at a price sufficient to cover the borrowings undertaken to buy the paper. The government’s plan does not specifically deleverage the financial institutions. In fact, healthy institutions holding toxic paper could sell it to the government as easily as insolvent institutions. The mechanism in our society for eliminating unaffordable debt is restructuring or liquidating under Chapters 11 (restructuring) or 7 (liquidation) of the Bankruptcy Act. The sooner companies go bankrupt, the sooner the companies will deleverage either through liquidation and paying what they can to creditors and writing off the rest or through restructuring in which creditors would receive stock in exchange for debt. In any case the sooner these companies go bankrupt, the sooner the creditors to the company will know their situation. This clarification of value will allow for lending and investing.
  4. The decision to stand behind all money market funds for a while is reasonable as this was, literally, going to cause a “run on the bank” by worried consumers. But this is one area where only short term relief is required as those who seek a Treasury guarantee can easily buy money market funds that only invest in US Treasury Securities. In the future, nobody should be able to buy a money market fund that invests in non-US government securities without signing a statement acknowledging that he or she has been informed that voluntarily electing to invest in a non-US-government-secured money fund is electing to speculate on credit quality in the hope of obtaining higher yields. The buyer recognizes that these securities could default and that the buyer of these types of money market mutual funds can thus lose their entire investment.

    After a few months of making all new account holders sign this statement, all existing money market mutual fund holders who do not return the signed statements should automatically be transferred to a money fund that only invests in US Treasury securities. Once this procedure is completed, anyone who elects to buy a money market fund investing in private securities deserves both the upside and the downside of the risk he has elected to take.
  5. A bailout allowing the Treasury Secretary to act at his discretion to buy assets at any price from anyone he chooses and sell them at any price to anyone he chooses is simply bizarre. It is a recipe for corruption and abuse of the taxpayer. Here is Section 8 of the Treasury proposal: Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

    Unfortunately the debate seems to be focused on issues such as restricting the paychecks of executives whose companies apply for help. This is probably a useful thing, mostly because it will reduce the number of companies turning to the Treasury for help — it is, however, a peripheral issue. If we want to intervene in the market, we would be better off intervening directly by providing, say, a special tax credit to encourage people who don’t own houses to buy one that had been completed by a certain date — thus increasing demand for housing and absorbing the surplus supply.
    This would increase the value of housing and thus the mortgages that depend on that value. If we simply must buy securities, we should set up a Dutch auction or other mechanism that is transparent to purchase the paper and then set up a public auction down the road to sell the paper. Otherwise the corruption will be incredible.
  6. This business of banning short-selling is a terrible strategy. Shorts give the market valuable information, and banning them reduces market confidence in the accuracy of market pricing. If you want to build confidence in markets, you allow all traders and you extend market hours to allow more opportunities for trading. Banning short-sellers simply makes people feel the government is desperate and the situation worse than we know.

Once we get beyond critique of this particular proposal and things the government is doing now, we can start thinking about broader changes that would make it less likely that we would have such problems in the future.

We think these five points would be a good start:

  1. Change FDIC insurance to facilitate transactional accounts. The FDIC program to insure deposits in banks is limited to $100,000 per depositor, per bank, with the limit $250,000 for certain retirement accounts. These numbers are both too big and too small.

    Because the government recognizes eight different ownership categories (a single account, a joint account, a retirement account, for example), it is easy to exceed the $100,000 maximum. And even $100,000 is enough to have launched a whole industry of deposit brokers who gather deposits in $100,000 increments that go to the banks willing to pay the highest interest rates — i.e., the weakest banks in America.

    Perhaps there is a public interest in allowing poor people to go to any neighborhood bank and open a passbook account without worry, but one suspects that $10,000 in coverage would more than suffice for that purpose. We need to keep these numbers low enough so as to make this CD brokerage business unprofitable. The bigger problem here, though, is that those who simply have money in a non-interest-bearing checking account are needlessly being exposed to risk, and they are the ones who will pull their money at the first sign of a problem and cause a bank panic.

    One doesn’t have to be a very large business to have $100,000 cash in a checking account. In the produce industry, a wholesaler that has a lot of cash business with small retailers and pays his suppliers in ten days could have many times that balance — although the money isn’t really his, it is owed to his suppliers. We would propose that non-interest-bearing checking accounts should have unlimited FDIC insurance. In other words, if the purpose of an account is simply to facilitate transactions and there is therefore no temptation to put money in a weak bank to get a high interest rate, the public interest is best served by allowing people and businesses to transact with confidence.

  2. Separate investment and speculation from providing services. Much of the “crisis” has come about because companies that provided valuable services decided to goose earnings with proprietary trading. Now there is nothing wrong with people or companies investing their own money and trading. But it really has nothing to do with any business and, in fact, creates the potential for a lot of conflicts of interest. So we would propose that if a company, say Merrill Lynch, is going to be a stock broker, it should not be allowed to do proprietary trading. In other words, its only function would be to engage in the legitimate business functions such as buying and selling securities for customers and earning a commission or managing money for consumers and earning a fee on that. Those companies that want to engage in trading to make profits could have an investment trust — public or private — set up for that purpose.

    There are all kinds of potential conflicts with both serving customers and investing for oneself: Front running, using the order flow of customers to gauge market direction, using a firm’s own sales force to dump positions you want liquidated, etc. Goldman Sachs, one of the few Wall Street firms that lightened up on its exposure to subprime mortgages before the crisis hit, has been attacked for, basically, shorting the same mortgage securities it just sold its customers. If Goldman believed that these securities were going to fall in value, shouldn’t it have told its customers rather than shorting them for its own account?

    The conflicts of interest are real and inherent and so proprietary trading has to be completely separate, done by separate people under separate ownership. In addition to avoiding conflicts of interest, a side benefit of this policy is that these investment funds will, by their nature, not interact with consumers. So if ABC Investment Trust goes broke, it just won’t have the emotional impact of Merrill Lynch or Lehman Bros..

  3. Agreements should be required to contemplate the inability of a party to execute the agreement. The bailout of AIG was prompted, principally, because AIG and its counter-parties had entered into agreements with terms that were self-evidently stupid. AIG would insure that, say, the value of a particular firm’s mortgage holdings would not fall below a certain level. This is called a credit default swap and for this “insurance” AIG got paid a fee. If, however, AIG’s credit rating were to fall, AIG was required to put up more collateral. This was a very big business, and every time its rating fell AIG had to come up with tens of billions of dollars. Now, obviously, the only time AIG’s credit rating would fall would be because it was in financial trouble so, just as obviously, it would not likely be able to raise all the money required by these collateral agreements.

    It was irresponsible of AIG to enter into such agreements on such a scale. It was irresponsible of the counter-parties to not realize this, and it was unforgivable that the ratings agencies did not wave a red flag around these deals.

    These types of guarantees are so disruptive and likely to cause bankruptcy that companies ought to be compelled to limit their exposure to this type of draw to a very small portion of their capital and thoroughly and specifically disclose these contingent liabilities. Even with disclosure, however, if both parties want to enter into this type of agreement, in order to avoid burdening the bankruptcy court system and causing shock to the financial system, the agreements should contain within them the answer to the question: “What happens if we can’t post more collateral?”
    Perhaps there would be a pledge of a specific asset, such as a building, or maybe the company would have to issue common stock to compensate for the decline in its credit rating. In any case, the answer should be intrinsic in the agreement and thus smoothly implemented in times of distress, rather than causing a panic.

  4. Many have claimed that a big part of the problem is the legal requirement that organizations “mark to market” assets. They have half a point. We doubt that the accounting is all that crucial; people fear to lend not because one’s official financial statement is bad but because one judges the situation to be bad. So if accounting rules allowed firms to keep assets on their books for prices they can’t sell them for, it would simply make it harder for people to feel confident in the financial statements — it might make people quicker to withdraw credit.

    Still under certain circumstances “marking to market” can be deceptive. If we were to buy zero coupon Treasury bonds to pay the Jr. Pundits’ (now age 5 and 6) college tuition with bonds due to mature when tuition will be due, then the fact that interest rates zoom and the sales value of the bonds thus fall is really not relevant. We bought the bonds to hold to maturity, and the vagaries of the credit market neither help us nor hurt us.
    So, if a business buys bonds for a specific purpose — say to ensure it has the cash to execute a non-qualified retirement agreement to pay the CEO money upon his reaching age 65 — and if the bonds drop not because their ability to pay is impaired but because interest rates have risen, it might make sense to allow some leeway in the “mark to market” requirement. However none of this would apply in the current situation where, first, most of these positions were acquired for trading and, second, the decline in value has little to do with interest rate fluctuations and much to do with the belief that the mortgage debts will never be repaid and thus these holdings are permanently impaired.

  5. The single most important reform required is that the two groups checking against excessive valuations — the real estate appraisers and the bond rating agencies — need new incentives. We wrote previously about the need to reform appraisers. The problem with the rating agencies is basically the same: Both get hired by people with skin in the game. A mortgage company makes money issuing mortgages which it typically sells. If an appraiser consistently kills the deal by coming in too low, the mortgage company doesn’t want to hire that appraiser any more. Equally, ratings firms, such as Standard and Poor’s, Dun & Bradstreet and Fitch’s are paid by people who want to sell debt. If they consistently give the debt low ratings, lenders will try to discredit the particular ratings officer that made the call or avoid using that agency.
    What we need is a system in which the appraisers and the rating agencies are not selected by anyone who has a stake in seeing business done. Maybe a board of appraisers locally or a board of debt-rating services nationally gets a fixed fee each year and then, upon submission, assigns an appraiser or a rating officer to issue an appraisal or a rating. But because the mortgage company or the debt issuer no longer has any say in who does the appraisal or rating, there will be less incentive to try to make everyone happy.

Obviously there is much more to explore on this subject but the key is that the Treasury plan has many flaws, both short term and long term, and we should think hard about the kinds of reforms that can actually help our financial system weather this storm and can lead to greater prosperity in the years to come.

Perishable Thoughts

A hat tip to Tim York, President of Markon Cooperative, based in Salinas, California, who sent a quote perfect for reflecting on a financial meltdown:

“Success is a lousy teacher. It seduces smart people into thinking they can’t lose.”

The Road Ahead
By Bill Gates, Nathan Myhrvold, Peter Rinearson
Published by Viking, 1995
Page 38

The quote appears in Chapter 3, “Lessons from the Computer Industry,” and continues with these next sentences: “And it’s an unreliable guide to the future. What seems to be the perfect business plan or the latest technology today may soon be as out-of-date as the eight-track tape player, the vacuum tube-television or the mainframe computer.”

There is no question that one learns more from failure than success and, as the quote implies, success can be positively dangerous. Few things worse can happen to a young man than to win a lot of money the first time he goes to a racetrack or a casino.

Indeed the arrogance of the “Masters of the Universe” played a big role in the actions leading to the credit crisis. Yet in our current situation, we are not so sure we would accept chalking it up to hubris born of success; in many cases it strikes us as a function of the way people were paid.

It is a truism in management that you get what you pay for. So if you pay a CEO based on that year’s stock price or return on capital, you are going to get a focus on boosting short-term earnings. Equally, if the upside is divided between the company and the employee so as to give the employee an incentive, whereas the downside is strictly limited for the employee, you will get wild gambles. In other words, if a trader makes the firm a billion dollars and his cut is $200 million, but if he loses a billion, all that happens is that he gets fired; the incentives are being set up, overwhelmingly, to encourage speculation.

One thing that has been missing from news reports is any notion of employees in the mortgage arena giving back their bonuses. Doubtless the employment agreement didn’t call for it but, obviously, if a person running mortgages makes a profit for the company of $100 million a year for four years and then loses a billion in year five, there is something wrong with a compensation plan that results in this manager getting paid millions in bonuses for his “great success” in running the mortgage division.

Success can breed arrogance and controlling that is hard enough. We shouldn’t add to the problem by designing compensation packages in a manner that distorts what true success actually means.

That is something to reflect on in the current climate as well.


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