Easing the mortgage crisis

As the Congress debates the stimulus package and the Fed cuts interest rates, the Senate Banking Committee is weighing in with a different tactic. According to a story in this morning’s Washington Post (Lawmakers Look to Tactic From S& L Crisis), Committee Chairman Chris Dodd is proposing a means to buy up bad loans:

The Home Owners’ Loan Corporation, as it is called, would offer to buy mortgages at steep discounts from mortgage firms and banks and then rework the loans based on the reduced value of the properties, making the payments more manageable for homeowners.

A hearing on the proposal is set for this morning.

I think this is a necessary step. It may not provide an immediate boost to the economy, but it will set the proper long term course. We need to be clear about one thing: this is a credit recession. Getting the credit market back on track is an important feature of any economic plan. We should take a lesson from what happened in the US and Japan at the last real estate bubble. In both cases, interest rates were cut. But the US created the Resolution Trust Corporation, took the financial hits and moved on. The Japanese banks and other financial institution kept the bad loans on their books. The US recovered; a decade of low (sometimes negative) interest rates in Japan were ineffective.
Bottom line: as long as the financial system is clogged with suspect loans, the credit market will be reduced to a dribble and the economy will falter. Take the pain, clean up the system and move on.

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In search of standards

It looks like the International Standard Organization (ISO) is taking up the issue of intangible valuations. Last year, at the urging of the German Standards Institute (DIN – Deutsches Institut für Normung), the ISO formed a ISO Project Committee for Brand Valuation:

The project proposal presented to ISO, the International Organization for Standardization, was based on guidelines set down by DIN’s Performance Capability and Services Standards Committee in cooperation with Markenverband e. V. – who represents the interests of German trademark holders – and numerous other stakeholders. Their motivation was the introduction of the “International Accounting Standards” which allow, under certain circumstances, the inclusion of brand values in financial statements.
Committee participants include financial and other service providers, and representatives from research organizations and high-profile industrial firms; the active participation of the latter shows the relevancy of the subject.
It is expected that the standard will be published in 2010.

Now DIN is pushing the formation of a similar project for patent valuations – see Developing a patent valuation standard, ISO moves to establish a global standard for patent valuation – Intellectual Asset Management and More on the moves to establish an international standard for patent valuation – Intellectual Asset Management. According to Dr. Alexander J. Wurzer, who is heading up the work at the German Institute:

The International Organization for Standardization, ISO, has published a new work item proposal for the standardization of patent valuation processes. The proposal was initiated by the German Institute for Standardization, DIN, and is based on a publicly available specification PAS 1070 “General Principles of Proper Patent Valuation” (SAB1), published in 2007.
. . .
ISO followed that initiative and will appoint a committee to develop an ISO-standard for patent valuation if all relevant and concerned groups articulate their interest to ISO through their national standardization bodies.

The relevant body in the US is the American National Standards Institute (ANSI). ANSI is going through the formal process of reviewing the proposal (comments are due by today as it turns out and voting by member organizations closes in March). This could be an interesting, but difficult project. The process of setting international standards is fraught with national and international politics on top of the already difficult technical issues. Nor am I sure that ISO is the right organization for setting financial standards. But if an agreed upon standard for valuing intangibles can be found, it will be a major step forward toward regularizing their role in the financial system.

Note on GDP slow down.

By now, you have seen the news reports that GDP growth dropped dramatically to 0.6% in the 4th quarter of 2007 (see GDP Growth Slowed in 4th Quarter, As Housing Continues Its Drag – WSJ.com, Growth Slowed Drastically in 4th Quarter – New York Times, Economy nearly stalled in 4th quarter; suffers worst year since 2002 – Los Angeles Times, Economic Growth Slows in Last Quarter – washingtonpost.com). Here is what BEA: News Release: Gross Domestic Product:

The deceleration in real GDP growth in the fourth quarter primarily reflected a downturn in inventory investment and decelerations in exports, in PCE [personal consumption expenditures], and in federal government spending that were partly offset by a deceleration in imports and an acceleration in state and local government spending.

Deceleration in exports? So much for the rest of the world picking up the slack.

Losing the customer experience

In a earlier posting this week, I made the point about the need for services to adopt a “customer experience” rather than an efficiency approach to growth. Apropos that comment, a story in today’s New York Times on Starbucks — what some think as ultimate “customer experience” retailer — caught my eye. The story, Overhaul, Make It a Venti contained this statement from another coffee shop owner:

After going head-to-head with Starbucks for almost 10 years, Mr. Cates, the Broadway Cafe owner, said he no longer worried much about competition from the company. Starbucks, he said, has lost its focus on coffee, noting that the company switched from making espresso by hand to robotic machines that pump out drinks with the push of a button.
“For them, the move to fully automated machines was inevitable, but they lost something,” Mr. Cates said. “If you are a barista, you have to roast your own coffee. It’s a necessity. You cannot compete by selling music or WiFi.”

Much of the rest of the story echoed that theme of Starbucks’ “lost soul”, including the efforts of the once-again CEO Howard Schultz to turn things around:

Mr. Schultz has said he wants to refocus on the “customer experience,” recapturing some of the magic of the chain’s early years, when employees — who had heard the term barista before Starbucks came along? — made the drinks by hand and customers were excited by top-notch coffee.

Earlier in the Starbucks’ growth period, I remember being told by company officials that they didn’t mind if there was a Starbucks on every corner because everyone would be different with their own micro-environment. Sounds like they went down the centralized McDonalds approach instead. Whether they can reverse that is unclear. As their competitor from Broadway Café noted, moving to automated espresso machines was “inevitable” as the industrial age growth through economies of scale mentality (which Steve Pearlstein pointed out so well – see the earlier posting) kicks in.

Funding for America COMPETES Act

From last night’s State of the Union Address:

To keep America competitive into the future, we must trust in the skill of our scientists and engineers and empower them to pursue the breakthroughs of tomorrow. Last year Congress passed legislation supporting the American Competitiveness Initiative, but never followed through with the funding. This funding is essential to keeping our scientific edge. So I ask Congress to double federal support for critical basic research in the physical sciences and ensure America remains the most dynamic nation on earth.

Let’s hope Congress and the President can work together this time to fund the bill — and not get into an exercise of finger pointing. (See earlier posting on how things fell about last year).

What to do in a recession

Steven Pearlstein gets it – big time. Here is his analysis of the new business model –
Biggest Is Not Best – washingtonpost.com:

as the country slides into recession, we are going to discover that this absurd fixation on scale and growth has made many companies weaker rather than stronger. Newly acquired divisions will be shuttered, spun off and written down. And many more industry leaders are likely to follow Starbucks and Wal-Mart in slowing the pace of organic growth.
What companies in many industries are about to discover is that the competitive sweet spot may not be in being No. 1 or 2 in your category, as General Electric’s Jack Welch once famously declared, but in being slightly back in the pack, where it’s possible to deliver a more profitable trade-off between price and quality.
Think for a minute about what happens, particularly in the service sector, when companies get big. What do they do? They get more efficient. And how do they get more efficient? By coming up with sophisticated systems that allow them to produce consistent, predictable outcomes in everything they do while using as few and low-paid workers as possible.
In the restaurant business, for example, the big chains spend lots of time and money coming up with demographic and financial parameters for locating outlets. They hire executive chefs who whip up industrial-style recipes for menu items that they test on focus groups and can be replicated by line chefs with little experience and culinary flair. They come up with standard prototypes for how the restaurants will be laid out, how they’ll be decorated and equipped, what plates, uniforms, napkins and menus they’ll use. They purchase a computer system that not only takes care of processing meal orders and keeping track of the money and reordering food from the central warehouse, but also identifies any store or shift or employee producing results that are outside the desired norms. They even come up with the standard responses the hostesses and waiters use in greeting customers and handling complaints.
In the end, what you wind up with is a company that has a small corporate headquarters full of highly-paid people who design and refine these systems. At the restaurant level there are large numbers of low-skilled workers who are easily replaced and paid relatively low wages for essentially showing up and following the standard procedures. Together they create a giant company with lots of scale efficiencies producing a predictable product at a competitive price that appeals to large numbers of consumers.
The first is that these companies are coming close to having saturated the U.S. market. There’s not much more cost they can squeeze out, so they can’t stimulate additional demand through price cuts. And as a result of their relentless expansion over the past two decades, there are no new regions to enter.
At the same time, I sense there’s a growing backlash against these models from customers who are dissatisfied with formulaic products and lackluster service. This backlash has provided an opening for competitors offering something different and better, even if it is more expensive.
This is the challenge facing Starbucks and Wal-Mart. And it lies behind the recent success of former “niche” players such as Whole Foods, JetBlue, Coach and boutique hotels such as those run by the Kimpton Group. Indeed, these “middle-tier” companies are so focused on growth that, ironically, they have wound up adopting many of the same characteristics as the industry giants.
But the other reason I see an opening for mid-tier companies is that the good ones are better able to attract employees who have the creativity and initiative key to success in service industries. Those kinds of employees attach high value to autonomy and independence and don’t work particularly well in organizations where regimentation is built into the corporate DNA. And because the focus at these companies isn’t driving growth by driving down costs, they are able to offer more attractive compensation packages, particularly in the area of incentive pay.
You have already seen this phenomenon in advertising, finance and the law, where many of the brightest people are gravitating to boutique firms. And if I’m right, you are going to soon find it in mid-size retail chains that employ knowledgeable sales people rather than clueless clerks, and health insurers that assign a nurse practitioner with a name and phone number to every customer to handle everything from choosing a doctor to correcting a billing error.

So, what to do in a recession? If you follow this mid-tier strategy, refine your innovation. Rather than chasing even greater levels of efficiency and economies of scale, look at ways to improve your “customer experience.” And that doesn’t mean adding tablecloths to your coffee bar. It means looking carefully at the reasons why your customers are your customers. Just as companies are beginning to involve their customers in product development, service companies are going to have to reach out to their clients.
In the I-Cubed Economy, production will become a joint venture – not a one-directional transfer transaction. That doesn’t mean that mass produced goods and services will completely disappear. I will still want to buy a mass produced light bulb and probably ride mass transit. But customization – “just in time, just for me” – is the new production paradigm. As Pearlstein points out, this future may belong to the mid-tier companies: small enough to move rapidly and big enough to carry it off.

The ecology of Wall Street

In his column today, Two Cheers for Wall St. – New York Times, David Brooks is peddling something call the Ecology Narrative of innovation on Wall Street. It goes like this:

When a new instrument enters the market, it takes a while before people understand and institutionalize it. Whether the product is high-yield bonds or mortgage-backed securities, there’s a tendency to get carried away.
In the first stage of this adolescence, investors look around and see everybody else making money off some new instrument. As Nicholas Bloom of Stanford notes: “They assume they are fine because they see everyone else buying it.” Individual bankers have a special incentive to get in on the ride because their yearly bonus is determined by how they do in the short term.
Then there’s a moment when people realize how stupid they have been. They’ve bought a pile of subprime mortgages without really knowing what they’ve purchased. The ratings agencies suddenly don’t look so reliable. The cycle of overconfidence becomes a cycle of underconfidence because nobody knows who is holding worthless paper.
Then, finally, maturity sets in. Those who have lost great gobs of money get fired. People still find the new product useful, but within parameters and with greater safeguards.
The lesson of the Ecology Narrative is that, in most cases, the market corrects itself. Maybe this year banks will change their pay structure so there’s not so much emphasis on short-term results. Maybe companies will change their boards to improve scrutiny over complex new instruments. In short, markets adapt.

There is some truth to this. But he misses a couple of key points. First, he sets this Ecology Narrative as a counterpoint the Greed Narrative:

The financial markets are dominated by absurdly overpaid zillionaires. They invent complex financial instruments, like globally securitized subprime mortgages that few really understand. They dump these things onto the unsuspecting, sending destabilizing waves of money sloshing around the globe. Economies melt down. Regular people lose jobs and savings. Meanwhile, the financial insiders still get their obscene bonuses, rain or shine.

This Greed Narrative is, of course, a strawman caricature. Brooks does this for a very simply reason: the Greed Narrative requires government intervention and the Ecology Narrative is self-correcting. Political point made.
In truth, both of these narratives are at work. They are not opposites. And both require a role for government. Governments have always played the role of stepping in and limiting and correcting the abuses of the capitalist system. Stemming those abuses is the genius of modern capitalism.
In the Ecology Narrative, regulation also plays a role in stemming not the just the abuses, but also the “adolescent” over exuberance. Regulation helps the markets adapt and regulations build the firewalls that prevent that adolescent from burning down the entire house. If the current meltdown turns out to be worse than we originally thought, it will be because we didn’t have the regulatory systems in place to prevent the meltdown from spreading – the dreaded “contagion”.
As Brooks points out, there is the balance between innovation and creativity. To survive, any ecology system has to have mechanisms in place that make sure that bad innovations don’t completely imperil the system. In the case of financial markets, we have learned that government regulation is part of the ecosystem, playing that key role.
In creating policy for the I-Cubed Economy, we need to put out brainpower to work getting the regulations right. Not simply writing them off.
Update: I just ran into this recent quote from Stephen Roach in > Global Economy” href=”http://www.theglobalist.com/DBWeb/StoryId.aspx?StoryId=6732″>The Globalist:

The Fed’s seemingly open-ended support of unfettered and unregulated financial innovation facilitated a derivatives-based revolution that turned out to have been a good deal riskier than the Greenspan libertarian mantra ever presumed.

Interesting.