Friday, November 7, 2008

As Easy As ABC

The insolvency of ABC Learning Centres is a clear example of the folly of taking a perfectly good business and destroying it by using it as nothing more than a vehicle to generate a short term cash return rather than long term value. The rapid expansion of the business came at the expense of an equally rapid expansion of its debt. As more cash flow was required to feed more debt, more debt was required in turn to generate more cash flow. As we have seen this will work well for a time, as long as the cash flow continues to grow and the credit continues to be cheaply available. In this way it is possible to quickly build an enormous structure, but the problem is that the structure is hollow. Any intrinsic value in the business is counterbalanced by the debt obligations.

ABC is far from alone in this. Already we have seen the so called “financial engineers” such as MFS and Allco fall by the wayside. Merchant bankers Babcock & Brown and even the previously glamourous Macquarie Group have been punished by the market for their indescretions. Macquarie has proven to be more resilient than the others, in part because it had already changed its business structure to ensure it is well capitalized, and partly as a fortunate beneficiary of the Government’s banking guarantee. Even so, Macquarie’s share price is a pale shadow of what it was a year ago.

At a time like this it’s also worth recalling the failed private equity takeover of Qantas. If that had gone ahead, as Geoff Dixon and Margaret Jackson had recommended, the subsequent debt burden placed on the company could well have destroyed it in current circumstances. The point is that such debt funded expansion or acquisition will always carry a high degree of risk compared with equity. While conditions allow, such high risk will often result in high rewards. Now that conditions have changed, the true extent of the risk is becoming apparent.

The important point to all of this is that these practices, labeled as “financial engineering”, have absolutely nothing to do with the actual operation of a business. A business can be perfectly viable on its own terms, but it can be destroyed by having its value hollowed out as more debt is taken on to fund either a change in ownership or a rapid expansion. In the case of ABC, the individual childcare centres are in most cases perfectly good businesses, despite the fact that the corporation which owns them appears to have been pillaged for the purposes of a quick buck.

The Government has now committed to spend $22 million of taxpayers’ money on keeping the operation running. The argument is that childcare has become an essential piece of community infrastructure, integral to the ability of the economy to function. There is plenty of truth to that notion, which then prompts the question: is it wise to allow a single company to acquire so much market share in an essential service without greater prudential regulation?

It seems obvious now that the answer is “no”. At the very least it is to be hoped that the Global Financial Crisis might ultimately lead to a change in the way debt financing is both employed and regulated, especially in the provision of essential services.

Thursday, November 6, 2008

Welcome to the 21st Century

The election of Barack Obama to be the next President of the United States provides a turning point in not only American history, but world history. It’s not just because he has made history as the first black President, although that has attracted a considerable amount of acclaim. Although that landmark is significant, it is the opportunity for genuine change and renewal in the United States, for itself and for its place in the world, which is of greatest importance.

The past eight years of the George W. Bush administration has been in every way a hangover of the 20th Century. His time as president has been marked by the prosecution of a war that had its seeds planted during the Ronald Reagan and George Bush Senior years. That war is in many ways a case of the son taking up the unfinished business of the father. Beyond that, the Bush Presidency has represented the ultimate pinnacle of the influence of the Bush family in American affairs going all the way back to Prescott Bush and his infamous connection to the Nazi party as a Director of the Union Banking Corporation in the 1940s.

The foreign policy of the United States in recent decades has become increasingly interventionist and increasingly unilateral, at a time when the rest of the Western World has been searching for greater unity and stability. The reputation of the United States has suffered because it has turned its back on the United Nations despite having been instrumental in its creation after World War Two for the specific purpose of circumventing war. The United Nations may be far from perfect, but it should be the role of the United States to strengthen that body, not undermine it.

W’s economic policies also owed much to those of Ronald Reagan, and at least in part the fallout from the present Global Financial Crisis can be traced back to those policies. The blind faith in the ability of the markets to self regulate has led to the inevitable result of unfettered greed being punished by those same market forces as the other primal driver, fear, tears apart the house of cards built upon hollow investment vehicles representing assets of no intrinsic value.

The election of Barack Obama is a turning point in world history because it provides the United States of America with an opportunity to restore its reputation as a world leader rather than an international bully. An opportunity to restore its own economy through investment in nation-building at home rather than military destruction abroad. An opportunity to look to the future rather than to be mired in the remnants of an imperfect past. An opportunity to once again truly embody the spirit and ideals of the founding fathers of the world’s greatest democracy, who wrote in their Declaration of Independence of the universal right to “life, liberty and the pursuit of happiness”. An opportunity to once again stand for the ideals of freedom, democracy and justice for all.

This is the moment of endless possibility, the opportunity for national transformation, the real beginning of the 21st Century in American affairs. All that remains is for the new President to actually deliver the change he has repeatedly promised. I wonder if he can.

Wednesday, November 5, 2008

Economic Outlook Still Gloomy Despite Interest Rate Cut

Just As everybody was starting to feel good after the Reserve Bank of Australia delivered a larger than expected interest rate cut, Treasurer Wayne Swan has poured cold water over the party. The RBA announcement yesterday was widely welcomed as good news, with the expectation of relief for homeowners and business operators. Today, the Treasurer has revealed the Mid Year Economic and Fiscal Outlook projections, which don’t inspire quite so much good cheer.

While the interest rate cut is good news for people struggling with loan repayments, it’s a double edged sword. For example, retirees who might have been smart enough to move money out of equities and into cash will now see their returns reduced again. On top of that, the fact that the RBA is repeatedly delivering larger than expected reductions in the official cash rate could be interpreted as indicating that economic conditions are worse than we thought and therefore warrant a more extreme response. Today’s report lends weight to that idea.

Wayne Swan has warned that the Global Financial Crisis has created a $40 billion hole in the Federal Budget. The projections indicate that economic growth will continue to slow, and unemployment will continue to rise. Now, while some optimists are hoping that there will be a turning point in the early part of next year which will see the economic sunshine pouring in once again by 2010, the Mid Year Outlook indicates that unemployment will still be increasing in 2010. If that’s the case, the economic slowdown will be with us for some time yet, rather than somehow miraculously turning around in the next couple of months.

Despite the seriousness of the situation, it remains true that Australia is better placed than almost any other country to survive the crisis. Even if the official forecasts prove to be optimistic and the pessimists who predict recession turn out to be correct, the Government has the capacity to cushion the blow with a combination of welfare and economic stimulation measures. The Government has a budget surplus, a substantial cash reserve, and no net debt.

That’s reassuring because if the doom merchants are right, interest rates, employment rates, property prices, and business profits all have a lot further to fall before the crisis is over.

Tuesday, November 4, 2008

Affordable Housing In The “Too Hard Basket”

The New South Wales greens have introduced a bill into the Legislative Council calling for up to 25% of new multi unit housing developments to be set aside for affordable housing. Under the plan, the housing could be managed by Councils, non profit housing organizations or the Department of Housing. Rents would be kept affordable by fixing them at no more than 30% of the tenants’ income.

Some such schemes already operate successfully abroad, and also on a limited basis in some Council areas here in New South Wales. The obstacle is that under current law Councils need special permission from the State Government to introduce such an arrangement. In the absence of adequate numbers of public housing properties, the need for more affordable housing of any sort is becoming more pressing.

Developers blame the affordability crisis on the undersupply of housing in the market, and in turn blame the undersupply on the tangle of red tape that strangles development, along with the excessive levies and charges that are imposed on new developments. For that reason, they say that the Greens’ scheme amounts to just another tax on development, likely to strangle the market even further and ultimately prove counterproductive in terms of affordability as it could force open market prices up, not down.

Unless the Government suddenly decides to inject more money directly into public housing, and with a budget black hole dominating their finances at the moment that is about as likely as pig farming on the Moon, the proposal by the Greens offers a way to address the shortage of affordable housing that would otherwise be ignored. The success of the scheme would depend upon developers being able to see a viable return from the project. That means those big fees need to go.

The developer levies and charges that currently add as much as $100 000 to the price of a property are the real villains in the affordability equation. They are up front charges for future infrastructure and services for which residents are already paying rates and taxes. If those unjustifiable levies and charges can by cut or at least reduced, then there would be scope for the Greens’ plan to actually provide at least part of the solution to a problem that has spent far too long in the “too hard basket”.

The challenge is for Premier Nathan Rees to keep his promise to empty out that basket, and support this plan.

Monday, November 3, 2008

Picking The Trifecta

Well it’s that time of the year again. Melbourne Cup time; when the real winners are the bookies and the betting agencies as everyday people become punters for a day and plunge millions on the race that reputedly stops a nation. This year of course the big race coincides with the United States Presidential election, which might be a two horse race, but is nonetheless just as difficult to pick. To complete the trifecta, the Reserve bank of Australia will have its monthly meeting and decide whether or not the economy needs another interest rate cut.

Although it seems to be a foregone conclusion that rates will be cut again, there are signs that some uncertainty exists. While the Global Financial Crisis continues to make its influence felt and retail and property figures are still down, it’s not all doom and gloom. The Australian economy is not in recession, the impact of the Federal Government’s $10 billion cash giveaway is about to hit next month, and inflation is still high. These three factors might just be enough to persuade the RBA to hold steady on interest rates. If they do, it would be a mistake. I expect the Reserve will play it safe and drop rates by 0.25%.

Across the Pacific, the United States is contemplating whether to elect a 72 year old war hero as President, or to make history by electing an African American to the post. Despite the best efforts of Hollywood to sell the idea in fiction, it remains to be seen if mainstream America is ready for that leap. It’s not simply a question of race, as only a minority will see that as an obstacle. It’s also a matter of age, experience, divided opinions about the Iraq War, and even the question of the right to own guns. While, the Republican Party deserves to be punished for its economic and foreign policies, conservative values can seem attractive in times of crisis. While the rest of the world might favour a Barack Obama victory, I’m not convinced that the American People will see it that way. I believe it will be tight, and that McCain might just pull it off, even though Obama would likely be the better President.

As for the Melbourne cup, there might be two dozen horses to choose from, but it’s the easiest one of the three to pick. Really, there is only one choice. The cup will be won by Mad Rush. So there you have it… a modest interest rate cut, McCain for President, and Mad Rush to win the Melbourne Cup.

Hang on a minute, I’m still not sure about McCain… That’s just too hard to pick.