Wednesday, January 28, 2009

Cost Shifting

Imagine you're a grocer. Your most frequent customers are also your most demanding. What's more, they pay below cost.

Oh, yes – not only is the price you charge different than any other grocer, you also don't even bother to list your prices because your customers simply don't care. That's not because they don't pay: they do – but you only bill them at a fraction of your official price.

Each of these high-demanders also happens to have the same extremely rich uncle who's already predetermined the difference he'll make up, having based this on an average of all grocers, not just you.

So, what can you do, besides ask yourself why did I ever open this business?

Well, you cut back on your product range and the time you spend with each customer: why bother with individual preferences? And, you keep your prices inflated: you know that your other customers' rich uncles will pay you much closer to your asking price, even if they don't actually make payment until months later.

This is health care at its most basic. Insert provider for grocer, Medicare/Medicaid beneficiary for most frequent customer, commercial health plan beneficiary for other customers, and you have the basis for cost shifting: one entity's cost passed to another as quality declines.

Last month, the consultancy Milliman starkly estimated cost shifting totals at 15% of total commercial health plan outlays, or $90 billion. Putting it another way, that's an additional 10% in premium expenses for employers and their employees.

No wonder grocers prefer cash.

Saturday, January 24, 2009

Put the Money Where the Growth Is

So where has Mr. Bernanke's money gone to?

It's there, for sure, soaked up by the dry sponge of banks' capital needs – the consequence of toxic assets and failed business models.

Less absorbent lenders, meanwhile, are having to manage lackluster books of business among risk-averse borrowers.

Both sides of the aisle agree that some sort of stimulus plan is necessary to restore risk-taking and unclog the system. The debate, though, is intensifying on the most appropriate release point: Should the incentive target public sector institutions, or private sector producers and consumers?

Last summer's tax rebates, argue many, indicate that consumers are unwilling – or unable – to spend. Others counter that the rebates weren't aimed at the right demographic. In either regard, the double whammy of deflation and deleveraging continues to hamstring a wide range of consumers.

And government itself is not immune to this unfortunate conundrum of having to unload debt when income values are declining – especially on the state and local level.

However, the one constituent whose balance sheet remains in comparatively good health is nonfinancial corporate America.

If we dismiss the noise and consider policy options pragmatically, then it would be these private-sector producers which are most likely to spend on future growth. A simple chain of events might look like this: already-healthy producers invest proceeds from tax reductions (or rebates) in new projects appropriate to the shifting marketplace; job creation restarts; government gains on an expanded tax base.

Capital targeted elsewhere might just be a waste of Mr. Bernanke's money.

Friday, January 23, 2009

In the Crapper

The UK is in crisis, and not because of economic downturn. Rather, it's the government's gross mishandling of the credit system – teetering on the precipice of total nationalization. This could destroy economic growth for years to come.

At the worst of last fall's credit seizure, the UK government led the charge in direct purchases of banks. (The US soon followed.) It now controls 100% of Northern Rock and Bradford & Bingley, 70% of Royal Bank of Scotland and 43% of Lloyd's. Combined, these stakes represent a majority of bank deposits and residential lending. What's more, its actions eliminated centuries-old independence. RBS, for example, has roots dating back to 1707.

Despite this, losses continue to escalate, which is eroding reserves and forcing immediate need for new capital. And with the country's recession worsening, the prospect of complete government takeover is hardening.

Only HSBC and Barclays remain 100% independent. Their self-reliance, however, pits them against government-backed competitors: an economic distortion, by the way, which continues to dog German competitiveness.

Already, producers and consumers will feel the damage for some time, as government control quashes financial innovation, distorts market pricing and restricts access to capital. Its effects will force businesses to relocate to lower cost-of capital-countries, taking with them job creation.

The weakened British pound, down 30% against the dollar since July last year, exposes Britain's enervated global ranking.

There's a lesson here in government intervention. Had markets settled the course, there would certainly have been substantial pain, but the longer-term opportunity of a stronger banking system would be firmly in place.

Wednesday, January 21, 2009

Rebalancing Act

Market pundits often discuss periods of inflection as "market rebalancing". They also describe movement in terms of "leadership": which sectors do others follow. For the past several years, the financials sector has been the distinct leader – both up and down.

During extreme moves, however, sector weightings can shift dramatically: one might sell off more than others; another might gain.

Four years ago, at President Bush's inauguration, financials accounted for more than 20% of the S&P 500, by market capitalization. The sector has since shed 68% of its value, falling from number one to six (of ten) – much of it happening over the past few months. As recently as October, it ranked second.

Now, at President Obama's inauguration, information technology ranks highest, but only 50 basis points ahead of health care. The spread between number one and number two four years ago was 500 basis points. Energy is third.

These current top-three, moreover, total 30% of the index – down from 49% in 2005, which means today's market is about 40% less sensitive to share price movement among its biggest constituents. It's also 65% less sensitive to financials, where a 1% move now equals seven basis points in the index versus 20 basis points previously (ceteris paribus).

What's this all mean? Two observations, both positive:
  1. the smaller financials get, the less drag they force on the overall market: market pain is becoming localized to a shrinking industry;
  2. as a whole, the market is more balanced than before: capital is becoming widely spread.
And let's not forget: this is a constant and rapid self-adjusting process.

Tuesday, January 20, 2009

New Direction

What's the market telling us this inauguration day (S&P 500 -5.3%)? Does today's rout speak to the consequences of old policy measures, or a fear of what's to come?

Whichever it is (perhaps both), it's speaking frantically: already, there have been four 3%-or-more–moves in just the first 12 trading days of 2009. That's twice the total number in the three years 2004 to 2006. (Okay, we had it worse the last four months of 08, but only slightly: the pace then was an explosive 3%-move every 2.6 trading days.)

Most would agree that credit markets have to return to some degree of normalcy before recovery can begin. But for this to happen, lenders have to be confident of their own equity. Double-digit share price declines do nothing to support this, especially when business models confront rapid extinction – Bank of America, for example, now facing the reality of building a defunct model: the universal bank.

If past measures are spooking the market, then the message to policymakers would be: Hey, you know that $2 trillion-plus of money you committed last year – some of it to nationalize our banking system, a lot of it the Fed’s deployment of backstop measures? Well, it ain’t working.

If it's a fear of what's to come, then the market is desperately calling out: We need a different way!

Nothing would be more opposite than government taking one big step back.

Perhaps the time has come to shift that responsibility back to consumers and producers who power the economic engine of this great country.

Sunday, January 18, 2009

Agency Reality

Given our monstrous, overgrown government structure, any three letters chosen at random would probably designate an agency or part of a department that could profitably be abolished.
– Milton Friedman

Okay, how about F-D-A? Consider this: For every dollar you spend, 25 cents goes to products regulated by the Food and Drug Administration. That's more than $1 trillion in total. This ranges from safeguarding the nation's food supply to approving new medical products.

And there's the other trillion-plus too in industry compliance costs.

The table below shows its budget's largest line items:

Of which
user fees

$540 million

Human Drugs
$740 million
$365 million
$245 million
$75 million
Animal Drugs
$120 million
$10 million
Medical Devices
$270 million
$20 million

If ever there were a case study in government bureaucracy crashing relentlessly into innovation, it would have to be the FDA. Its roots date back more than 100 years, which means it's overseen some of the greatest scientific achievements in human history.

Until just a few years ago, the volume of these advancements in the drug industry skyrocketed. The number of new approvals has since collapsed, however – ostensibly due to safety issues, though many argue headcount and budget constraints.

Against today’s exploding government, it's worth considering the example of the FDA's current state. Has it simply reached a point where the massive strides in innovation across its oversight are accelerating beyond its own capacity, whatever dollars Congress throws its way or it charges in fees? Can we extrapolate this to other agencies and their mandates?

The new commissioner will have to navigate not only political opportunism (remember, he or she will be Senate approved), but, perhaps more important, the agency's evolutionary reality.

Ten years ago, Congress toyed with the idea of privatizing many of its functions. Such a pursuit might seem unthinkable today, but we live in unpredictable times. Other than its breakup, fiscal realities might limit the commissioner to no other option.

Now that would be one great twist of fate for Mr. Friedman.

Thursday, January 15, 2009

The Text Generation

One of the more remarkable news stories this week was of a 13-year old California girl and her mobile phone.

Texting on average once every two minutes every waking hour (more than 14,000 texts in total), she racked up a massive 440-page monthly statement. To AT&T's regret, her splurge incurred no expense other than the standard $30 texting fee. Her charges otherwise would have totalled just under $3,000.

For kids her age, the average monthly text tally is 1700: about one message every 17 minutes.

For parents, the conversation seems to be about, well, kids’ lack of conversation. Talk is something old people do; younger people prefer the written word, or, should we say, the instant message.

By the way, there's the similar shock in Facebook when the older generation connects with the younger one, and one person's several dozen friends link with another's several hundred. How can someone half my age know five times as many people? (Well, fact is, 40+ers text a mere 200 times per month on average, preferring instead the real-world handshake.)

In the work environment, this spills over into how twenty-somethings communicate with each other, and their managers – usually folks older than twenty-something, who came of age when it was cool just to be able to speak on the hoof, and whose open-door policy is lost on deaf thumbs.

Against today's recession, we wonder whether there's not some unharnessed dynamism in all that IMing.

Maybe that’s where Congress should look to target the stimulus, rather than pouring it into ancient, voice-era state and local bureaucracies.