Seed the Bottom of the "Food Chain"

Scorning the Financial Gods --
And Paying the Price

After the tech bubble, the healthy and natural progression dictated we enter recession. Alan Greenspan never allowed us to take that medicine, opting instead to inject the economy full of fiscal and monetary drugs. The resulting imbalances steadily built through the years and arrived at our doorstep with a thud. It’s not wise to mess with Mother Nature. We’re now witnessing the other side of risk gone awry and the cumulative comeuppance of a scorned business cycle.

--Todd Harrison, "The Future of Wall Street"; Minyanville (2/11/09)

If Harrison's take is right -- and I believe it is -- a couple conclusions and observations logically follow:

--Beware of cures that are worse than the disease (anyone else have deja vu right now?). Or, if you want a "folksier", Upper Midwest analogy: don't drive your car into the ditch -- or oncoming traffic! -- just to avoid a deer.

--The stage we're in now could be called "financial de-tox." It's perfectly appropriate -- and maybe even life-saving -- to use "financial methadone" ("hair of the dog," etc.) to help an acutely addicted patient wean themselves from their addiction (I put tax credits for home buyers, stimulus spending, federal aid to states, etc. in that category). Just be clear that that's what you're doing, and that such a strategy is temporary.

--There's something deeply ironic (if not foolhardy) about relying on an institution, The Fed, that helped cause today's financial melt-down to oversee its rescue. Ditto for too-big-to-fail financial institutions, GSE's ("government-sponsored enterprises") such as Fannie Mae and Freddie Mac, etc.

--Instead of breaking with past financial blunders -- and sequestering flawed institutions -- we appear to be doubling (if not quadrupling) down. In that vein, you'd speculate that, once the financial dust settles, there will be calls to strip the Fed of some of the vast new powers it now wields (and to unwind what now very well may be the world's scariest balance sheet -- ever).

"Financial Food Chain"

Life does go on after the meterorite kills off the dinosaurs, the forest fire clears away the old giants, etc.

However, we would do well to *mimic how nature regenerates herself after such cataclysms: not by resurrecting the species at the top of the old, collapsed food chain but by seeding -- literally -- those at the bottom.

The meek may not inherit the earth, but birds and all types of microscopic plants sure seem better adapted to -- indeed, capable of adapting to -- a new and dramatically leaner environment.

*Manufacturers are just now beginning to exploit the secrets of what's called "biomimicry" -- for example, studying how a spider makes silk that is stronger, ounce for ounce, than tensile steel, while using vastly less energy and creating none of the waste or pollution.

Birds and Dinosaurs

Credit Crunch Casualties:
Publicly-Traded Builders

While Washington is focused on rescuing the financial dinosaurs, outside of Wall Street, the future appears to belong to much smaller, sleeker, and more mobile organisms. Specifically . . . birds.

Take the home construction industry.

For the last 20 years or so, size conferred a huge advantage. Big, publicly-traded builders like Toll Bros., Pulte and Lennar all enjoyed practically unlimited access to healthy (if not hyperactive) financial markets. Like REIT's ("Real Estate Investment Trusts"), they used that access to raise capital and debt (especially debt), which let them muscle out (or acquire) smaller, local competitors.

Now, size is a distinct liability, for three reasons.

One. Short-term debt isn't available from the credit markets anymore. That's why all the investment banks -- plus entities like American Express and GMAC -- have rushed to turn themselves into bank holding companies (that, and to be eligible for government bailouts).

If you can't tap the credit markets, you either have to find another way to access capital (from depositors, operations, etc.) -- or go on a diet, quick.

Two. Highly-leveraged builders are poor credit risks.

Eventually, the credit markets will thaw. But that still doesn't make the national builders a good credit risk.

Their assets -- raw land and unsold, finished new homes -- are declining in value; their cash flow is dropping; and they have crushing debt service, courtesy of their long, expansionary period. Not a very promising business model!

Three. In a lean environment, small is more nimble and sustainable.

Small, local builders ("birds") don't need tons of fresh meat or vegetation every day to live. They can subsist on worms -- and go to wherever they are. With the inventory of unsold homes at record highs, "worms" may be all there is to eat for awhile in many beleaguered housing markets.

Fortunately, there is ample evidence that decentralized industries not only may be more efficient, but are healthier for the economy (and less expensive to taxpayers).

They could hardly be more expensive. Fannie Mae, Freddie Mac, AIG, Citigroup, Goldman Sachs, the "Big Three" automakers -- the complete list is quite a bit longer and growing -- have cost taxpayers more than $1 trillion just to date because they were all putatively "too-big-to-fail."

Far from realizing economies of scale or "operational synergies," they appear to have been bloated, oblivious to risk, and, at least in retrospect, shockingly fragile.

"Small is beautiful" -- again.