When politicians masquerade as economists

What a brilliant opportunity to point out a stupid policy put in place by politicians with short term outlooks, to try and solve one problem, but at the same time making another problem worse. It’s the perfect example of politicians trying to be economists, but forgetting that economics isn’t about spending, it’s about incentives. Let me explain.

The housing market on the Gold Coast has been hit especially hard. Its economy is dependant to a large extent on tourism, and holidays are the first thing to go when people run into financial trouble in recessions, especially when the Aussie dollar is at record highs, making it more expensive to come here. With less tourists coming and spending money, businesses have lower sale, hire less workers, who then have less money, blah blah blah… demand for housing falls. It is suffering at the moment from an oversupply of housing which could take years to work through. This oversupply depresses the price of houses, and hence the price that construction companies can get for their finished product. Construction companies who are unprofitable at these prices go bankrupt, and the ones who can stay afloat build fewer houses at the lower price, a painful adjustment. What’s the obvious solution? Either reduce supply by knocking down houses, which I wouldn’t recommend (but I wouldn’t put it past some politicians to suggest it) or keep supply relatively constant and let demand catch up.

What’s the government’s solution? The government is deciding today whether or not to offer increased subsidies aimed predominantly at first home buyers purchasing, wait for it… new homes. When what the market needs is people to purchase existing homes which have already been built, the government is looking at construction companies crying out that there is no demand for new houses (a symptom of the problem of an oversupply of housing) and throwing money at the symptom instead of solving the problem of oversupply. Not only are they not getting at the root of the problem however, but they are exacerbating it by giving incentives to build new homes, increasing supply. And just to show how short term they are, the politicians are only offering these increased subsidies for six months, at which point demand goes back to where it was, except that we now have a greater supply of houses.

This is a fantastic example of a politician trying to think like an economist. And completely blowing it.

It is also a fantastic example of the government distorting the free market economy, and disturbing the Darwinian process which is supposed to guide our economy towards strength and efficiency. “Creative destruction” is this Darwinian idea; that by allowing fierce competition in the market, and letting weak companies fail, only the best will survive and the economy will be stronger for it. Of course this requires short term pain in recessions as weak companies who made bad decisions, aren’t nimble enough, or simply offer a product (like a house for example) that no one wants, go bankrupt. But in the long term a stronger, more nimble economy arises. Of course the government isn’t a fan of any short term pain, because it doesn’t win votes. When the government gives money away to people to keep a flailing industry alive, it is diverting resources towards an industry the free market is trying to say that no one wants.

The free market scenario, when allowed to play out, also snuffs out the stench of moral hazard, which no one will talk about but hangs quietly in the back of people’s minds. In the extreme moral hazard occurs when companies say, “I won’t worry about the fact that I’m building too many houses and that there is an oversupply, because if I am going to go bankrupt the government will bail me out,” and the government either does this explicitly by giving the company money (like the US government did for AIG) or it can do it implicitly in a number of ways, like offering people incentives to purchase a company’s product. Either way it gives a company the incentive be less careful when making decisions because it believes the government will bail it out. This mindset becomes an issue when it spreads throughout the whole economy. A construction firm under the influence of moral hazard in 2006 might have seen an oversupply of housing on the horizon, but thought I’m going to continue building houses while the going’s good and when the housing market hits the fan the government will bail us all out.

The government is keeping a flailing industry alive, when what the economy needs to do is to restructure. People need to go through the painful process of losing their jobs and finding new ones in booming industries. Unfortunately the long term good of the economy has a small voice, few lobbyists and no vote, and is often on the other side of a spike in short term pain, so policymakers rarely take note of it.

Is the Australian economy “diseased?”

Sorry people time for something bearish. A phenomenon in Australia normally associated with low income developing countries is becoming more and more obvious. “Dutch disease” refers to the de-industrialisation of an economy that tends to happen when natural resources are found. In the late nineteen fifties in the Netherlands large deposits of natural gas were found and exploited, and the ensuing decay of its manufacturing sector resulted in the term “Dutch disease”. Here’s how the story goes.

When a resource is found the demand for it raises the real exchange rate as overseas countries scramble to buy the gold; silver; iron ore; coal; oil; you name it, we’ve got it. To do so they must first use their currency to “buy” (exchange for) ours, and then they use this Australian currency they’ve bought to buy our resources from us (well actually, most of these commodities are traded in US dollars, so they buy US dollars, give us those in exchange for the resources, and then we exchange them for Australian dollars, but the result is the same). Just like most goods, as the demand for Australian currency skyrockets, its price soon does too. This increase in the price of the Australian dollar has the familiar effect of making overseas goods cheaper. As overseas countries begin to offer more and more of their currency for each Australian dollar (as they clamber to get at our resources) you can jump in and get some overseas dollars at favourable rates making overseas shopping cheaper. However just as other countries goods become cheaper for us; our goods become more expensive for other countries.

All else being equal Australian exporters are hurting from the high Aussie dollar. Companies like National Australia Bank, QBE Insurance (I’m sure I’m not drumming up a whole lot of sympathy here, but come on people; CSL, Billabong!?) suffer as their products either become more expensive or their margins suffer (see How will high Aussie dollar hit retailers). These sorts of companies shed workers, reduce production and investment, and in the worst case scenario fail. Meanwhile mining companies spend up big playing in the dirt, and an economy’s investment funds and labour (think of that mate who quit his high skilled job as a carpenter or manager to go to the mines to watch rocks go by on a conveyor belt) are diverted towards pulling rocks out of the ground and away from other businesses who survive by innovating, adding value, cutting costs, and producing goods and services. It is in this manner that innovation (and all these other desirable qualities in an economy) is stifled and the economy is said to deindustrialise, doing less of the aforementioned innovating and value adding, and more of the simple digging up of dirt out of the ground.

However the model also talks about a third sector, the so called “non tradable” sector. This is the part of the economy that isn’t mining, and isn’t exporting overseas. This sector supposably booms because the influx of spending in the mining sector trickles down through to the rest of the economy. It does this through the same process described in paragraph three of Is gold a good hedge against inflation except this time the initial increase in spending comes not from the government printing money, but from the mining investment.

This boom in the “non tradable” sector is likely to be tepid however, because mining is a very capital intensive business and employs few workers, and a lot of the "non tradable" sector like JB Hi Fi and Woolworths are having problems of their own (the internet is making these guys more tradable by the day) as described in How will high Aussie dollar hit retailers. And the model acknowledges this! Unfortunately the RBA doesn’t, at least not until the last monetary policy meeting.  The RBA has been, as described by some analysts, trying to “make room” for the mining boom by crushing growth in other industries. Higher interest rates in Australia certainly doesn’t decrease the Chinese (and others’) demand for Australia’s resources, but it does decrease Australian residents’ demand for other products like computers, cars, televisions etc. It does raise the real exchange rate and make our exporters products even more expensive. In this way demand is driven away from retailers, car dealers and pharmaceutical companies (basically anything that isn’t a resource company) and towards resource companies. Many argue the RBA has in effect been doing everything it can to exacerbate the Dutch disease!

The other reason the spending affect is mitigated is the trend towards foreign ownership of Australian mining investors. The profits of the mining companies are increasingly going overseas to foreign investors to be spent there instead of here. But this in itself is not bad; it simply reflects the decisions made by people about how much to save. Ironically, the fact that the miners are owned by overseas investors can alleviate the Dutch disease in a small way, because as the Australia dollar profits are sent back overseas to foreigners, they convert the Aussie dollars back to their home currency, which alleviates some of the upward pressure on the aussie dollar (they’re effectively doing the opposite of what pushed the Aussie higher in the first place. However because of the capital intensive nature of mining, a large proportion of the profits are kept in Australia and reinvested in the company to build and maintain the assets required to carry out their business.

On its own it’s hard to argue that this type of process is even bad. Australia has a comparative advantage in natural resources and it benefits us to specialise in this industry. This comparative advantage is amplified by the well developed infrastucture in Australia (minerals like coal and iron ore are so abundant that having a profitable mine is not about finding minerals, but about getting them to a port cheaply). However the deadweight loss comes in the drying up of innovation. This innovation isn’t completely lost; as Australia has become one of the preeminent mining services providers to the world, but one day the minerals will be gone, or at least the insatiable demand for them will be. Currently about fifty percent of China’s GDP is investment. As china transforms to an economy more consumer driven this demand for our minerals will fall (consumers don’t have much use for iron ore). Mind you this could take a while, we’ve been waiting for the Japanese to do it for about thirty years, and large portions of Africa are yet to industrialise. This one day will provide significant headwinds as we end up with lower mining exports and uncompetitive export industries.

Are the banks excesively profitable data

This is an explanation of the numbers used in Are the banks excessively profitable?.

To leverage up JB Hi Fi’s balance sheet I simply used the Dupont model, which breaks a company’s return on equity into five parts:

-Sales/assets

-EBIT/Sales (operating profitability)

-Pre-tax profit/EBIT

-Profit/pre-tax profit

-Assets/equity

Sales/assets is about how much revenue the company can generate from its assets. For Tanz THIS IS THE LOANS IT has on its books, and for JB Hi Fi it’s the shops it operates. The next three are about how much of this revenue falls to the bottom line as profits, and isn’t eaten up as costs. Finally the last ratio measures leverage. Equity is the amount of money put into the business by owners, and if the amount of assets the company owns is much larger than this then the money to buy them must have come from debt issues (or to be more precise, liability issues). To apply leverage to JB Hi Fi’s business it’s simply a matter of working out how much debt has to be raised to equate JBH’s leverage ratio (assets/equity) with ANZ’s, and then using it to buy assets, which you assume it gets the same return on as the currently owned assets, and then keeping all the other profitability ratios constant on the way down. But it’s even simpler than that, because the five ratios of the Dupont model are such that when multiplied together they conveniently show the return on equity. So keeping all of them constant, and just increasing the leverage ratio to equal ANZ’s, the numbers are:

Leverage ratio:                  15.57

Return on assets:             3.82

EBIT/sales:                          6.46%

Pre-tax profit/EBIT:         96.06%

Profit/pre-tax profit:      69.96%

Which when multiplied together show a return on equity of a whopping 258% and change. But if you don’t believe me (or DuPont Corporation) here are the numbers:

	Actual	Leveraged
Revenue:	2,731,320.00	17,444,483.51
EBIT:	176,558.00	1,126,913.63
Pre-tax profit:	169,601.00	1,082,513.24
Profit:	118,652.00	757,326.26
Equity:	293,296.00	293,296.00
Assets:	714322.00	4,566,618.72
Profit/equity:	41%	258%

The share buyback calculations are just working out what JB Hi Fi needs to have in debt to ensure a net debt to equity ratio equal to ANZ's:
=equity*ANZ's net debt to equity+cash and cash equivilents
=293 296*10.6+51 735
minus already existing debt:
=3 160 672.60-69 624
to show the amount of money they raise. divide* by the share price on 8/7/2011
=178776668.59/17.29
which shows that they could buy back at the market price 178 776 668.59 shares, 182% of their 108 118 000 shares outstanding according to their 2010 anual report. take that ANZ.

*the amount shown in the next equation is multiplied by 1000 because the values shown are directly from the balance sheet and are divided by 1000.

Are the banks excesively profitable?

A widely used measure of profitability in business, particularly for shareholders, is return on equity. This is because it measures the return on all the money that shareholders have put into the business, including their profits that the company has made and reinvested into itself. It is often preferred to ratios like return on assets because it takes into account the advantage of leverage which can increase returns: when making an investment it is not the return on the asset you bought which matters, it’s the return on the amount of money you put into the investment (your equity).

The return on equity ratio also makes it easy to compare companies in so far as seeing how well they can use the cash they were given to generate profits, which is after all what the shareholder wants them to do. Return on equity is also generally positively related to debt to equity ratios. A firm that utilises more debt than equity to fund its assets will simply have less shareholders with equity to spread profits over, so more profits for each shareholder. The amount that the firm must pay a debt holder in return for giving the firm his funds (the interest rate) is generally less than the amount that the firm must give a shareholder (in the form of dividends) due to the fact that debt is a senior form of funding relative to equity. This simply means that in the event o bankruptcy, the debt holder will get paid back his money before a shareholder who will generally rank last in this queue (assuming there’s anything left for either of them). The lower return also stems from the fact that debt has a fixed, unchanging return in the interest rate, whereas dividends can go up, down or ceased altogether. This reduces the risk for a debtholder by providing certainty of cashflows, and hence lowers the required return. This equates to more profits left over for the company if it chooses debt over equity. Interest payments on debt are also tax deductible, whereas dividend payments on equity shares are not. The tax reducing properties of debt also mean higher profits if a firm chooses debt over equity. Largely due to these three points debt tends to reduce the amount of equity and increase profits, which increases ROE (profits/equity) and results in more profits for you and me.

These are the same reasons property investors borrow to buy a house. They don’t have to put in as much of their own money (less equity to spread profits over), the bank only wants at the moment about eight percent or so return on the money it gives you in the form of a loan whereas people often like to think they’ll make around twenty percent per year on the money they put into an investment property (lower return on debt than equity), and finally the interest payments on loans come straight off people’s taxable income.

So what stops people from leveraging up to the hilt to maximise profits and returns on shareholders’ equity. Unfortunately not a lot if the GFC is anything to go by, but it should be obvious to most that having debt is a risk. Debt must be paid before the owners of the company (equity holders) get paid, so if there isn’t enough profits to go around equityholders get burned. So companies can generate higher returns by taking on more debt, but this increases risk.

Now to the point. There’s a lot of political “debate” at the moment (I don’t think the rubbish politicians talk, deserves a word with quite so much intellectual “feel” to it but that’s what they call it on the telly) about how obscenely “profitable” the banks are at the moment, and you’re hearing a whole lot of big numbers going around like 5.66 billion dollars and even bigger phrases like “record profits at Australians’ expense”. $5.66 billion dollars sound like a lot of money, but that’s right, I’m gonna tell ya it’s not (sometimes ya gotta be mainstream to be contrarian). Now here’s why.

Equity holders and debt holders have put an extraordinary amount of capital into the business to generate it. Particularly debt holders. A simple return on assets for National Australia bank, commonwealth bank, Westpac and ANZ are 0.62%, 0.88%, 1.04% and 0.85% respectively. What’s more their ROEs are 11%, 16%, 16% and 13%. Their debt to equity ratios are 1112% 1457%, 1240% and 1060%. Are these numbers big or small?

Compare them to JB Hi Fi, who has a return on its assets of 17% and a return on equity of 40%. But as discussed a firm can engineer high ROE with high debt levels and hence higher risk. Is that JB’s secret? No. It manages to generate such high returns for shareholders with a debt to equity ratio of just 6%. These figures are reproduced below for easy comparison.

METRIC	NAB	CBA	WBC	ANZ	JBH
ROA %	0.62	0.88	1.04	0.85	17
ROE %	11	16	16	13	40
NET D/E %	1112	1457	1240	1060	6

A bank by the very nature of its business is always going to be very highly leveraged; it borrows money from people and then lends it out. This is a very important function that ensures that borrowers can find savers easily, and it is unlikely that similar rates of economic growth could be achieved without our complex financial system. But it doesn’t change the factors that make debt a risk for an equity shareholder in a bank, namely that the debt gets paid back first, whether there’s enough profits to go round or not. For the astonishing leverage that banks take on they are miserably unprofitable for their shareholders. This can be seen by applying ANZ’s leverage to JB’s balance sheet (ANZ being the bank with the lowest net debt to equity ratio).

If JB Hi Fi leveraged its balance sheet to the extent that ANZ did, and was able to deploy all the raised capital (from issuing all that debt) at the same rates, it would have a return on equity of 258%! And this doesn’t take into account the positive effect on margins of the deductibility of interest payments for tax purposes (for an explanation of where this and other numbers in this blog came from see Are banks excessively profitable data).

Companies who want to leverage up can also issue debt and buyback shares to dissolve with the proceeds, which is simply good because it means there are less shares to distribute profits over. If JB Hi Fi were to leverage to a level similar to ANZ’s they would have to issue $3,091,048,000.60 worth of debt, enough to buyback all the shares, and then nearly enough to buy them all back a second time (if that were possible). Of course they’d have to buy them all up because no-one in their right mind would invest in JB Hi Fi, it’d be too risky!

JB Hi Fi and ANZ are completely different businesses and this is an extreme example to illustrate the point. Comparing ratios across industries like this is a dangerous game and is no basis for an investment, but the point is that banks aren’t that profitable, and when you take into account the amount of debt they use, they are anything but. Next time you hear someone screaming at you that banks make obscene profits (and people do scream when it comes to this topic) you can tell them that banks are a far cry from the most profitable entities on the ASX, and if they think it’s such a great deal then they should buy some shares themselves. They’ll probably tell you that all their money’s tied up in their house.