Thinking Things Over
Musings on the Markets from Inside the Beltway
By John L. Chapman, Ph.D. Volume I, No. 9
In this Note:
- Solyndra, Inc. and its continuing lessons
- The Federal Reserve meets this week — what to expect and why it matters
I. Solyndra, Inc.: Another Update
As our colleague Joe Gomez noted in his weekly market wrap yesterday, U.S. equity markets rose 5.2% last week for their best week in 2 1/2 months, along with significant rallies in both Europe and Asia. Does this signify a turn from a lousy run for both the U.S. economy’s GDP growth and the markets, and a thwarting of the “double-dip” recession threat that many fear? Count us as skeptics because no new fundamental news materialized; indeed, markets merely ingested and then confirmed Eurozone talking heads’ affirmations of determination to prevent either a Lehman-style bank flame-out or outright sovereign default for Greece or others — a temporary palliative at best (see below). And more directly core to our skepticism, about both the markets and the economy, our caution was reaffirmed with the latest news about Solyndra, Inc., that paragon of the green economy that Mr. Obama stated was “leading the way toward a brighter, more prosperous future,” in his May 2010 visit to the firm’s brand new, and now shuttered, plant.
Why is Solyndra, which we have mentioned not once but twice before in recent weeks, both a prototype investment of the economy Mr. Obama seeks to develop for the United States, as well as a canonical example of this Administration’s abject failure in economic policy? Let us count the ways:
— First, we were dismayed to learn that the Energy Department Loan Guarantee program which underwrote Solyndra’s $535 million loan was actually a creation of the Bush 43 Administration (2005), proving that crony capitalist stupidity is bipartisan. Then came details of the flame-out of this company, less than two years after its receipt of the loan guarantee; it was revealed the company had sales of $100 million in 2010 and a net loss of $172 million. Clearly, the Energy Department had not done their homework.
— Then we learned that Solyndra’s chief advocate investor was George Kaiser, a billionaire oilman who had been a big fundraiser for the Obama 2008 campaign; Mr. Kaiser made at least 16 trips to the White House beginning in 2009. And then to add insult to injury, it was revealed that Mr. Kaiser was one of two lenders to the firm earlier this year (for a collective $75 million) who received a priority call on their loans, meaning they get paid in full before the federal government gets a dime back from the bankruptcy liquidation. This is cronyism on steroids.
— And finally this week the finances of the firm were made fully public: Solyndra had lost over $500 million in the three years prior to the federal government’s “stimulus” funding, and prices for technology available from competitive offerings had come down dramatically in 2008. Thus, to pour money into this firm in 2009 was seen to be foolhardy after a cursory 20-minute review of the industry and competitive landscape. Indeed the situation was so bad by the spring of 2009 that it is likely the firm was headed toward bankruptcy that year, and was saved only by the federal loans. Solyndra was at that point making tubes costing $4 per watt output, but was only able to charge $3.24; after the government’s loan, the company spent tens of millions building a new plant with a 500-million megawatt production capacity to add to its existing 110-megawatt facility, yet in 2010 total firm sales only came to 65 megawatts, just over 60% capacity for the smaller existing plant.
Pardon our bluntness, but consider that breathtaking stupidity: a firm whose best sales year led to 65 megawatts of output in a 110-megawatt plant builds a new plant with 500-megawatts capacity to take the firm to 610 total. All this for 1100 jobs, which are now gone in any case?
The lessons here are stark, and show why Mr. Obama’s economy is one in which the cronyism-led destruction of capital will entail a lower standard of living moving forward:
- Without the discipline of private capital markets, the firm was able to obtain financing without acute concern over profitability. Waste of scarce capital is the sure result of this, and of course no Department of Energy employee will lose his or her job over this, as would happen in the private sector, where there is a cost to gross incompetence.
- Of course with the FBI now investigating both the factory and the homes of key executives, criminality (that supersedes mere incompetence) cannot be ruled out: sadly, it is possible the Department of Energy and Obama Administration knew this firm’s prospects were effectively non-existent, but did the deal anyway in support of the crony-insider, Mr. Kaiser. There is email traffic in support of this thesis, apparently. By definition, cronyist-driven deals always involve transactions that would not be supported in a free and competitive market, and hence involve waste of society’s scarce resources — that is to say, make society poorer in terms of standard of living — as well as, potentially, fraudulent activity, upon occasion.
- Solyndra is the logical consequence of policies flowing from a chief executive who has virtually no experience in the private sector, no prior P&L responsibility, and indeed in this case, has shown disdain for the business community.
- The broader philosophical point is that Solyndra-type deals are perfect examples of what F.A. Hayek called the fatal conceit of all socialist central planners: without the discipline of profit-and-loss calculation, without the benefit of being able to make use of the dispersed knowledge conveyed by open and competitive markets, it is only by accident that a government-backed enterprise will ever create economic value. No better example of this is to be found anywhere than the U.S. Postal Service, which for several decades now has been unprofitable in most years, even though having a monopoly on letter delivery for almost the entire period. Indeed, most every government enterprise across history has been loss-making; this is the primordial reason for the eventual collapse of the Soviet economy — none of their state-run companies could ever turn a true profit. And it is the “fatal” conceit of the central planners to continually believe otherwise.
Solyndra offers a huge lesson for the American public — and for policymakers. And we end this sorry tale by asking two questions: will they learn anything in Washington DC from this? And, meanwhile, in a time of business depression when we can scarcely afford even a paltry loss of resources, where is the outrage over this?
II. Federal Reserve Meeting This Week: What Does It Portend for Investors?
This week the Fed’s Open Market Committee meets both Tuesday and Wednesday, after Chairman Bernanke added the extra day of deliberations. Why the extra day and what will happen?
We fear the turmoil in Europe is worse than has been publicly reported, and was the reason for both the US Treasury Secretary’s unprecedented attendance at the Eurozone Finance Ministers’ summit (in Wroclaw, Poland) for the first time ever last week, as well as the Fed’s ready agreement last week to open 3-month swap lines for the European Central Bank’s capacity to borrow against euros. This followed the latest developments in Greece last week, with its new 8-billion euro backstop being negotiated, along with word of further restructuring talks to be held with the IMF and banks next month; all this needs extended Fed deliberation now.
What will the Fed be thinking about, and what will it do? We fear it isn’t pleasant news that is coming:
- The fundamental problems — two rolled into one, really — are an overleveraged banking system that is hobbled by bad debts and write-downs that need per force happen. This is true in much of the world, but especially in Europe, with France being in the worst shape. The largest 3 French banks currently have $4.7 trillion in debt, or 250% of France’s GDP; the entire French banking system reportedly carries debt equal to 400% of GDP. Similar to Bear Stearns and Lehman Brothers of three years ago, these banks are levered 30 to 40 times their available capital; that is to say, if they lend out $100, they have $2.50-3.00 in reserves against loan losses. If the bank’s debt falls in value by only 2.5-3%, they become insolvent, and must close their doors.
- The problem, of course, is the high likelihood that “bad” debts currently held in the Eurozone banking system at original face value do need to be marked-down; how much these write-downs end up being will of course determine the degree of undercapitalization Europe is now facing. The French banks hold $57 billion in Greek sovereign debt, which analyst Sean Egan thinks will need to take a 90% write-down. As we stated last week, total U.S. exposure to Europe’s banks totals $1.2 trillion including derivatives; no one can be certain how severely U.S. financial institutions’ exposure to the Eurozone will end up being, but the bigger downside of course is recession in Europe, and along with it decline in demand for 20% of U.S. exports.
- Lending directly to the ECB itself for up to three months in and of itself may not be anything other than marginally (de minimis) inflationary; any ECB-money printing of euros to make up for bad debts may be cancelled out by a drop in the euros’s exchange value against the dollar, pari passu. But the Fed is now considering swapping out short-term debt for 10- and 30-year issues, to lengthen the maturity spectrum of its portfolio. This would be done to lower long term interest rates (and mortgages) in an effort to spur lending activity in the U.S. This could be inflationary, as indeed a similar uptick in credit in force in the last 12 months is what is behind the 3.8% rise in consumer prices and much bigger wholesale increases (double digits in any industrial categories).
The European banking system is somewhat opaque to us (and frankly, so is the U.S., more than we would like to admit, though data here are easier to come by), so we cannot comment on the efficacy of ECB swap lines. But in general, this is not a good development: it is happening because Eurozone banks are stressed and undercapitalized, and it leaves US taxpayers vulnerable to potential loss of real purchasing power, however marginal.
We’ll cut to the chase for our readers the way we wish Chairman Bernanke would with us: the Eurozone, like the United States, has suffered a multi-trillion dollar loss of wealth since 2007 (US household net worth peaked at $65 trillion in 2007, fell to $52 trillion two years ago, and is now back to $58 trillion). Profligacy has continued relatively unabated in many Eurozone countries (though not all) since 2007-08; Greece, Italy, Portugal, Spain, and a few others are in trouble. That is to say, these countries have run up debt and fiscal obligations (often in terms of generous pay and welfare services to public employees) that they can now no longer meet. The banks holding these profligate sovereign governments’ promissory notes are now exposed to debt write-downs (or, write-offs, in the case of a total default, such as may happen in Greece very soon, Treasury Secretary Geithner’s comments to the contrary notwithstanding). The question of the hour is, who is going to bear the risk of loss on these debts? Shall it be investors in the equity of these institutions holding the downgraded paper, or Eurozone (and perhaps U.S.) taxpayers? Similarly, who will bear the risk of sovereign defaults, if and when they (Greece) happen?
We think the Federal Reserve has made serious mistakes in answering these questions in recent years. There is a world of difference between illiquidity and insolvency in these institutions: for the Fed to address the latter via monetary policy necessarily entails a transfer of risk, and likely wealth, from Americans to, in this case, European bankers. This is just a continuation of the weak dollar policy (viz., destruction of real capital) in place at the Fed for over a decade now; in seriatim, we continue to believe this must and will have a big impact on U.S. interest rates and inflation in the time ahead.
What do Solyndra and the Federal Reserve have in common? Both are emblematic of the moral hazard that has been loosed on the U.S. economy over time: the Fed’s very existence encourages profligacy on the part of actors, leading to bail-outs, as does federal government Solyndra-type “investment” in what clearly should be private sector-based activity. The taxpayers are stuck with the bill in this game of heads-the-special-interests-win, tails-the-powerless-citizens-lose. Perhaps the 2012 election in the U.S. can elicit a broad discussion of this phenomenon, and its inherent inefficiency — let alone immorality.
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Dr. Chapman is chief economist at Alhambra Investment Partners, and director of research at Hill & Cutler Company in Washington, D.C. He and Alhambra founder Joe Calhoun are writing a book on investing and capital preservation in the current turbulent era. Chapman can be reached at firstname.lastname@example.org.