Economic Foresight, Part II: And Another Thing…

April 21st, 2008

I left an issue unresolved in writing the first piece.

The collapse of Bear Stearns makes me uncomfortable. I say that because I saw something they apparently did not. Or if they saw it, they went ahead anyway and I wouldn’t have joined in. In fact, I didn’t, having liquidated any mortgage or real estate holdings, including my own then-overpriced house, because I thought it was clear what was coming.

Not many years ago a client told me of his plan to triple his business. In general economic terms I was opposed because it was an expansion during very good times. Not only was demand high and of course prices, but the price for the capital assets to expand followed suit, and credit supply was easy and cheap.

Tom, Jr. and I made a trip to talk with them face-to-face about the proposal. It was short notice so all we had was the general argument about avoiding capital investment in high times. I hold that position because it is just buying high, which in the best of times is only breaking even by selling even higher. Our visit came with just enough notice so that they were prepared for our disagreement.

The sum and substance of their position was that expansion would be profitable. The client was a good operator his numbers proved it.

I hollered and screamed. What they had built took 10 years. They credited us with their success. We rightly credited them and expressed appreciation for getting to play a part. What they had already done was not easy, not without objections and resistance from others, but they had done it. I feared it was all at risk for virtually no upside potential other than the thin argument of profit.

Why that is almost business sacrilege – that profit is a thin argument. But that is my position.

Profit is not the basis for doing something, it is only a means of continuing to do something.

As you may know Goldman Sachs invested in sub-prime mortgages opposite of others. They shorted. That is they bet on sub-prime becoming a big loser. They were in thin company.

I have long suspected that the fastest way to the highest immediate profits is riding a wave. I have suspected that failing to ride the wave while it was still rising would deliver less profit. I hesitate to write it that way because it sounds like doing nothing is better than doing something. A recent Economist article compared the profits of Bear and others with Goldman. Sure enough, while the wave was cresting Goldman lagged in profits behind the others who rode the sub-prime wave.

Telling somebody that profit is not a reason is a sure way to get ridiculed. Because you can’t get the words out of your mouth fast enough that you’re not proposing as some sort of goal that they would be better off with less profit. Even from an exalted position such as we enjoyed with this hell-bent-on-tripling client, getting it said and offering the reasoning just doesn’t do it. At least I couldn’t persuade them.

I spent years trying to fix things after they went bad. To avoid the problem in the first place is to see something as a problem before it is a problem. This is why I wondered if such things could be foreseen in a useful practical way.

Back in the 80’s I was working on computer-based models with 10-year time horizons. It seemed to me that what hit firms — what was economically relevant — was three things every owner understands: prices, volume, and credit. We finally found outside price data we could afford (far easier today than 15 years ago). I had long dreamed of the day we could afford to get the data into our computers. The internet made that happen. Tom, Jr. was working with the model and the price data. He inadvertently found — that is, he found something even though he was actually looking for something else — a way to read and draw conclusions about when to sell something and at what price. It was for commodities.

We pitched several clients on the idea of developing Tom Jr.’s work and they provided the rest of the front money. It worked. It really worked. But not for all of them, which brings me back to Bear Stearns.

Did Bear Stearns even look? I can’t imagine they didn’t, although very few actually do look. Assuming they looked, did they see? I’ve seen people deny what they plainly see. I can’t imagine that at least someone at Bear Stearns did holler and scream as I did. That’s all speculation on my part. I think it a reasonable speculation.

Bear Stearns won’t make that mistake again…they’re gone.

Do I write to scare? Yes. Almost all the cases I’ve had were like Bear Stearns: people who had something to lose and lost it, or nearly so. Having a great deal to lose shows by results these were people of skill, experience, and judgment. Yet all three failed in an instant.

Therefore, Bear Stearns makes me uncomfortable.

I talk (about 20 minutes) about these things and take questions at our Wine & Cheese Salon Tuesday, April 29, 4:30-5:30. This is the last salon on economic foresight for awhile; I will deal with new topic materials at our May salon. Bring a friend. Registration is limited.