“While the public votes only every few years,
the markets vote every minute”*
For the first half of 2005 our average account declined in value approximately -3.71%.
Samuel Insull might have been the most famous capitalist of the Jazz Age. He made the cover of Time Magazine by providing cheap and plentiful electric power first to the citizens of Chicago, and then through a bewildering series of mergers, to more than a quarter of the country. Then came the Depression, and he couldn’t pay his debts, leaving parts of the nation in the dark and municipalities everywhere scrambling to keep the lights on. Seventy years later, it is hard to convey what a villain he was. President Roosevelt personally vowed to, “get that man.” Captured in Turkey, and extradited to Chicago without benefit of an extradition treaty, Insull was put on trial in May, 1934. The jury took five minutes to consider its verdict, and declared him innocent. It has always been hard to get juries to treat corporate executives as criminals, no matter what their actions or infamy. The recent disappointing verdicts in the HealthSouth trial brought the Insull case to mind. The Scrushy case is the first Sarbanes-Oxley prosecution, and the innocent verdict in the face of so much incriminating evidence has left us shaking our heads. The cost of compliance with this law is burdensome in the extreme, and in many other ways besides its staggering legal bills. The deterrent value against malfeasance is currently nil. We wonder, though, whether this is society’s and government’s last word about corporate cupidity.
We got to thinking about this as we read for the second time Daniel Yergin and Joseph Stanislaw’s brilliant history of government versus market jousting, “Commanding Heights”. Published seven years ago, and almost out of print now, their book is the first place we went to remind ourselves of the details of the Insull case. It is also the source for the quote that begins this letter, which captures the spirit of our age in a single luminous sentence. That markets should be heard from at every hour was not, however, the dominant thought in most of the last century. Yergin’s title, “Commanding Heights”, comes from Lenin’s dictum that the Soviet state needed to own the most important industries to command all below. This idea only came to Lenin after he had been in power six years and the Russian economy was a shambles around him. He needed an excuse to lighten up on the heavy-handed tactics of collectivization, and a New Economic Policy was what he tried. Ten years and one stock market crash later, his ideas were more popular in the West than in Stalin’s Russia.
Roosevelt’s rage at Insull’s “innocence” put the New Dealer on the warpath. Within months, so many regulatory burdens had been placed on the generation and distribution of American electrical power, that a casual observer from Mars couldn’t have told our private enterprise system from Stalin’s Five Year Electrification plan. It didn’t stop there. The opening four years of the New Deal separated markets from businesses in dozens of industries. The next forty years intensified the belief that governments were wise and markets were stupid, and then oftentimes venial to boot. Looking back today, it is hard to imagine what conditions were like thirty years ago when the turn to market dominance came.
Yergin and Stanislaw’s book is particularly brilliant in limning where we were, and encyclopedic in its knowledge of where the turning points came. The moment for maximum contempt for markets in America came in August, 1973. Inflation was spiraling out of control and President Nixon summoned an army of advisors to Camp David for a weekend to see what was to be done. Yergin reports that the solution of a 90 day freeze on wages and prices was decided almost immediately, with little debate, but the issue of whether the President’s speech should pre-empt Ponderosa took up much of the rest of the weekend. What to do after the ninety days were up was never addressed at all. In Britain, a similar hatred for markets and love for government control was also in full force at the same time, such that a cabinet minister actually found himself calling the Vicar of Trumpington warning him not to increase the church fees for burial. These were people who really hated market outcomes.
The turning point can be decisively called on the evening of March 28, 1979. At that moment after five years of strikes that intermittently cut off electrical power, leading one minister to explain in a television interview how best to shave in the dark, the Labor government of James Callahan fell and Margaret Thatcher came to power. The no confidence vote in the House of Commons that night carried by only one vote, and the catering staff had been on strike that day, making us wonder about cause and coincidence.
From that time to this the change in society has been astounding. Electricity, oil, natural gas, interest rates, stock commissions, airline fares, currencies, gold, railroad and truck fares, and much else besides was rigidly fixed in price by laws, and changing those prices on any terms required a regulator’s approval. Many cities had rent control. The country’s biggest business was the telephone monopoly, and so extraordinary was AT&T’s power that the company effectively prohibited the placement of “foreign appliances” on any of its wires. A “foreign appliance” was a phone made by some other company. The internet, the computer, and the cell phone would have all been stillborn had this form of market suppression through regulation continued. We have many times in past letters praised Irwin Jacobs for his brilliant invention of the mobile phone standard that Qualcomm sponsors and that today allows high speed data exchanges on the run and all over the country. It had never occurred to us till now to thank Keith Joseph, Mrs. Thatcher’s mock “Minister of Ideas”, or Judge Harold Greene, or Alfred Kahn, the first deregulator of them all, who knocked down airfares single handedly. So completely is the landscape changed that, though we watched most of it go on within the life span of Levy, Harkins & Co., it still seems as though the ascendancy of markets has always been the case.
The change from government fiat to market outcome has been profoundly beneficial to us. For one thing, it has led to a change in multiples accorded to earnings streams such that we got what growth we deserved, and then a whole lot more as a result of having the wind at our backs. But Yergin and Stanislaw speculate that these sort of secular changes have something like thirty year lifetimes, and there are two things today that have us thinking of windshifts. They are housing and pensions.
The average Joe only comes into contact with the capitalist system twice in his life. Once when he buys a house and again when he collects a pension. The average listener to sports radio doesn’t care at any time about trust funds, inheritance laws, stock-bond portfolio balancing or currency rates. He isn’t going to Europe during the Yankees’ season, and it’s cold there the rest of the time. If you have a job you hate, you think about your pension all the time, for the obvious reason that retired life is much to be preferred to this one. But “Modern Portfolio Theory” does not come into your thoughts, nor any other calculation of value. Average Joe thinks only what his monthly payment from a pension plan will be. And now the capitalists seem poised to play a cruel trick.
According to the Washington Post, over the last four years corporate defaults on pension plan promises have gone from $50 billion to $450 billion. This has happened because, as the New York Times noted, “Under current accounting rules, companies are allowed to report that the investments in their pension funds have earned money, even in years when they did not, and to factor the illusory pension gains into their operating profits. They can also ‘smooth’ pension values by spreading year to year changes over several years.” It is clear enough what the corporate motive is here. According to David Zion at CSFB, if the hypothetical returns and other nonmarket pension values were stripped out of the earnings of America’s 500 largest companies, earnings in 2001 and 2002 would have fallen by 67%.
The Washington Post of June 13 has a heartbreaking story of just what this shabby behavior has led to in practice. Victor Saracini was the United Airlines pilot whose Flight 175 crashed into the second World Trade Tower. His widow Ellen will lose half her pension because United Airlines filed for bankruptcy and turned its pension obligation over to the Federal Guarantee Corporation. The government only pays full benefits to those who retire at age 65. Pilots must retire by law at age 60. Throughout the 1990’s, these employees were given stock in lieu of wage increases, which they were required to hold until retirement. The stock is now worthless. Worse yet for Mrs. Saracini, she already came to a settlement with the September 11th Victim Compensation Fund, which deducted the full value of a pension she will never see. United’s chief executive officer Glen Tilton is being paid his $4.5 million benefit in full, under a different clause of the bankruptcy settlement. We called this behavior “shabby” a few sentences above. When does the public call it criminal?
We pointed out in a letter two years ago that Boeing is the only company we own with a large pension plan that is partially unfunded, and with assumed rates of return that make us nervous. Since we last wrote, Boeing has cut its unfunded obligation almost in half. We continue to own Boeing because it remains the nation’s leading exporter, and we are very concerned to have some hedges against a likely fall in the dollar, and because its competitor, Airbus, has a new plane that is half a million pounds overweight. This means the A380 will not carry as many passengers with as many bags as far as was promised, giving an even greater competitive advantage to Boeing’s existing fleet. However, we are not kidding ourselves about this. If the spreading wildfire of pension defaults is not put out right quick Congress is likely to punish the guilty, the only partially culpable, and every capitalist bystander.
Similarly, the mortgage market has us worried. In the last three years, the number of mortgages taken out that allow the borrower to pay interest only over the first five years has gone from negligible to 30%. We cannot tell a lie; Countrywide has been a leading proponent of this. It makes us uneasy because we are not convinced the majority of buyers and re-financers know what they are getting into. To take an example, not quite at random but we think representative, imagine a couple buying a house for $400,000 and borrowing $300,000. If they get a traditional 30 year mortgage at the current 5 ¾% their monthly payment is $1,750. If they pay only interest that number drops to $1,437, a healthy savings. Until the 61st month, that is, when the payment jumps to $1,887, if rates are not then higher, which we think is a heroic (read foolish) assumption. Are kids starting out really ready for a 31% jump in home payments shortly after they’ve gotten done furnishing the place? Are the middle aged ready for a jump like this while facing a pension future as uncertain as this? This is a problem that will take a long time to come to a boil, and perhaps the change in the yield curve that seems to be lying ahead will take housing off the simmer. But it does not seem stable to us, and we have been seeing some of the country’s leading mortgage holders to ask them about it.
We do not want to close on a pessimistic note because that is not traditionally how you make any money. We are also well aware that America has proven herself exceptional in avoiding pitfalls that seemed directly in her path. These problems are likely to take a long time in gestation and American exceptionalism may prevail again. The businesses in your portfolio are doing well, and the absolute prices of investments have always mattered more to us than any abstract theorizing, including our own. If the mid-year estimates hold true our stocks are likely to earn on aggregate more than 10% better than they did last year. Since their share prices are down a little, this makes them significantly better investments than they were at year-end, when you might remember we were last feeling a little queasy. Yet we do not want to close our eyes to the cavalier way the capitalist class has been treating its own gift horse. Those of us with money have had things go all our own way for 30 solid years. That some of us now want to dupe and beguile is dangerous for us all, and threatening to a marvelous system.
Sincerely yours,
Edwin A. Levy
Michael J. Harkins
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*From “Commanding Heights”, written by Daniel Yergin and Joseph Stanislaw in 1998 and published by Simon & Shuster