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Vol. 29 Smmer Break AuguSt 26, 2011Two Wall Street, New York, New York 10005 www.grantspub.com

(April 24, 1992) In Houston, of-

fice rents are falling again, fully adecade after the Texas energy busi-ness stopped inflating and began de-flating. Rents continue to fall in NewYork, too, and Citibank is reportedlytrying to sell the mortgage it holdson 40 Wall St. at a distress price.The amount that Citi is owed on the70-story building, once a holding ofthe late, great Ferdinand Marcos, is$80 million. The amount that it iswilling to accept in payment, accord-ing to Crains New York Business, is$20 million, or $20 a square foot. Asource of ours relates that the offeredside of the market is, in fact, lower;a spokeswoman for Citicorp declinesto provide a number. If the cost ofrefurbishing the building to attractan institutional clientele is anythinglike $100 million (as Crains reports),the buildings true, economic valuemight well be less than zero. It wouldcertainly be low enough to rattle thedowntown real estate community.

Real estate is an admittedly slowand illiquid asset, but it isnt in everypostwar cycle that tall buildings col-lapse on the heads of the billionaireswho own them. Recently, David Shul-man of Salomon Brothers predictedthat the slump in commercial real es-tate may last, in some regions, untilthe end of the decade and that it willbe 12 years before the national officevacancy rate returns to 5% from about20% today. To equity investors whohave become accustomed to measur-ing bear markets in terms of days,weeks or months, such a thing is al-most beyond imagining.

rents up. In the meantime, my costs

are still going up.. . . What Olympia &York is looking for is a short-term solu-tion. I dont know how that works.

The period selected for this inves-tigation was the last glacial, deflation-ary bear market in New York City realestate, that of the 1930s. We skippedthe 1970s bear market because it wasan inflationary downturn, one thatfeatured rising commodity prices andexpanding bank credit. In the Depres-sion era, occupancy rates and interestrates fell, and chastened lenders hungback from committing new funds. Ithas been a little like that in the 1990s,too. What is most interesting about theEquitable story, however, is what hap-pened in the long succession of disin-flationary years between the allegedreturn of prosperity in 1933 and theU.S. entry into World War II in 1941.The company stumped through theDepression only to seek bankruptcyprotection at a time of relative prosper-ity. For those who like to use the stockmarket as a leading indicator of busi-ness activity, the failure occurred somenine years after the Dow Jones Indus-trial Average made its all-time low.

We are relating this story becauseit helps to convey a sense of therhythm of a deflationary liquida-tion. It is slow motion, like a familyreunion. If past is prologue, lessonsfrom the 1930s may also apply to the1990s (with certain modifications, ofcourse, allowing for the mature wel-fare state, the full paper monetarystandard and the possibility that thefederal government may yet engi-neer a new inflation). For instance,

Precedent is on Shulmans side,

however, and the documentary evi-dence is available at the New YorkPublic Library. One instructive storyis that of the Equitable Building, 120Broadway, a still-magnificent WallStreet skyscraper built in 1914-15.Weve been reading up on the Eq-uitables past to try to reach a clearerunderstanding of the future. What wewant to know is whether the reales-tate-related credit cycle is over or end-ing, or, as Shulman and others suggest,still unfolding. The answer to thatquestion is easy: It is still unfolding.H. Dale Hemmerdinger, a reader andNew York City property owner, con-tends that years of misery lie ahead aslong-term leases are replaced by new,lower-cost leases. Costs are front-endloaded, Hemmerdinger says. Evenif the market turns tomorrow (which itwont), it will take me a long time toget rid of my free rent, of my $30 to$50 work letters, and Ive got to get my

The slowest asset


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construction activity will not makethe hoped-for contribution to thenext business expansion, reales-tate losses will continue to weighon banks and life insurance compa-nies, and the patience of newspaperreaders will be sorely tested. Like

the man who came to dinner, PaulReichmann might move onto thepages of The Wall Street Journal in-definitely. He and his lenders andtheir lawyers may carp and cavil andnegotiate into the next millennium(but to strike a bullish note not into the one after that).

The best reason to study the Equita-ble Building is that the Equitable Of-fice Building Corp. was once an inves-tor-owned company, and its financialhistory is available in Moodys Banks?Finance. The original Equitable

Building burned to the ground in 1912on the same Broadway site, and Cole-man DuPont came up from Delawareto organize a corporation to put up abigger and better successor building.No visitor to 120 Broadway is likely toquibble with managements appraisal(c. 1915) that the building, originallyhousing 1.2 million square feet, isamong the great business structuresof this hemisphere. It was so great,in fact 40 stories rising straight upfrom the building line without a singlesetback that theshadows it cast onlower Manhattan galvanized a politicalmovement to restrict the constructionof anything so overpowering in the fu-ture. The Equitable Life AssuranceSociety of the United States gave Du-Pont a longterm, $20.5 million mort-gage, one of the largest ever writtenup until that time. The interest ratewas 41/2%.

It is impossible to appreciate theEquitable story without a proper re-spect for the buildings gleaming placein the Wall Street skyline. Emphati-cally, and unequivocably, said theoriginal sales brochure, perhaps re-flecting market conditions as well asmanagements sense of decency, wewill not make to one tenant, regardlessof his size or his importance or his de-sirability, any concession which is de-nied to others. The capitalization ofthe Equitable Office Building Corp.was conservative, and the tenants weregrade A. The fact that 41/2% eventu-ally became an unmanageable rate ofinterest is a useful lesson in the relativ-ity of nominal yields and the change-

ableness of rents. What seems low may

later appear high, even oppressive;and, of course, vice versa.

The moral of the Equitable story isthat a decline and fall takes time. Inthe roiled credit markets of 1930 and1931; the Equitable Office BuildingCorp. 5s of 1952 were still quoted inthe low 90s and mid 80s. In the night-mare year of 1931 marked not onlyby a global liquidity crisis but also bya rash of real-estate foreclosures byNew York savings banks and life in-surance companies the companyshowed a profit and comfortably cov-ered its fixed charges; rental incomewas almost $6 million, or $5 a rentablesquare foot. After expenses, depre-ciation and taxes, net earnings totaled$2.4 million. Cash on hand totaled$1.5 million. Altogether, it must haveseemed to the Equitables creditors asif the Depression were happening tosomebody else.

In 1932, rental income dropped byless than 5%, earnings per share by alittle more than 10%. The commondividend was cut to $2.50 a share fromthe old $3 rate, but at least there was adividend. So far, so good.

If the phrase world coming to anend has ever pertained to the resilientAmerican economy, it was descriptivein 1933. Rental incomes plummeted,and 25% of the mortgage investmentsof the major U.S. life insurance com-panies wound up in default. In thatharrowing year, the Equitable OfficeBuilding Corp. was able to earn $1.4million, or $1.54 a share, a testamentto the quality of the tenancy and thelong terms of the leases.

Inevitably, of course, leases came

up for renewal. Some tenants did re-new (others moved out and still oth-ers went bankrupt) and the new leaseswere signed at low, Depression-erarates. In 1933, rentals fell to an aver-age of $4.16 a square foot. In 1934,they averaged $3.66 a square foot.Operating expenses and real-estatetaxes happened to drop in 1934, butthe capital expenditure program wenton. Hoping to save on energy costs the price of oil had vaulted by 71% inthe first year of the Roosevelt recovery management converted the build-ings oil-fired steam generating plantto anthracite coal power. Earnings in1934 just topped the $1 million mark,or $1.25 a share, representing less thanhalf of the 1931 rate. In the summer of1934, the common dividend was omit-ted. It was reinstated at a lower rate in1936: a false harbinger of recovery, itturned out.

The worst of the Depression wasover, but rental income continued tofall as high-cost, 1920s leases were an-nually converted into low-cost, 1930sleases. (For 1920s and 1930s, of course,read 1980s and 1990s, respectively.)By 1936, the buildings rental incomeamounted to just $2.68 a square foot,down by 46% from the levels prevail-ing in 1930. The Equitable Buildingsvacancy rate in the mid 1930s hoveredaround 15%. For perspective, the 1992vacancy rate stands at 15.8%. Count-ing space available for sublease, itwould amount to 20.5%. (We leave itto the real-estate scholars to determinethe underlying cause of the decline ofrents in lower Manhattan in the 1930s.

The lobby of the Equitable Building. If only beauty could be capitalized.


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Was it the still-weak national economyor overbuilding in the boom? Our betis on the first hypothesis. In the 1920s,no self- respecting New York bankmade real-estate loans.)

Periodically, but without great suc-cess, management petitioned the city

for tax relief. The corporation paid$807,533 in real-estate taxes in 1935.It paid $788,800 in 1937 but $846,800in 1939. War broke out in Europe inSeptember 1939, and America be-came a haven for frightened money.It might have seemed to the averageWall Street investment strategist thata rally in rental income was imminent.But the building realized only $2.41 asquare foot, on average, in 1939, andreported a net loss of $14,685, or twocents a share, its first annual deficitof the decade. It just barely covered

fixed charges.The company fell short in 1940, and

again in 1941; management gave up theghost eight months before Pearl Harbor.The [bankruptcy] petition said that, al-though the company would not be ableto meet its current obligations as theyfall due, it has an income and assets suf-ficient to make possible an equitable re-organization, Moodys reported.

The same slow, dream-like pace ofactivity continued during the reorgani-zation proceedings another caution-ary precedent for todays lenders.

Committees were formed, planssubmitted and meetings held. Paul

J. Isaac, the reader who inspired thispiece, tells a story about one suchproceeding. He says that he got theanecdote from his father. An arbitra-geur named Lou Green, of the firmof Stryker & Brown, was questionedby an SEC examiner, Isaac relates.Asked what class of security holderhe represented, Green did not replythe debenture holders, the seniormortgage holder or the preferred.What he said was, the short interestin the common. Wartime prosperitynotwithstanding, the vacancy rate inearly 1942 was almost 14%. On July10, 1942, Federal Judge J.C. Knox ap-proved the purchase of a $16 millionwar and bombardment insurance pol-icy for $16,000 a year. Rents and mar-gins were down: The net loss grew.

As for the Equitable reorganizationproceeding, it was conducted withoutundue haste. Competing plans of re-organization were submitted, and atleast once the U.S. Circuit Court of

Appeals reversed Judge Knox. By thetime the final plan was confirmed, inOctober 1948, fees and allowances tothe trustees and attorneys had piledup to $792,521. In November 1947,the building got a new, 25-year mort-gage from the John Hancock Mutual

Life Insurance Co. In place of theoverbearing 41/2% interest rate was areasonable 3.7% interest rate (whichwould later increase to 33/4%). Thedownward adjustment was just in timefor the start of the long postwar risein interest rates and also, of course, inrental rates. Still, the rent roll in De-cember 1948 had returned only to anaverage of $3.47 a square foot, lowerthan the average for 1934.

Scrolling ahead a half century, to1992, the Equitable Building is ownedand managed by Silverstein Proper-

ties. A fund managed by J.P. MorganInvestment Management holds a par-ticipating mortgage on the property(entitling the creditors to a share of thecash flow). The lobby is still splendid,and the rentable area of the buildingis now put at 1.9 million square feet,an increase of 58% since the 1930s.According to a broker, the reasons forthis miraculous growth relate, first, tothe expandable definition of a squarefoot under New York law and, second,to the general tendency of potato chipbags to hold fewer chips every year.He implied that space inflation wasin the air. As noted, the vacancy rate,not counting available sublease space,is 15%. One big tenant nowadays isthe office of the New York State At-torney General; another is the law firmof Lester Schwab, Katz & Dwyer. Thedefunct Crossland Savings Bank oc-cupies ground-floor space. Brokers saythat deals can be struck at an effectiverent of less than $22 a square foot overa 10-year lease for a 10,000-square-footspace. The number includes a workletter to finance construction and a cer-tain amount of free rent. Neither Mor-gan nor Silverstein would comment onthe economics of the building, but thenumbers can only be bleak and inview of the weakness of rents and thelong-term nature of big-city leases getting bleaker.

At a meeting of the New York RealEstate Board the other day, Larry A.Silverstein, head of Silverstein Prop-erties, explained the real-estate prof-itand-loss dilemma, and the April 15Real Estate Weekly gave this account:

Silverstein said the real problem is thatcommercial rents are so low the dealsare not economically viable for the own-ers. He said operating expenses amount to$7 and $8 per square foot, real estate taxesare running from $7 to $11 per square foot,

tenant work letters are at $5 per square footand $1 is going for leasing expenses. Thisadds up to $21 per square foot before debtservice, he said.

Postwar building debt service averages$25 per square foot so Silverstein said own-ers need to see $46 per square foot just tobreak even. In a $30 market, he said.its hard to see a profit and impossible notto incur a loss. In fact, he added, Thereis no profit and the question is the magni-tude of the loss.

In other words, losses loom indefi-

nitely. If $21 per square foot is the av-erage operating cost of a building be-fore interest expense, its a cinch thatthe owner of the Equitable Build-ing is showing no profit after payingits lenders. Quality projects in theend will become profitable, a vicepresident of Olympia & York Prop-erties (Oregon) assured the PortlandBusiness Journal recently. Its just amatter of time. Based on the historyof the Equitable Building, we wouldamend that claim. In a deflation, evenquality projects will become unprofit-able. Its inevitable.

The future is Italy

(February 12, 1993) Italy is the Ro-man Colosseum of borrowing and thecatacombs of taxation and the AppianWay of compound interest. It has apublic debt that is larger, and moregross, than its gross domestic product.Interest on its public debt amounts tomore than 10% of its GDP. Italy is notthe worlds third largest economy - itis No. 7, according to the InternationalMonetary Fund - but it does have theworlds third-largest government bondmarket. The Italian bond screen, Mer-cato Telematico dei Titoli di Stato,displays 94 issues. Things have cometo such a pretty pass that the Italianwho recently said, The state can nolonger guarantee everything to every-body, was the Socialist prime minis-ter, Giuliano Amato, himself.

Mathematically, the growth of a


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countrys borrowing may not indefi-nitely exceed the growth of a countrysoutput. Yet, for a decade (or more) inItaly it has.

In the United States, the $4 tril-lion gross public debt representsabout two-thirds of the nearly $6 tril-lion GDP. Between 1987 and 1992,the U.S. GDP grew by 5.7% a year,whereas the U.S. public debt grew by11.3% a year. If those rates persisted,the debt would hit the $8 trillion mark,overtaking GDP, in 1999. An Ameri-can may ask of his own country, as wellas of Italy: How much longer?

The lesson of Italy is sobering andhopeful, all at once. It is most hope-ful that Italia is still on the map. Un-less he or she is taxed and regulatedby New York City, is a veteran of theU.S. armed forces, is employed bythe Tennessee Valley Authority orcan remember the Hundred Days of

the Roosevelt administration or themore imperial moments of the GreatSociety, an American may not under-stand the voracity of the Italian state.In Italy, government spending repre-sents 56% of GDP. In America, federalgovernment spending (investment,

in the argot of the Clinton adminis-tration) represents 24% of GDP. Still,in New York and Rome, life goes on.

We turn to Italy because, barringchange, it is Americas fiscal destina-tion, and there are questions to answer:What damage has this vast debt done?Is there such a thing as a point of bud-getary no return? If so, has Italy reachedit? What are the prospects for the Ital-ian stock market and also, not least, fora readers lira- denominated specula-tion, the IMI Bank Internationals 13-year zero- coupon bonds? Finally, whatdoes the Italian dilemma suggest aboutAmericas financial future?

On to the first question: Is a hugepublic debt clearly and unambigu-ously bearish? In the United States,where a rising debt has been accom-panied by falling interest rates and aflyaway stock market, many wouldanswer, No. However, in Italy, we

believe, there is no one who would notanswer, Yes. The greater concern inItaly stems not only from the greatermass of its debt, but also from a morevirulent case of statism. If in Americaentitlements are the root cause ofthe growth of the public debt, in Italywhats to blame is the very structureof things.

In any case, Italian real interest ratesare among the highest in Europe, theMilan stock exchange is stunted in sizeand price and the Italian governmentsown credit rating is not a reproachless

AAA but a diminished Aa3. Italian bor-rowers were virtually barred from thesyndicated European loan market lastsummer when Efim, the state indus-trial holding company, went into liq-uidation. Much to the dismay of thebank creditors, who had assumed thata loan to an arm of the state was a loanto the state itself, the Italian treasurydeclined to pay. Then, in November,the government reconsidered and nowthe Euromarket has begun to accom-modate Italian borrowers again. Andnow Ilva, the Italian states loss-mak-ing steel company, is threatening tobecome Efim2. It is hard to conceiveof such a run of bad luck befalling apurely solvent country.

In public life as well as in business,too much debt can be stifling. Theproof of this maxim is that Italy is nowrunning a taut fiscal policy in a time ofeconomic stagnation. We can be surethat if the Amato government had lirato spend, it would spend them. Then,too, as you will remember, Italy aban-doned the European Rate Mechanismduring last Septembers currency cri-sis; to reenter, which is the govern-ments stated top economic ambition,the public debt must be brought inline with the national income.

But how? As this piece was com-posed in lower Manhattan, we do notpretend to grasp every single nuance.One such imponderable is the resil-ience of the Italian economy, in whichtransactions occur aboveground, un-derground and underworld. Italiansare legendary savers and famous taxevaders. Surely, therefore, the denom-


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inator of the Italian debt-to-GDP ratiomust be chronically understated.

Also under the heading of life goeson, Italy has rolled financial rocksuphill before. Great problems haveelicited audacious, sometimes larce-nous solutions, as in the wake of the

tripling of the public debt between1862 and 1877. Shepard B. Clough, inThe Economic History of ModernItaly, records that the governmentseized and sold Church propertieswhich were not used for religiouspurposes, sold state property (alittle like the RTC), privatized staterailroads and instituted the CorsoForzoso, a declaration that the papermoney of the banks of issue was nolonger convertible into gold. This lastgambit, at least, is unavailable to theAmato government, as all the world

is now on a full paper monetary stan-dard. (By the way, the lira-denomi-nated gold price, shown nearby, mustbe counted a disappointment to thosewho are pinning their principal hopesfor a gold bull market on the fiscal de-terioration of the U.S. Treasury. Un-til last falls lira devaluation, gold, interms of lira, mainly went down.)

Giuseppe Volpi, Benito Mussolinisfinance minister in 1926, met still an-other fiscal crisis by forcing the holdersof five- and seven-year Italian bonds,which the Treasury could no longereasily redeem, to exchange them forlonger-term consolidated 5s at a priceof 87/a. This Littorio loan length-ened the maturity of the public debt,but not without arousing what Cloughdescribes, perhaps with understate-ment, as considerable resentment.

In the Depression, Il Duce cre-ated Istituto Mobilare Italiano (IMI)and Istituto per la Ricostruzione In-dustriale (IRI), a pair of Hoover- andRoosevelt-style public corporationsthat grew and grew, in debt and po-litical influence if not in efficiency,and survive until this very day.America would look more like Italyif the Reconstruction Finance Corp.were still buying preferred stock inU.S. banks, or if the Civilian Con-servation Corps were still plantingtrees. As it is, the Agriculture De-partment brings a little bit of Tus-cany to Washington, D.C.

Statism in Italy is the man whostayed for dinner, and the fiscal crisisis therefore also a political and socialcrisis. Running up debts, the govern-

ment has simultaneously run down thenations capacity to service them.

To turn the tide, the Amato gov-ernment, just seven months old, hasproposed a vigorous privatization cam-paign, the creation of a private pensionsystem and an increase in the retire-

ment age (to 65 from 60 for men and,chivalrously, to 60 from 55 for women).Last summer, the government madehistory by abolishing the scala mobile,the allegedly eternal postwar Italianinstitution for indexing wages to infla-tion. Besides the liras undignified exitfrom the European Rate Mechanism,the autumn also brought labor riots.

An American observer, at least, cantake heart in the relative simplicity ofhis own countrys debt predicament.In the United States, it is Bill Clintonvs. the laws of compound interest. In

Italy, it is Amato vs. the laws of com-pound interest compounded again bythe state enterprise system. In Ameri-ca, there is nothing quite like IRI, noteven the former military- industrialcomplex. In Italy, the something-for-nothing political constituency is large,far-flung and ill- tempered, more soeven than in America.

The first impression gained by aweeks long-distance study of Italianfinance is that reform would be verybullish indeed. Erich Stock, managerof the Italy Fund, tells Grants: Youcan imagine what the U.S. marketwould look like if there were no pen-sion funds. You can imagine whatthe Italian market will look like oncethere are pension funds. The second

impression is that such a great reformhangs by a thread. Thus, a wire-servicedispatch last Friday, only a little morealarming than average:

ROME (Feb. 5) UPI Prime Minister

Giuliano Amatos seven-month-old gov-

ernment defeated a no-confidence motionin the Chamber of Deputies Friday, avert-ing a crisis that his supporters feared couldhave plunged Italy into chaos.

The four parties of Amatos coalitionstuck solidly together to defeat the no-con-fidence motion presented by the formerCommunist Party by 321 votes to 255, witheight abstentions in the 630-seat lowerhouse of Parliament.

If Amato, a 54-year-old Socialist, hadlost the vote he would have had to re-sign his coalition of Christian Democrats,Socialists, Social Democrats and Liber-

als....The government is Italys 51st sinceWorld War II and was put together aftera three-month crisis that followed parlia-mentary elections in April 1992, in whichthe traditional coalition parties sufferedheavy losses.

Not plunging into chaos is good,but not coming close to plunging intochaos would be better. To the holderof Italian debt, it would be infinitelybetter, because the upside of seven-year Italian Certificati di Credito delTesoro is a very finite 11/2%, after the12A% withholding tax. The downside,in political terms, would be a victoryby Achille Occhetto, leader of the for-mer Communist Party, now renamedthe Democratic Party of the Left. It is


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public sector showed a net profit fromprivatizations of some $3.4 billion,about $403 million more than the IMFminimum. In 1991, the economy grewby 8/2%; in 1992, by more than 7%.Why cant Italy do the same?

We mentioned the lira-denominat-

ed, zero-coupon issue of IMI Bank In-ternational. A subscriber, who boughtan odd lot, describes his position: Iown a billion lira [i.e., at current ex-change rates, about $660,500 worth].I dont get them now. I get them in2006. To be exact, on June 13, 2006.Compare and contrast with a zero-cou-pon U.S. Treasury issue of the samematurity, he suggests. The Americanissue is priced at 40 cents on the dollarto yield 7.2%. The lira issue is pricedat 20 cents on the dollar to yield 12.9%.The lira exchange rate would have to

go to 3,000 from last Tuesdays 1,500or so before the Treasury issue wouldoutperform the IMI issue, other thingsbeing the same. Other things may notbe the same, of course, because IMIBank International is under review fora possible downgrade by Moodys (ithas been on watch since November).It is rated Aa3. The Treasury is notwithout risk, as the Clinton admin-istration may be demonstrating rightnow, but it is backed by the Bureau ofEngraving and Printing and the Inter-nal Revenue Service and the FederalReserve Board.

Every time I shave, our readercontinues, I make a point of saying,

`Were not going to pay it back. Heis referring to the U.S. public debt.The lira is just another paper emis-sion of another social democracy, headmits, but capital invested in lira iscompounding more briskly than capi-tal invested in dollars.

For our part, we would prefer Italianstocks to Italian bonds if we could onlysee through the brick wall of Italianpolitics. If Amato is going to succeed,the Milan market is going to excel, be-cause the success of the governmentmust imply the overhaul of the pen-sion system and the privatization ofstate assets. According to Stock, theItalian market as a whole is valued at19.7 times 1993 earnings. Excludingthe richly priced insurance companies,however, it is valued at 15.5 times1993 earnings.

Amato may or may not succeed, buthe is fighting the good fight, and theItalian bourse is down by more than

a matter of guesswork. The table con-tains some projections for the next fiveand 10 years, based on the palpably

unrealistic assumption that noth-ing changes. In 10 years time, as youcan see, the U.S. debt would be biggerthan Italys is today, as a measure of

GDP, although the burden of servic-ing it would be far lighter. Italy wouldbe still deeper in the hole, but who isto say that 149% on the debt-to-GDPscale would spell oblivion? Certainly,though, it would not be bullish.

If there is hope, we think, it is thatthe Socialist Amato is able to followthe liberalizing example of the Argen-tine president, Carlos Menem. In the1930s, Mussolini inspired the Argen-tine dictator Juan Domingo PerOn,Evitas husband, with his feats of statesocialism. Later on, PerOn inspired

Menem. It is only fair that now, in roll-ing back the state, Menem should in-spire Amato.

Coming into power, notes Caro-lina Guevara-Lightcap of this staff,who was born and raised in Argen-tina, Menem made the capitalists de-spair. On taking office, however, hethrew over the unions, embraced therhetoric of enterprise and surroundedhimself with right-of-center advisers.The results surprised everybody,she says, and many cried treason, butArgentina started on its way to recov-ery. Through November last year, the

were, and remain, the highest inEurope). To reduce reserve require-ments is traditionally one of the mostbullish things a central bank can dofor equities.

Traditionally, an Italian ana-lyst said last week, investors have

preferred short-term bonds, becausewith long-term bonds there was littlechance that the government wouldhave the money to pay the yieldswhen they came due. Now BTPbonds are favored; they are five- or10- year bonds. The government islooking to lengthen the maturity ofthe bonds because its finding it moreand more difficult to refinance theshort- term bonds.

The average length of the UnitedStates public debt is five years, 11months, and falling. The average

length of the Italian public debt isabout three years, down from aboutfour years as recently as 1987, but upfrom the bill-length maturities that thetreasury was forced to issue in the badold inflationary days of 1975.

In highly leveraged backward coun-tries, debts are rescheduled. As Italyis a highly leveraged industrializedcountry, however, its debts must berefunded. The question is: Can itrefund them?

Barring a change in the rate ofgrowth in borrowing, the governmentmust inevitably fail, although when is


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40% from its 1986 high. PresidentClinton may or may not succeed, buthe seems to be fighting the wrongfight, and the American equities mar-kets stand at new highs. As Amato hasdemolished the scala mobile, Clintonhas hinted at raising the minimum

wage. Italy may yet show us that thereis no such thing as a fiscal point of noreturn, and America may prove that toomuch public debt is not in fact a stand-ing bull argument for financial assets.A benevolent observer will purchase arooting interest in the Italy Fund andremember Amato in his prayers.

Emulate Henry Singleton

(February 24, 2003) Something went

haywire with American capitalism inthe 1990s, and we think we know whatit was. There werent enough HenryE. Singletons to go around. In truth,there was only one Singleton, and hedied in 1999. He could read a book aday and play chess blindfolded. Hemade pioneering contributions to thedevelopment of inertial navigationsystems. He habitually bought low andsold high. The study of such a proteanthinker and doer is always worthwhile.Especially is it valuable today, a timewhen the phrase great capitalist hasalmost become an oxymoron.

Singleton, longtime chief executiveof Teledyne Inc., was one of the great-est of modern American capitalists.Warren Buffett, quoted in John TrainsThe Money Masters, published in1980, virtually crowned him king. Buf-fett, Train reported, considers thatHenry Singleton of Teledyne has thebest operating and capital deploymentrecord in American business.

A recent conversation with LeonCooperman, the former GoldmanSachs partner turned portfolio man-ager (hes the managing generalpartner of Omega Partners), was thegenesis of this essay. It happened inthis fashion: Cooperman was flayinga certain corporate management forhaving repurchased its shares at ahigh price only to reissue new sharesat a low price. He said that this wasexactly the kind of thing that Single-ton never did, and he lamented howlittle is known today of Singletonsachievements as a capital deployer,value appraiser and P/E-multiple ar-

bitrageur. Then he reached in his fileand produced a reprint of a critical Business Week cover story on Tele-dyne. Among the alleged missteps forwhich Singleton was attacked was hisheavy purchase of common stocks.The cover date was May 31, 1982, 10

weeks before the blastoff of the inter-galactic bull market.

The wonder of Singletons life andworks is the subject under consider-ationadmittedly, a biographical sub-

ject, as opposed to a market-movingone. We chose it because Singletonsgenius encompassed the ability to makelemonade out of lemons, a skill espe-cially valuable now that lemons are sothick underfoot.

Singleton was born in 1916 on asmall farm in Haslet, Texas. He beganhis college education at the U.S. Na-

val Academy but finished it at M.I.T.,earning three degrees in electrical en-gineering: bachelors and masters de-grees in 1940, and a doctorate in 1950.In 1939, he won the William LowellPutnam Intercollegiate MathematicsCompetition Award. In World War II,he served in the Office of StrategicServices. At Litton Industries, in theearly 1950s, he began his fast climbup the corporate ladder: by 1957, hewas a divisional director of engineer-ing. In 1960, with George Kozmetsky,he founded Teledyne.

Anyone who was not reading TheWall Street Journal in the 1960s and1970s missed the most instructivephase of Singletons career. When the

Teledyne share price was flying, as itwas in the 1960s, the master used itas a currency with which to make ac-quisitions. He made about 130. Manymanagements have performed thistrick; Singleton, however, had anoth-er: When the cycle turned and Tele-

dyne shares were sinking, he repur-chased them. Between 1972 and 1984,he tendered eight times, reducingthe share count (from high to low) bysome 90%. Many managements havesubsequently performed the share-repurchase trick, too, but few havematched the Singleton record, eitherin terms of market timing or fair play.Singleton repurchased stock when theprice was down, not when it was up(in the 1990s, such icons as GE, IBM,AOL Time Warner, Cendant and, ofcourse, Tyco, paid upand up). He

took no options awards, according toCooperman, and he sold not one ofhis own shares. Most pertinently tothe current discussion of corporategovernance, he didnt sell when thecompany was buying (another popularform of managerial self-enrichment inthe 1990s).

The press called him enigmaticbecause he pursued policies that, untilthe mists of the market lifted, appearedinexplicable. For example, at the endof the titanic 1968-74 bear market, heidentified bonds as the high-risk as-set and stocks as the low-risk asset.Accordingly, he directed the Teledyneinsurance companies to avoid the for-mer and accumulate the latter. To most

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12/851/841/821/801/781/761/741/721/70

Repurchasing at the lowspoints on the S&P 500 Index at which Henry Singleton

bought Teledyne stock

source: The Bloomberg, Leon Cooperman

Sept. 72

May 74

Dec. 74

Dec. 73

April 75

Feb. 76

May 80

May 84


10/26


people, stocks were riskier, the proof ofwhich was the havoc they had wreakedon their unlucky holders during thelong liquidation.

Some were vexed that, for years onend, Teledyne paid no dividend. Themaster reasoned that the marginal dol-

lar of corporate cash was more produc-tive on the companys books than in theshareholders pockets, and he was sure-ly correct in that judgment. Teledynesstable of companies (many in defense-related lines, others in specialty metals,offshore drilling, insurance and finance,electronics and consumer products, in-cluding Water-Pik) generated consis-tently high margins and high returns onequity and on assets.

Singleton made his mistakes, andTeledynes portfolio companies madetheirs. A catalog of some of these er-

rors, as well as not a few triumphsmisclassified as errors, appeared inthe Business Week story. We lingerover this 21-year-old piece of journal-ism because it illustrates an eternaltruth of markets, especially of marketsstretched to extreme valuations. Thetruth is that, at such cyclical junctures,doing the wrong thing looks like theright thing, and vice versa. In thespring of 1982, few business strategiesappeared more wrongheaded to themajority of onlookers than buying theears off the stock market.

On the BW cover, the handsomeSingleton was portrayed as Icarus ina business suit, flying on frail wingsof share certificates and dollar bills.The article conceded that the mas-ter had done a pretty fair job forthe shareholders, and it acknowl-edged that the share repurchaseshad worked out satisfactorilytodate. They had, in fact, boosted per-share earnings and also enabledSingleton, who held on to his ownTeledyne shares, to amass 7.8% ofthe companys stock. He was thecompanys largest shareholder andits founding and indispensable brain.

Yet the magazine was not quite sat-isfied, for it perceived that Singletonhad lost his way. For starters, it accusedhim of having no business plan. And heseemed not to have one. He believed,as he later explained at a Teledyne an-nual meeting, in engaging an uncertainworld with a flexible mind: I know alot of people have very strong and defi-nite plans that theyve worked out onall kinds of things, but were subject

to a tremendous number of outside in-fluences and the vast majority of themcannot be predicted. So my idea is tostay flexible. To the BW reporter heexplained himself more simply: Myonly plan is to keep coming to work ev-ery day and I like to steer the boat

each day rather than plan ahead wayinto the future.

This improvisational grand designthe magazine saw as the milking oftried-and-true operating businessesand the diverting of funds to allow thechairman to play the stock market.A BW reader could imagine Single-ton as a kind of Nero watching Romeburn while talking on the phone withhis broker. He didnt invest in busi-nesses, the magazine suggested, onlyin pieces of paper. He either managedtoo little (as with the supposedly aging

and outmoded operating companies)or too much (as with the insurancebusinesses, where, according to BW,he managed to no great effect). His re-serve was icy.

Singletons disdain forthe press wascomplete and thoroughgoing: The BWarticle just rolled off his back. It puzzledhim that his friend Cooperman wouldbother to draft a nine-page rebuttal,complete with statistical exhibits. Whygo to the trouble? Cooperman, who hasfire where Singleton had ice, wantedthe magazine to know that, during theacquisitive 1960s, Teledynes sales andnet income had climbed to about $1.3billion and $58.1 million, respectively,from essentially zero, and that duringthe non-acquisitive 1970s, profit growthhad actually accelerated (with net in-come of the 100%-owned operatingbusinesses rising sixfold).

As for those share repurchases,Cooperman underscored an achieve-ment that appears even more laudablefrom the post-bubble perspective thanit did at the time. Just as Dr. Single-ton recognized [that] he had an un-usually attractive stock to trade within the 1960s, wrote Cooperman, hedeveloped the belief that the com-panys shares were undervalued in the1970s. In the period 1971-1980, youcorrectly point out that the companyrepurchased approximately 75% of itsshares. What you did not point out isthat despite the stocks 32% drop fromits all-time high reached in mid-1981to the time of your article, the stockprice remains well above the highestprice paid by the company (and mul-

tiples above the average price paid)in this ten-year period. And whatCooperman did not point out was thatnone of these repurchases was ear-marked for the mopping up of sharesissued to management. He did notpoint that out, probably, because the

infamous abuses of options issuancestill lay in the future.

Business Week, however, was rightwhen it observed that nothing lasts for-ever and that Singleton couldnt man-age indefinitely. In 1989, he formallyrelinquished operating control of thecompany he founded (and, by then,owned 13.2% of). Even then it wasobvious that the 1990s were not goingto be Teledynes decade. Appendedto The Wall Street Journals report onSingletons withdrawal from opera-tions was this disapproving note: The

company hasnt said in the past what itplans to do. It doesnt address analystgroups or grant many interviews. Tele-dynes news releases and stockholderreports are models of brevity. Some se-curities analysts have given up follow-ing the company because they cantget enough information. Imaginationcannot conjure a picture of Singletonon CNBC.

The dismantling of Teledyne be-gan in 1990 with the spin-off of theUnitrin insurance unit (later camethe sale of Argonaut, another insur-ance subsidiary). Singleton resignedthe chairmanship in 1991, at the ageof 74. Presently, the financial resultsslipped, the defense businesses wereenveloped in scandal and Teledyneitself was stalked as a takeover candi-date. Surveying the troubles that camecrowding in on the company after themasters departure (andunhappilyfor the defense industryafter the fallof the Berlin Wall), Forbes magazineremarked: For many years HenrySingleton disproved the argument thatconglomerates dont work. But it turnsout Teledyne was more of a tribute toSingleton than to the concept.

In retirement, Singleton raised cattleand became one of the countrys big-gest landowners. He played tournamentchess. Most recently, according to atribute published shortly after his death(of brain cancer, at age 82), he devotedmuch time to computers, programmingalgorithms and creating a fine computergame of backgammon. . . .

To those not attuned to the nuancesof corporate finance, Singletons contri-


11/26


bution appeared mainly to concern thetechnique of share repurchases. Thus(as an obituary in the Los Angeles Timeshad it), Teledyne was the forerunnerto the white-hot growth stocks of theClinton bubble, including Tyco Inter-

national and Cendant. Singleton knewbetter. To Cooperman, just before hedied, the old conglomerateur confidedhis apprehension. Too many companieswere doing these stock buybacks, hesaid. There must be something wrongwith them.

There ought to be deflation

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The world is a cornucopia. Thanksto the infernal machine of Americandebt finance, the Internet and theeconomic emergence of China and In-dia, among other millennial economicforces, goods are superabundant. Moreand more services, too, are globallytraded, therefore cheaper than theywould be in the absence of interna-tional competition. Yet the measuredrate of inflation in the United States ispositive, not negative, as it was in somany prior eras of free trade and tech-nological progress. Following is a med-itation on the meaning of this fact andsome thoughts on what to do about it.

From George Washington until theA-bomb, prices alternately rose andfell. They rose in wartime and fell inpeacetime. As Alan Greenspan himselfhas pointed out, the American pricelevel registered little net change be-tween 1800 and 1929. Four years afterthe Crash, the Roosevelt administra-tion put the gold standard, or what wasleft of it, out of its misery. In 1946, theTruman administration passed an act tomandate full employment. In effect, in-flation became the law of the land. Inthe two decades following the aban-donment of the gold standard in 1933,Greenspan noted not long ago, theconsumer price index in the United

States nearly doubled. And, in the fourdecades after that, prices quintupled.Monetary policy, unleashed from theconstraint of gold convertibility, hadallowed a persistent overissuance ofmoney. That is, Greenspan added,

until now.The chairman was holding forth in

December 2002, a time whenso hiscolleagues and he insistedthe U.S.confronted a meaningful risk of fall-ing prices. To forestall this supposedcrisis, the Fed pushed down the fundsrate to a 46-year low. The object ofthis policy was to restore the famil-iar postwar lift to the American pricelevel. Oddly, the public registered noprotest, though, as consumers, Ameri-cans love a bargain. Economists haddrummed it into their heads that fall-

ing prices were bad for growth, bad foremployment, bad for debtors and, notleast, bad for the way the Fed conductsmonetary policy. Let the central bankguide the price level gently higher, thecall went out.

Which, by appearances, the central

bank has done. Supposedly, the greatGreenspan has implemented a perfectmeasure of monetary stimulus. He hasaverted deflation while steering clearof what the bond market might regardas a worrying rate of inflation.

At least, so say the members of the

loosely organized Greenspan for MountRushmore Committee. Grants has analternative view, which requires a shortdefinitional preface. What inflation isnot, we believe, is too many dollarschasing too few goods. Pure and sim-ple, it is too many dollars. What the re-dundant dollars chase is unpredictable.In recent months, they have chasedstocks, commodities, euros, junk bonds,emerging-market debt and houses. OnWall Street, such inflationary episodestake the name bull markets. Theyare always welcome. When, on the other

hand, the surplus dollars chase skirts(or sweaters or automobiles or medicalcare), that phenomenon is called infla-tion. It is usually unwelcome.

Deflation is not quite the oppositeof inflation. We would define defla-tion as too few dollars chasing too

3/043/023/003/983/963/943/923/903/883/86

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3/043/023/003/983/963/943/923/903/883/86

Inflation: measured and not

OFHEOs repeat-observation house price index,year-over-year change

in core personal consumption expenditures deflator,year-over-year change

core personal consumption expenditures deflator,year-over-year change

source: The Bloomberg

housepriceinde

xh

ousepriceindex

PCEd

eflator

PCEdeflator

Sept. 30, 2004:13%

Sept. 30, 2004:1.6%

Sept. 30, 2004:13%

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14%

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14%

Sept. 30, 2004:1.6%


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much debt. Dollars extinguish debt;too few dollars in relation to the stockof debt is the precondition for what,these days, is euphemistically called acredit event. A second-order effectof a credit event is falling prices. Pric-es fall because, in a big enough credit

event, business activity stops cold. Inthe absence of liquid markets, cash isking. But we would not throw aroundthe term deflation to describe ev-ery episode of weak or falling prices.If prices fall because the global supplycurve has shifted downward and to theright, we would call that circumstancefalling prices. Deflation, to us,means debt deflation.

Pending the worldwide acceptanceof these ideas (which we have bor-rowed from economists long dead),we will accommodate our views to

the worlds. This means we will notpedantically enclose the convention-ally employed words inflation and de-flation with quotation marks. But theworld is doing itself no favors by sonarrowly defining inflation and by socarelessly crying deflation.

The Fed is, of course, a prime per-petrator of sloppy thought, loath toacknowledge that inflation is any-thing other than an unacceptable rateof rise in its favored inflation index.This index is the personal consump-tion expenditure deflator, excludingsuch minor and discretionary itemsas food and energy. It is not that theMaestro has refused to acknowledgethat the worlds cup of goods and ser-vices runneth over. In so many words,he has conceded that the global supplycurve has shifted in the direction ofplenty. But, as far as we know, he hasnot followed this observation where itlogically leads. If everything else wereleft the same, the measured inflationrate might, by now, be negative. Weemphasize might, as the cornucopiaeffect of greater, and cheaper, globalsupply is offset to a degree by the de-preciating dollar exchange rate. How-ever, we are certain that, except forheavy Fed intervention, the measuredrate of inflation would be lower than itis now. So, too, the unmeasured rateof inflation, by which we mean houseprices, credit spreads and other suchmarkers of asset valuation.

We are prepared to wager that theMaestro knows more than he lets onabout the true nature of inflation anddeflation and about the tendency of

the U.S. price level to subside in aworld so generously supplied as thisone. And we are equally prepared towager that he has some appreciationof how highly leveraged are Americanfamilies and businesses. In relation toincome, the stock of debt has been ris-ing for decades. If the price level re-versed course and declined, uncountednet debtors would struggle to stay sol-vent. Falling prices, even if they werenot caused by a credit event, could eas-ily provoke one (in which, for example,trillion-dollar government-sponsoredenterprises just might have to call intheir chits to the Treasury).

Small wonder, then, that everythinghas not been left the same. The Fed,warning about the dire consequences ofthe zero bound (by which it means afederal funds rate stuck at zero percent)and invoking the specter of Japanesestagnation, or worse, assumed a radical-ly easy monetary stance in 2001. It hastaken five tightening moves to bring thefunds rate back to 21/4%, at which pointit is still 75 basis points lower than whatpassed for an ultra-low funds rate duringthe 1992-93 easing cycle. The late Dan-iel Patrick Moynihan spoke of defin-ing deviancy down. The Fed has beenredefining accommodation down. It hasbeen pushing low interest rates lowerand lower.

The interest-rate stimulus admin-istered by the Fed in 2001-03 show-ered wealth on the homeowners whorefinanced their mortgages not oncebut over and over, extracting equity as

they went. But as interest rates havestopped falling, the shower is over.So it goes with monetary palliatives.Friedrich von Hayek, winner of theNobel Prize in economics, touched onthe risks of credit creation in a speechas he accepted the prize 20 yearsago. Beware the nostrum of printingmoney to boost aggregate demand, hewarned. Such a policy is, of course, in-flationary, but the problem goes deep-er than that. Money printing distortsprices and wages, the traffic signalsof a market economy. Responding tothe wrong signalsspending on redand saving on greenpeople take thewrong jobs and capital flows into thewrong channels. All were misled bythe wrong prices, or, in the past coupleof years, by the wrong interest rates.

Said Hayek: The continuous injec-tion of additional amounts of money atpoints of the economic system whereit creates a temporary demand whichmust cease when the increase of mon-ey stops or slows down, together withthe expectation of a continuing rise inprices, draws labor and other resourcesinto employments which can last onlyso long as the increase of the quan-tity of money continues at the samerateor perhaps even only so long as itcontinues to accelerate at a given rate.What this policy has produced is not somuch a level of employment that couldnot have been brought about in otherways, as a distribution of employmentwhich cannot be indefinitely main-tained and which after some time can

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3Q041Q041Q031Q021Q011Q001Q99

Borrowing trouble?

growth in household debt vs. growth in disposable income,measured year-over-year

source: Federal Reserve Board

growthrate

growthrate

household debt,9.7%

disposable income,2.1%

household debt,9.7%

disposable income,2.1%


13/26


be maintained only by a rate of infla-tion which would rapidly lead to a dis-organization of all economic activity.

Hayek spoke of injecting money atpoints of the economic system, and itis in these favored niches that prosper-ity temporarily smiles (until the money

printing or the interest-rate slashingcomes to a stop and throws the processinto reverse). To an investor, still more toa speculator, temporarily is the magicword. Could the Nobel laureate not bea little more specific? We must try tofill in the blanks ourselves. One notes,for example, reading the January 5 Wall Street Journal, that With Market Hot,More People Now Have Third Homes.Rising interest rates must sooner or latercause the marginal third-home ownerto become a two-home, or a one-homeor even a no-home owner. One would

suppose that a similar chain reaction isgoing to take place in other highly lever-aged sectors of the U.S. economy. Whichmight they be? The FOMC itself, ina much-quoted passage in the just-released minutes of the December 14meeting, serves up a helpful list. Someparticipants, the text relates, believedthat the prolonged period of policy ac-commodation had generated a signifi-cant degree of liquidity that might becontributing to signs of potentially exces-

sive risk-taking in financial markets evi-denced by quite narrow credit spreads,a pickup in initial public offerings, anupturn in mergers-and-acquisition activ-ity and anecdotal reports that speculativedemands were becoming apparent inthe markets for single-family homes and

condominiums.In a provocative letter to the edi-

tor of the Financial Times last week-end, Ann E. Berg, a former director ofthe Chicago Board of Trade, offereda Hayekian coda to the discussion ofthe U.S. trade deficit. To correct thehuge and growing gap between whatthis country consumes and what it pro-duces, the market has focused almostentirely on the dollar exchange rate. Ihave yet to see a single analyst suggestthe trade imbalance could be solvedby a general contraction of consumer

creditsomething that would surelycorrect the import/export imbalance,Berg writes. For 25 years, U.S. con-sumers have enjoyed increasingly easycredit due primarily to a declining in-terest rate environment.

But, as Berg goes on, in additionto falling interest rates, the Americanshopper has gained from the growthand resourcefulness of Wall Street inprocessing, packaging and distributingdebt. The advent of futures and op-

tions, of swaps and securitizations hasfacilitated American borrowing andlined consumer pockets with severalhundred billion dollars over the pastfew years, particularly with the turn-ing of unsecured credit card debt intoasset-backed security agreements

(home equity loans). Convenientlyfor the United States, the emergingeconomies are better at producing andsaving than at banking and consuming.Rising U.S. interest rates will likelyslow the pace of borrowing, thereforeof consumption in this country. How-ever, as Berg notes, for the time be-ing, consumer debt continues to risefaster than consumer incomes. And itis this fact that will cause some credi-tors to demand higher risk premiumsdue to the greater default probabili-ties of borrowers. Anecdotal evidence

suggests that some credit card issuersare demanding significant increasesin monthly minimum payments. Fur-ther dollar depreciation helping spurexport growth is therefore only onesolution to the current account defi-cit. A tighter credit environment forc-ing a leaner consumer might provean equally likely resolution, howeverunwelcome. However un-American.

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Snoopy deploys capital

(April 8, 2005) MetLife, once upona time known as the Metropolitan LifeInsurance Co., sold its self-branded,58-story New York City office tow-

er last week (the one that starred inGodzilla) for $1.7 billion. On $83million in projected annual net oper-ating income, thats a 4.9% yield, orcap rate, a remarkably low numbereven for this sky-scraping real estatemarket. It is, in fact, just remarkableenough to inspire a meditation on therisks presented by low interest ratesand rampant overvaluation.

Question: How does one investin an era of low rates? Answer: Oneinvests poorly, because the availableinvestment options are themselves

often impoverished. MetLife, thenations soon-to-be No. 1 life insur-ance company (pending completionof its acquisition of the Travelers),has survived each and every interest-rate cycle of the past 137 years. Justhow remarkable is this achievementbecomes apparent when one consid-ers that every investor is a prisonerof the times in which he lives. Yieldsare what they are. Valuations arewhat they are. And, belief systemsare what they are. A half-centuryago, the Met earned rates of returnthat, adjusted for inflation, taxes andexpenses, could not have been muchgreater than zero. Seeking safetysecurity of principalit boughtbonds yielding 3% or 4%, while dis-daining equities yielding more thanbonds. It accepted uncritically theultra-conservative 1950s invest-ment-belief system.

Looking back on 2005 from theperspective of 2055, what will pos-terity say about us? Will it shake itsknow-it-all head over our own errorsand omissions? Of course it will. Atthe top of the list of millennial short-comings will be: uncritical acceptanceof an ultra-progressive and optimis-tic investment-belief system (e.g.,stocks excel in the long run, becausethey always have excelled in the longrun) and the headlong purchase oflow-yielding bonds denominated inthe leading unstable currencies. Pos-terity wont believe that we didntsee the breakdown of the post-1971monetary system as it was unfoldingbefore our eyes, or that we imputed

to the Federal Open Market Com-mittee powers of judgment and pre-knowledge given to no mortal human.What were they thinking about?one member of posterity will sadlyremark to another.

MetLife has been selling real es-

tate to finance its recent $11.5 billionpurchase of Citigroups insurance as-sets (besides the MetLife building at42nd Street, it sold its former NewYork City headquarters at 1 MadisonAve.). The Citi businesses, valued at1.54 times book and 12.8 times 2004earnings, did not come dirt cheap,except in comparison to the valua-tion of the buildings. The companyis capitalizing on a Manhattan marketwhere top office buildings now sellfor more than $700 a square foot af-ter rarely touching $500 before 2002.

. . , Bloomberg News noted. Thinkabout it, Rob Speyer, a managing di-rector of Tischman Speyer, one of thebuyers of the MetLife Building, toldThe New York Times. Its the opportu-nity of a lifetime. To buy one of NewYork Citys iconic properties is an op-portunity we just leapt at.

Today, at a 4.9% cap rate, onecould buy an iconic building or somenot-quite-iconic bonds. Which wouldyou prefer? Bonds have no windowsto wash, walls to paint, carpets tovacuum, tenants to litigate with orgovernments to pay property taxesto. On the other hand, the buildingwouldnt be subject to early call ifinterest rates fell. Then, again, eachstream of incomerentals and cou-pon paymentsis denominated indollars, of which the world is verylong. And if interest rates, and/or theinflation rate, were to climb? De-

pending on the timing of lease expi-rations, the buildings new manage-ment could raise rents. Bondholderscould reinvest their coupon income athigher and higher yields. And in theabsence of an adverse credit event,they would receive 100 cents on the

dollar (whatever a dollar happenedto be) at maturity.

But neither the building nor thebonds provide the margin of safetythat value-seeking investors demand.On the contrary, both asset classescommand some of the fanciest valu-ations in memory. Only last year,MetLifes real estate and real estate

joint ventures yielded 11.6%, or morethan twice the cap rate to which thebuyers of the MetLife Building saidI do last week. Does overvaluationalone assure a disappointing total re-

turn? Emphatically, yes. We consignour judgment in confidence to theGrants time capsule.

It is easier to sift through the pastthan to speculate about the futureeasier and often more remunerative.Economic cycles wax and wane.Ditto, skirt lengths, necktie widthsand geopolitical alignments. But lownominal interest rates present thesame basic investment challenge toa deployer of capital whether thepresident be Dwight D. Eisenhoweror George W. Bush. Famously, com-pound interest is the eighth wonderof the world, but some rates of inter-est are more wondrous than others.Invest $100 at 4% a year for 50 years,compounded twice a year, and youwind up with $724.46. Invest $100 at8% for 50 years, compounded in thesame fashion, and you get $5,050.49.To borrow from Sophie Tucker

MetLifethe more things change. . .(invesment portfolio, in $ millions)

1955 2004

percent percent

total of portfolio total of portfolioGovernment bonds $1,766 12.7% $ 30,310 12.7%Corporate bonds 7,298 52.4 101,853 42.6Equities 156 1.1 5,114 2.1Mortgages 3,170 22.8 77,006 32.2(includes MBS)

Real estate 518 3.7 4,329 1.8Other assets 1,026 7.4 20,677 8.6

Total $13,934 100% $239,289 100%


15/26


(1884-1966), the Met has investedat high interest rates, and it has in-vested at low interest rates, and highinterest rates are better. High realinterest rates are especially better.Low rates are undesirable not onlyfor what they fail to deliver in invest-ment return, but also for the tempta-tions they present to prudent peopleto invest imprudently.

The financial hand dealt to theparents and grandparents of present-day Grants readers featured (besidesmidget bond yields) high marginaltax rates, cheap equities, unlever-aged capital structures, regimentedinvestment markets and deep-rootedinsecurity. Many Americans fearedthe resumption of the Great Depres-sion or the onset of World War III, orboth. Rare is the individual who canimagine a different set of circum-stances than those that surround him.Rarer still is the organization that canimagine them. Imagination is not agift usually associated with bureau-cracies, wrote the 9/11 Commission.Insight for the future is . . . not easyto apply in practice, the commissionalso noted. It is hardest to mounta major effort while a problem stillseems minor. Once the danger hasfully materialized, evident to all, mo-bilizing action is easierbut it thenmay be too late. Here, though thecommission believed it was discussingnational security, it could have beenruminating on the art of investing.

Constant readers know that inter-est-rate markets are long-trendingmarkets; complete cycles, low ratesto high rates back to low rates again,can span a generation or more. Accord-ing to Sidney Homers A History ofInterest Rates, a bull bond marketbegan in 1920, with corporate yieldsat 5 1/4%, and ended in 1946, with cor-porate yields at 2 1/2%. The ensuingbear market got off to a slow start. In-deed, so measured was the rise in rates(which were still under the thumb ofthe Fed and Treasury) that hardlyanyone noticed the change in trend.Yields stayed low into the early 1960s.Who expected that this greatest ofbond bear markets would culminatein a great inflation and, in 1981, a 15%long Treasury yield? Not the invest-ment committee of the MetropolitanLife Insurance Co.

As ever, the Met addressed itspolicyholders in the 1955 annual re-port, the prime consideration of theCompanys investment policy is safetyof principal, combined with a reason-able return, and consideration of re-gional and national interests. Whatpassed for reasonable in 1955 was3.48% before tax. Last year, the port-folio achieved 6.53% pretax.

In 1955, the Met was a mutualcompany, meaning the policyholdersowned it, even if they couldnt con-trol it. It had $13.9 billion in assets,by which measure it was the biggestcompany in America (not just the

biggest insurance company, but thebiggest of any kind). It insured 38.3million people, one person in five inthe 48 states and Canada, and it em-ployed 50,000. It had no mandate tomaximize earnings, or, for that mat-ter, anything else. Rather, it sought

to protect principal and contributeto the national economic agenda: de-fense in wartime; prosperity in peace-time. Compare the mandate of thede-mutualized, profit-maximizing,capital-markets savvy MetLife of2005: The companys primary in-vestment objective is to optimize, netof income taxes, risk-adjusted invest-ment income and risk-adjusted totalreturn while ensuring that assets andliabilities are managed on a cash flowand duration basis.

Todays MetLife, a holding com-

pany, deploys billions of dollars incorporate assets to build sharehold-er value; as it acquires the TravelersInsurance Co., it sells Manhattan realestate. It insures 46 million peopleworldwide and employs 54,000. In1955, the Mets surplus amounted to6.4% of its total liabilities; in 2004,the MetLife insurance subsidiaryhad surplus in the amount of 3.7%of total liabilities. We know thatpeople across the globe are under-insured, under-saved and, in thecase of the baby-boom generation,in need of retirement solutions thatwill guarantee income, declaresmanagement in the new, approvedlanguage of globalization. The Metof yesteryear was in business to servethe policyholders and the country(and, of course, its own officers andemployees), not a self-selected coreof stockholders. Even if the Eisen-hower-era company had decided tochange its methodology of allocat-ing capital to its business segmentsfrom Risk-Based Capital (RBC) toEconomic Capital, as the contempo-rary Met just did, management prob-ably wouldnt have felt the need todisclose the fact in the annual report.The millennial MetLife, with its bat-talions of quants, CFAs and MBAs,not only hedges its interest-rate andcurrency risk with derivatives, andspices its bond portfolio with junk,but also discloses these facts in thestandard regulatory format.

But despite these epochal chang-es, asset allocation today is little dif-ferent than it was in 1955. Now as

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life expectancy for Americans

source: Centers for Disease Control

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then, the emphasis is on corporatebonds, an asset class subject to earlycall, event risk and credit risk. Cor-porates constitute 43% of the invest-ment portfolio, as compared to 52%in 1955. Mortgages and mortgage-backed securities make up 32% of

the portfolio, as opposed to 22.8%in 1955. Today, as in 1955, govern-ment securities account for exactly12.7% of the portfolio. Now as then,equities figure only marginally inthe asset mix. Ditto, real estate. Andnow, as then, alternative assetstimber, hedge funds, convertible-bond arbitrage, etc.seem to figurehardly at all. The millennial MetLifedoes go in for foreign securities, asthe 1955-edition Met may not have(31% of the 2004 corporate portfoliowas foreign). But they are only so for-

eign: the company has no unhedgedcurrency exposure.

In the past half-century, life ex-pectancy in the United States hasclimbed to 77 years from 68.2 years.From a demographics standpoint,states the 2004 MetLife annual, thebulk of the United States populationis moving from an asset accumula-tion phase to an asset distributionphase. People within 10 years of re-tirement hold significant assets. Withcontinually lengthening life spansand unstructured asset distribution,the company believes many of thesepeople may outlive their retirementsavings and/or long-term care. As aresult, the company expects that the

demand for retirement payout solu-tions with guarantees will increasedramatically over the next decade.

Fifty years ago, Americans were stillbriskly accumulating. Certainly, Met-ropolitan Life was accumulating as-sets. In 1955, it enjoyed $6.5 billion of

new premium income, an astounding33% jump over 1954. How to investthese massive inflows?

The guiding light of a seven-maninvestment committee in the early1950s was an octogenarian. Freder-ick H. Ecker had been with the com-pany since 1883. Possibly, he wasstill young at heart. But he had beenpresident during the 1930s, when thedelinquency of 58% of the companysagricultural loans resulted in the re-possession of two million acres offarmland (the Met had its own De-

partment of Agriculture). Reputedlya shrewd investor for his personal ac-count, Ecker tried nothing fancy withthe policyholders savings. Safety ofprincipal must be the primary con-sideration of life insurance funds,declared the president, Charles G.Taylor, for emphasis.

Noble words! But what kept prin-cipal safe? There was precious littlesafety to be had in the asset markets inwhich the Met chose to invest. Fromthe close of World War II through theearly 1950s, the companys invest-ment returns barely kept up with (oractually lagged behind) the measuredrate of inflation. And that measuredrate was flattered by price controls.

To earn a return greater than the mi-croscopic prevailing bond yields, theMet, late in the 1930s, stepped up itsinvestments in apartment buildings.It built, among other big projects,the Parkfairfax in Alexandria, Va.,the Parkmerced in San Francisco and

Peter Cooper Village and StuyvesantTown in Manhattan. But it could findno economic relief even in bricks andmortar. Inflation pushed up build-ing costs and rent controls cappedincome. In the 1948 annual report,management wistfully recalled the5 1/4% rates it had earned late in the1920s: If the interest rate earned lastyear had been the same as in 1928, itwould have meant about $182 millionmore in income, which would haveenabled the company to pay substan-tially higher dividends to policyhold-

ers. That year, the company earneda grand total of 3.03%, whichto lookon the bright side, which the Met al-ways tried to dowas up by ninewhole basis points from 1947.

Interest rates were flat on theirbacksbut so, too, were commonstocks. Here is a paradox for the mod-ern portfolio theorist to ponder. In1951, long-dated Treasurys fetched2.6%but the S&P 500 threw off adividend yield of 6.1% and an earningsyield of 10.9%. We mention 1951 be-cause that was the year the New YorkState Insurance Department revisedits draconian investment rules to allowlife companies some exposure to com-mon stocks. Did the Met avail itselfof this opportunity? We have no in-tention of acquiring common stocks,president Taylor told The Wall StreetJournalin 1952, having taken a year tothink it over.

Fast-forward four years, to thepress conference at which a new Metpresident presented the 1955 finan-cial results. A reporter asked if thecompany had changed its mind aboutstocks. Frederic W. Ecker, the son ofthe eminent Ecker, said, No. Forone thing, the law didnt allow thepurchase of enough stocks to make ameaningful impact on the investmentresults. For another, the market reallywasnt cheap any more (in 1954, theDow had finally pushed above theold 1929 highs). As he spoke, the div-idend yield on the S&P was a mere104 basis points higher than the long-term, triple-A-rated corporate bondyield. But even if the company had

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Investing with Truman and Ike

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sources: MetLife annuals, the Bloomberg

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been allowed to buy enough stock tomatter, it wouldnt have. The marketmight go down.

Suppose, reported The NationalUnderwriter, paraphrasing Ecker, only10% were in stocksand there were a40% drop in the stock market, as hadhappened several times in the last half

century, it would probably come closeto wiping out the companys surplus.Moreover, if at a time when the stockmarket was falling apart the news shouldget around that life companies sur-pluses were being virtually destroyed itwould not be a very good thing for pub-lic confidence. These violent fluctua-tions, Mr. Ecker indicated, are implicitin the nature of common stocks.

And what characteristics were im-plicit in senior securities? Ecker ac-knowledged only one: safety. A clair-voyant would have seen that bonds,as then valued, were only apparentlysafe, because yields would keep risinguntil Sept. 30, 1981. But clairvoyantseither dont need jobs or cant holdthem. Especially are they unsuitablecandidates for work in the investmentdepartment of the big insurance com-panies. The climate of conformitythat the authors of the new Robb-Silberman report on U.S. intelligencebemoaned in the CIA and allied agen-cies is just as prevalent in the world ofinstitutional investing. Bonds? Per-fectly sound, long-term investments,the investment committees broadly

judge. Look at the past quarter-centu-ry: Interest rates fell, inflation becamequiescent, the dollar achieved world-wide acceptance as a reserve currency.Why must any of that change?

To finance World War II on thecheap, the U.S. Treasury and Feder-al Reserve suppressed interest rates.Fifty years later, to mitigate the dam-age from the bursting stock-marketbubble, the Fed suppressed interestrates again. The first manipulative

episode visited huge losses on bond-holders. We expect that the secondepisode will deal sizable losses toholders of the same kinds of securi-ties. Fifty years ago, refugees fromthe fixed-income markets foundvalue in equities. Today, theres no

such haven (now that every knownmember of Mensa International isrunning a hedge fund, investmentopportunities are increasingly scarce,both across markets and time zones).The Met deserves a salute for thenimbleness of its real estate sales.And it deserves commiseration onthe immensity of its bond portfolio.In filing future complaints about thecompanys lamentable investmentperformance (which the presentdearth of investment value all butguarantees), policyholders should

not forget to copy the Federal OpenMarket Committee.

Boats for alla cautionary tale

(April 30, 2010) For this confidentnation, disaster is a call to arms. Nev-er again, we vow, even before thedust has settled. To prevent a recur-rence of whatever it was that took usby the scruff of the neck, we summonexperts, glean facts, issue bipartisanreports and legislatenot necessarilyin that order.

So it is with the great financialupheaval. And so it was in a long-ago maritime disaster. The subject athand is what the capsizing of the S.S.Eastland in the Chicago River in 1915has to teach about the contemporarydrive to risk-proof the American fi-nancial system.

We shouldnt put in place a regu-latory regime that overly reacts and,as a result, significantly dampens ourcapacity to have the most vibrant capi-tal and credit markets in the world,Sen. Judd Gregg, a New HampshireRepublican, was quoted as saying onMonday. Without choosing up po-litical sides, a student of the Eastlandsinking may judge that Gregg has apoint. The intended consequences ofgovernment regulation are frequentlyless potent than the unintended ones.

From both sides of the congres-sional aisle today come measures to

protect the economy against WallStreet malpractice. The represen-tatives and senators would, amongother things, implement a Volckerrule (no proprietary trading by fed-erally insured depositories) and akind of Tobin tax (leveraged specu-

lators should pay a toll, just as motor-ists do). A bipartisan bill, accordingto Tuesdays New York Times, wouldauthorize the government to shutdown a financial institution deemedto pose a threat to the stability ofthe system, using a $50 billion fundfinanced by big banks to help thefailed company meet financial com-mitments while it is being wounddown. Derivatives activity wouldbe curtailed or eliminated. A newfederal consumer protection agencywould interpose itself between bor-

rowers and lenders, breathing heavi-ly down the necks of the latter. Youreditor, too, has a big idea, a proposalto adapt the Brazilian convention ofholding senior bank directors and se-nior officers personally liable for thesolvency of the institutions in whichthey are interested. This particu-lar notion seems not to be gettingmuch traction in Washington. (Visitthe Grants home page for a link tohis Washington Postop-ed column ofApril 23.)

Concerning the Eastland, an eye-witness said it rolled over at docksideas though it were a whale going totake a nap, shortly before its planneddeparture to a picnic site in MichiganCity, Ind. The vessel was loaded withholiday-bound workers of the WesternElectric Co., 2,752 in all, the maxi-mum allowed under newly revisedregulations; 844 passengers and crewwere killed.

It was the Titanic disaster of April14, 1912, that set in train those regu-latory revisions. Or, rather, concludesan historian of the Eastland, it wasthe worlds response to the Titanicdisaster that activated the regulatorychanges that led to the horror in Chi-cago three years later. That responsewas, perhaps inevitably, highly emo-tional, and, in retrospect, excessive,writes George Hilton, an emeritusprofessor of economics at UCLA, inhis history, Eastland: Legacy of theTitanic (Stanford University Press,1997). More important, that re-sponse was poorly related to the causeof the disaster.

Then and now1955 2005

Aaa-rated corporates 3.04% 5.40%Baa-rated corporates 3.53 6.14Long-term governments 2.84 4.44

S&P yield 4.08 2.04Price/earnings ratio 11.46x 19.59x

sources: Federal Reserve, the Bloomberg


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Hilton contends that a shortageof lifeboats wasnt responsible forthe deaths of 829 passengers and694 crew of the pride and joy of theWhite Star Line. Blame rather at-taches to a poorly designed rudderand center screw and an unfortunate

series of commands from the bridgein the moments following the colli-sion with the iceberg.

Embarked on the Titanic were2,228 persons, of whom only 705 weresaved; the ships lifeboats could haveaccommodated 1,178. The owners hadnot skimped on lifeboatsthere weremore seats than existing regulationsrequired. So rose the demand for newregulations, Hilton relates, and Boatsfor all became the worldwide rallyingcry of maritime reform.

Actually, the author observes,

the probability of a ships hitting aniceberg did not differ after the Ti-tanic disaster from what it had beenbefore1 in 1,000,000, in the evalu-ation of the Titanics underwriters inwriting her insurance contract. Sucha suggestion would have been highlyunpopular, howeverabout as un-popular as the comment that mostships run no risk of hitting icebergs atall. Similarly, it went unremarked inpopular discussion that many marine

disasters are of such a character thatno boats can be launched.

No matter. International conferees,meeting in 1914, drafted the Funda-mental Principle that there must bea lifeboat seat for every passenger andcrew member. Congress responded

with the La Follette Seamens Act of1915, which, in the spirit of the Fun-damental Principle, required boatsand life rafts for all hands. The lawwas passed over the prescient objec-tions of, among others, A.A. Schantz,general manager of the Detroit &Cleveland Navigation Co. Regula-tions intended for the high seas wouldlikely backfire on the Great Lakes,Schantz testified before the SenateCommerce Committee.

The boats now operated couldnot comply with the requirements of

the bill, Schantz said, on accountof the light draft and the constructionof the cabins and upper works. Theextra weight of lifeboats and raftswould make them top-heavy andunseaworthy, and in our judgment,we believe some of them would turnturtle if you attempted to navigatethem with this additional weight onthe upper decks.

The Eastland was notoriously top-heavy before the addition of three

lifeboats and six rafts to quiet theBoats for all outcry. The extraweight evidently pushed it to doexactly what Schantz had predictedthat some Great Lakes vessel wouldeventually do. Nor was Schantzalone. An editorial in the trade maga-

zine Marine Journalrebuked Con-gress for writing Boats for all (or,more exactly, Boats or life rafts forall) into the statute books. TheTitanic disaster, the magazine edi-torialized in the issue dated July24, 1915, which happened to be thevery day the Eastland foundered, .. .should never have caused the ir-reparable damage that it has to themarine industry through the inimicalmeasures that Congress and the Ad-ministration have favored.

So unlikely was a repeat of the Ti-

tanic sinking, Hilton suggests, that itwarranted no regulatory response. Asfor the debt debacle of 2007-09, a re-currence is not just probable. Becausethe incentives that caused it are still inplace, another such crisis is virtuallycertain. Still and all, the story of theEastland is a powerful reminder thatpoliticians and regulators dont alwaysget what they want. Sometimes, infact, they get the opposite.

The whys and whereforesof QE3

(April 22, 2011) For the institu-tional elite of American finance,money is literally free. Federal fundschange hands at 10 basis points, theone-month Treasury bill at two ba-sis points. In the repurchase, or repo,market, the lending rate on generalcollateral stands at five basis points,that on certain named, or special,collateral at less than zero percent.The dollar exchange rate sits nearrecord lows, the dollar-denominatedgold price at a nominal high. In a func-tioning free-market economy, moneyis no more free for the taking than areneckties or movie tickets. Yet, almost30% of the respondents to a poll con-ducted by UBS a few weeks back saidthey anticipate a third round of so-called quantitative easing. Maybe oureconomy isnt so functional or so free.

QE3 is the subject at hand, a topicas speculative as it is timely. In pre-

Call today for group and bulk rates to GRANTS.

212-809-7994

Why wait around?


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view, we count ourselves among theexpectant 30%. To its congressio-nally directed dual mandatestableprices and full employmenttheBernanke Fed has unilaterally addeda third. It has undertaken to makethe markets rise. The chairman

himself has more than once takencredit for the post-2008 bull market(on one such occasion in January, hereminded the CNBC audience howfar the Russell 2000 had come underFed ministrations). Could he there-fore stand idly by in the face of a newbear market? Byron Wien, vice chair-man of Blackstone Advisory Ser-vices, went on record the other daypredicting a summer swoon in stocksfollowing the scheduled windingdown of QE2 in June. Let us say thatWien is right, and that, furthermore,

drooping stocks are accompanied bysagging house prices and a weaken-ing labor market. Bernanke was hardput to explain why he chose to letLehman go while acting to save BearStearns. He would be harder put toexplain why he chose to implementQE1 and QE2 but, in another hour ofneed, refused to launch QE3.

A different Feda Grants Fedor a Hoisington Fed, for instancewould cease and desist quantita-tive easing this very minute. VanR. Hoisington, eponymous chief ofHoisington Investment Manage-ment Co., Austin, Texas, is out witha new critique of the Bernanke pro-gram. If the objectives of Quan-titative Easing 2 (QE2) were to: a)raise interest rates; b) slow econom-ic growth; c) encourage speculationand d) eviscerate the standard of liv-ing of the average American family,his colleagues and he write in theirfirs

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Grant's 29_summer 11