Security in Securities?

Bill Gates has $72 billion. Mark Zuckerberg is worth $9.4 billion. Chase Bank's value is $212 billion. We hear these numbers thrown around the financial media. Is it actual money, as in currency, that those people possess? In theory, yes: they could sell the shares of the company and have that much in cash. However, the act of those two individuals selling their shares would cause the price to go down – perhaps Gates less so now that he is no longer CEO of Microsoft, but Zuckerberg very much still IS Facebook. Gates, by the way, has sold around $2.5 billion worth of Microsoft shares in the last year. Even if he did the same thing every year, he would need 30 years to sell it all.

Securities form a central pillar of America's economy. The corporation may have been born in Britain, but the New York stock exchange brought the idea of sharing corporate wealth with the public. We have gotten closer and closer to the idea of a free and fair market where instead of goods or commodities, companies are bought and sold.

We previously discussed currency, real estate, and intellectual property as being part of America's assets. A great deal of those three asset classes are owned by corporations. We don't want to dive into the deep end of corporate law, but for most purposes, corporations can act just like an individual. It can buy and sell property, physical assets, and patents and hold all forms of currency. One can even sell percentages, or shares, of itself to others that have no involvement with the day to day operation of the company's business.

Sidebar here: the federal government has been very kind to corporations as far as laws regulating them. We have one of the most lenient bankruptcy systems in the world. If a corporation goes bankrupt, the individuals holding shares are not personally liable for those debts outstanding. So, the risk of going out of business is spread outside of the corporation to those who lend to it. At the same time, individuals profiting from corporate dividends or selling a stock at an increased price currently pay a 20% tax rate, well below that of real “income” for most people. Large corporations also receive favorable treatment by state and local governments who want those manufacturing jobs in their area. Washington and Seattle governments continue to woo Boeing to leave its manufacturing facility in the Seattle area while Boeing continues to leverage the power that comes from employing 168,000 workers, many of them well paid skilled engineers and specialized tradesmen. To be fair, those workers spend money in the local economy, so their continued presence in Seattle benefits the entire population there, Furthermore, a recent Supreme Court decision allows corporations to give directly to political campaigns, including through an anonymous scheme through non-profits to SuperPACs, so corporations have a way to influence government regulations that will continue to favor them.

Ok, let's jump back to Facebook. As of Friday, the company's stock is valued in total at $132 billion with a share price of $54.25. Facebook's business model is that of an advertising platform – companies purchase ads or information from Facebook for the purposes of marketing to a specific group. The entire advertising economy, including billboards, radio, print, etc., is estimated to reach $177 billion in 2014, with the internet gobbling up about a fourth at $47 billion. Facebook releases its 2013 numbers soon, but in 2012 they made around $4.5 billion. Somehow, Facebook is worth its annual revenue 24 times over. One might argue that Facebook is a disruptive technology that changes the way we live and work. Indeed, people use the network to communicate with one another. But, unless they start a dramatic fee for service structure (which would likely lead to the mass exodus of their users), they are still only an advertising company. Forecasts show a healthy increase in the online media ad spending from $47 billion to $60 billion by 2017. If Facebook continues to receive around 10% of that total, they will still only be bringing in $6 billion in revenue each year. By comparison, McDonald's corporation is valued at $96 billion on 2012 revenues of $27 billion. Somehow, with revenue less than a fifth of McDonald's, Facebook is worth $20 billion more.

My point here is that there isn't hard data to support why Facebook is valued so highly. They have gotten by with good justifications up to now that the internet is the future of advertising, people want to buy things their friends have, so on and so forth. It's just hype though. People assume that, hey, I have a facebook page, and everyone I know does too. That's gotta be worth something, right? They are now a couple of years old as a public company, and investors will want to see some hard cash. Facebook earned a penny per share in 2012, whereas McDonalds earned $5.36. Considering there are half as many shares of McDonald's out there as Facebook, you have to wonder why I would want to own part of Facebook instead of part of McDonald's. You heard it here first – Facebook's share price will fall, dramatically, and most likely settle in around $20 per share or less. And if they are very successful at what they do, they might continue to serve the role they currently do 10 years from now, maybe 20. This is assuming the next big thing in social media doesn't clobber Facebook and figure out how to monetize this industry. The Internet economy is only one piece of the pie, and strangely it seems that this particular piece is like a lost boys' dessert.

The dollar value of these companies goes up and down on a daily basis. But the shares are only worth something when there's a buyer to purchase them. Let's back the lens off a bit and think back to 2008. This timeline is very helpful to recall the events, and remember that most of the U.S. public wasn't paying attention to this until September 2008. When the public was brought in through the news of Lehman brothers, faith in corporate wealth plummeted, and people issued sell orders essentially regardless of price: show the U.S. the money! The Dow lost about half of its value, and America millions of jobs, in 6 months. The crazy thing is that some companies were trading below the price of their cash on hand – they could just liquidate the company and make more money than their shares were worth! At that point, there was no way to go but up, and for the last 5 years, it basically has.

We come to realize that not only are these corporations important to America, these corporations ARE America. When you read down the list of the Dow 30, these are the brands we recognize, household names. We work for corporations, and we retire based on the money we have put into IRAs which invest in them. You could invest in local, privately owned companies. Then, you are trusting that those people are giving you the right information and an honest return on your investment. The public stock market requires honest information, and there are people whose job it is to check up on the info they provide and make sure it's accurate and the companies are following the law. By “going public”, those companies are opening their accounting books to public auditors who make sure the money is actually there. We trust this system – indeed in 2012 we had $18.7 trillion tied up in it. On first glance, it might worry us that this number is higher than the entire M2 money supply we discussed in week one, but these companies will be around tomorrow. Indeed, they have a good portion of that M2 money themselves. They will probably be around next year, and it's pretty likely a lot of them will be around five years from now. We can put our money to use by investing in those companies – they will take the money and attempt to make more from it. And we don't need all of that money this year – we will gradually sell some shares in companies in exchange for money that we will purchase goods with, which will be sold to us by corporations which then pass that money down the chain to investors.

The stock market is open to more people than ever in history. Gone are the days when you need to work through a middleman to buy and sell stocks. Online brokerage firms allow someone to trade in their pajamas at home. Company 401K's and IRA's allow workers to put a portion of their paycheck into investments to save for future real estate purchases or retirement, tax free. Other than real estate, the stock market and public ownership of corporations is where we put our money. You make 0% interest with money in the mattress, less than 1% (currently) on a savings account, and potentially 5-10% on stocks. Of course, there's significant risk putting money into stocks, but in the long run, they've been a fantastic investment over the previous 80 years, basically since 1933. The big question is how good of an investment are they for the future? Will we continue to see 4-5% average growth in our economy like we did for years? Or will we continue in the stagflationary period of the last 5 years? Which will dominate – fear or greed?

Finally, back to government intervention, we've seen unprecedented government involvement with the stock market since the 2008 crash. Bear Stearns, Fannie and Freddie, AIG, the auto industry, many other smaller scale investments: all of these were enormous government bailouts that have made Wall Street very unpopular with average Joes. The idea of companies that are too big to fail continues to perplex both corporations about where their limits are and regulators about how far they can push companies to follow the law. Politically, the Tea Party hammered politicians over government bailouts, and we haven't seen them since 2009. Instead, beginning in 2010, we've seen instead of direct government investment, the Federal Reserve has provided trillions to banks through quantitative easing. All of those bad loans banks made? They still have them. Except the Fed has been purchasing them, in exchange for newly “printed” money. What do the banks do with the money? They are loaning as much as they can, but since they are allowed to, they invest in the stock market. So, the stock market which has been pushed up by the banks which are pushed up by the Fed has been on a tear ever since. The big question will be how long can this bubble last? Will the rising tide of bank investment bring back millions of investors who fled stocks for safer investments? Tax free contributions are still going in, many times because those contributions are automatic.

If You Build It, You Can Profit From It

We started our exploration of what the United States owns with currency, and then went to the more tangible real estate. This week we're moving towards the far less tangible intellectual property. The laws governing IP enable creative people to “own” their creations and thus profit from their exclusive sale. For example, a composer writes a musical and copyrights it. She then sells the music and the rights to it to a publisher in New York. The show is picked up and produced on Broadway. That music cannot be performed legally, for profit or not, without the consent (read: rental!) from that publisher. And believe it or not, they check – publishers have people scouring music programs for their titles to ensure rogue performances aren't benefiting those who didn't do the difficult work of creating the original music. The punishments are severe enough to end the career of most average musicians, not to mention the stigma of violating the music business sacrosanct.

But no IP attorneys enact vengeance like those of tech giants such as Apple and Samsung. The two Goliaths seem to be in constant legal skirmishes over patent infringements. Of course, this market has been nothing but explosive, with sales nearly quadrupling in the last 5 years. Billions are at stake, and the loser will fork over billions to the winner.

But how can Apple and Samsung even go to court with one another? One is in California, subject to U.S. law, and one is in Korea. Well, the United States has given a portion of its trade sovereignty to the World Trade Organization. I was surprised to find that it began in 1995 – I was under the impression it had been around for much longer. Boil it down, and the WTO represents the solution of an eight year set of talks called the Uruguay Round that require member countries to have free trade policies towards one another. If you're wondering who the members are, check out this helpful map. Notable exceptions: Syria, North Korea, Russia – wonder why we always see them in such a negative light? They are quite willing to steal ideas and inventions and refuse to offer a legal framework for justice for creative people.

I don't want to get too bogged down in international trade policy. Suffice to say that most tariffs on imported goods are gone, and those making things in Vietnam can sell them without additional tariff in Austria or the United States, or in any member nation. The idea is to encourage invention and innovation and to provide the market with the best the world can come up with. The winners make money, and the losers keep trying to stay ahead of the curve. Globalization has nearly reached its peak.

This system has quite a lot of weaknesses. Mainly, the legal costs of challenging an infringement are so high that only large corporations can afford to fully protect their inventions. I once investigated what it would cost to get an IP attorney: $5000 to have them look at your case and investigate if anyone already owns the patent. Thousands more if there is an actual conflict and even then there's no guarantee you would win. Average Joes can't go up against an Apple or Samsung or even Broadway. There is no patent on ideas, only on the creations utilizing them, so one must have a working prototype or completed work in order to get a patent. And even then, if a large company takes your idea, you have to retain counsel to sue them and could be in court for years.

Transportation to get goods to the market uses a tremendous amount of the world's energy; the costs of getting goods to market rivals the costs of producing those goods. For example, trucking companies spend more on fuel than their employees. Even IF global effects of this energy use are in dispute (and for the record I believe this energy use is behind global climate change), a televised sunrise because the real one is blocked by the smog in Beijing shows there at least localized effects. Some day, we will have to pay the piper. We can do it with a little bit of extra currency to pay for solutions, or we can pay by losing a sizable portion of real estate in the tropics and subtropics.

Globalization in general has the potential to cause greater income inequality. It's not as obvious to us because we are currently the benefactors, but imagine a world in which all invention is done by the already super-rich, and then the production done only by the poor. Indeed, the inventors can live in Darien or Los Altos while those who produce the physical goods live in Mexico City or Shanghai tenements. Large companies quash new rival inventions in capital intense legal fights and then buy up the patents once the small company goes bankrupt. That company then uses its new, purchased patent to become even larger. The potential result is one that actually stifles innovation even though the intent of the laws is to promote it.

But, for all of the negatives, the United States is in a pretty good position as far as intellectual property goes. While some decry the education system's poor statistics, we have raised one of the most creative populations in world history. Modern life looks nothing like it did in 1914 – a hundred years ago our grandparents toiled in fields, walked to work, and lived mostly a localized lifestyle. The inventions that make it possible for me to write a blog that could be read the world over began in the U.S., and many of those companies are still producing new goods today. John Deere sold $35 billion worth of equipment in 2013, up from $10 billion in 2001. The world still buys our goods, if those goods are great.

Of course, we cannot take this advantage for granted. We as the public must realize that we are better off bringing money in from the world than sending it away. We shouldn't borrow money from China to buy gas from the Middle East so that we can drive to work for an hour each way;-) We also shouldn't be giving information and knowledge to the rest of the world for free. For example, how many foreigners are attending U.S. colleges on scholarship? This is perhaps needlessly anecdotal, but I was friends with graduate assistants who sent part of their monthly living stipends back to their families in South America and Asia. Now, that's noble of them personally, but is it in our country's best interest to be providing money at public universities for those in other countries to live off of while we educate their children free of charge? Canadian and Chinese colleges certainly aren't paying American students to come there and earn degrees. In my undergraduate computer programming class, we had graduate assistants who helped out in the lab while we wrote programs. Every one of them was from southwest Asia. I'm guessing that was similar at other colleges, and today we have foreign computer hackers breaking into U.S. systems and stealing credit card information from millions of Target shoppers. Yes, there is nobility in education, but there is nothing to insure ethical use of the information we teach people once they go home. Protectionism? Of course it is. But do we just leave our front doors unlocked for anyone to wander in and take what they want? Of course not!

My point here is that even though the WTO has established a legal framework for the entire world, all countries do not enforce those regulations equally. Chinese companies frequently skirt the authority of the WTO, and China and other countries engage in anti-competitive practices in their own markets while insisting on open markets in the U.S. for their exports. Organizations like the U.N. and the WTO are starting to realize that the enforcement of their regulations is perhaps more important than the regulations themselves. We have to all start playing the same game with the same referees before we can decide who wins the game.

Real Estate Macroed

Most people understand a lot more about real estate than they do about money. In America, most people's biggest asset is their home. Of course, we take for granted favorable government policies towards home ownership: the mortgage interest deduction, FHA loans for first time buyers, and even the recent refinance options for homeowners due to the financial crisis. But step back from short term events and fluctuations and look at our land from a historical standpoint. The United States of America controls one of the most valuable tracts of land in human history. This value is evident in multiple ways: strategically, agriculturally, economically, and politically.

The United States of America comprises of 3.54 million square miles. Subtract Alaska and Hawaii from the total and the lower 48 have nearly 2.96 million square miles. In perspective, the lower 48 are very near the size of the continent of Australia. A few states in the U.S. are larger than many countries – for example, Texas is larger than France, Oregon is slightly larger than the United Kingdom, and including all 50 states, the United States is only 400,000 square miles smaller than all of Europe. Furthermore, the average population density of the lower 48 is 107 per sq. mile and is actually lower than the world's average of 120. All of this being said, we have room to grow here. Our population is generally moving south and west – away from the original states towards the more undeveloped west.

Tangent – we are not the original owners of this land. We stole it from the Indians shortly after discovery of the continent by Europeans. We can make many arguments for or against this as a benefit to the world, but we still need to acknowledge that we stole the land from those who are native to the land. That doesn't make us unique on this planet – humans have been stealing land from each other for a long time, especially those peoples originating in Europe. I'm also not making recommendations on what, if anything, to do about it. But we as Americans do need to acknowledge this not so proud fact of our history here.

Strategic security is a major benefit of our geography. We split North America with only 2 neighbors, and we occupy the territory between them with the most temperate climate. Our northern border is a frozen tundra in the winter, and our southern border is an inhospitable desert in the summer. Both are defensible with an observation force – a limited number of people can respond quickly to problem spots when necessary. To our east and west, enormous oceans with only a few islands to pay attention to militarily. We have not fought a war on our own soil in 150 years, and even that was an internal conflict and not one with an outside aggressor. Indeed, the last time a foreign power had troops on our soil was during our war with Britain and Canada, 200 years ago.

With our military technology and outlying territory in Hawaii and Alaska, we would have ample warning to prepare for any potential invasion from a foreign power. Combine that with the most armed general public in modern history, there is an extremely low chance that any foreign power could forcibly enter the lower 48 (sorry AK and HI) and take land by force. We really take this for granted, and in my opinion this is an advantage we should guard jealously. Our strategic security has prevented devastating wars that have torn apart economic capabilities on three other continents in the last century. Strong security allows our civilian population to worry about the other strengths our land has.

Our fertile land is perhaps the most valuable on the planet. We have 8 states that border the largest freshwater lakes on the planet, and 31 states in the watershed of the continent's largest river. Other sources of fresh water abound, and we generally do not have to worry about finding and using water. The climate is very conducive to consistent crop yields, and we have settled enough farmland to feed our population twice over. This matters – not only are we safe at home in our beds, our bellies are full and we never thirst. I say this generally of course. And I say it in comparison with not only the rest of the modern world but with the rest of history.

The land is so fertile that we've started to figure out what to do with all of the excess grain. We even made a law requiring the inefficient process of turning corn into fuel for vehicles. We aren't worried about getting a meal, but worried about what that meal will consist of. I recently saw a report that Americans meat of choice is now chicken instead of beef. Would that the rest of the world could be so fortunate to get to choose

On top of that, our land has many valuable things BESIDES farming capability. The United States is abundant with natural resources, and we have become very good at taking them from the earth and using them for economic benefit. We have innovated many new industries in part because we have the ability to get raw materials cheaply and easily. We have a diversified economy with the most productive workforce on the planet.

Our economic strength is related to our politics – we've established the freest large society in human history, and it is possible to flourish economically here. It is possible to buy almost anything that humanity has created in our stores and markets. Our laws, generally, are enforced so people don't steal things from others and get away with it. We have consistent systems of weights and measures to ensure we get what we pay for, and a system of checking consumed goods to make sure we don't get sick from them. Indeed, we enjoy most of the comforts of modern life without giving a second thought to where they come from or where they go when we're through with them.

One could even say we are TOO comfortable. With productivity as high as it is, we don't even require all of our population to work in order to accomplish what we need to meet our basic needs. The last 5 years have brought this problem to the forefront. We have so much efficiency in our economy that we don't need a great deal of manual labor in order to accomplish the work we want to accomplish. This problem will need to be addressed in a way that allows those able bodied adults to be able to find gainful employment and contribute to our society.

This article is meant to highlight the macroeconomic strengths of the real estate of “America.” We continue to be the oldest country on the planet with a consistent government. We should not only be thankful for this fortune but take steps in order to protect its value.

The Money Supply

So, in the first article in a journal about the economy, it would be useful for me to describe my background. I can say firmly that I am only a student of the economy. My college degrees are both in music performance, a career I had for about 5 years professionally and 10 years semi-professionally. However, I can also firmly say that I have been a student of news, politics, and economic issues for at least that time period. Consider it my avocation during the time I was a musician and teacher. I currently work in the transportation industry driving trucks for a local heavy materials delivery company.

Also, in this first posting of this particular blog, I would like to identify the purpose: to share with others my findings about the economy and my opinions about its future. I am not an expert. I am simply interpreting what I have learned over my years of observance and attempting to provide an understanding for those who don't spend as much time studying it.

This particular anecdote will help you understand why I begin this project. I became acquainted with a bank teller. She has only been in the industry for about 6 months. At one point I asked her what she thought about the Fed's quantitative easing program. She did not know what it is. Now, I don't expect everyone in the U.S. to have an understanding of macroeconomic policy. But I think that would be pretty useful information for someone who wants to be a career banker. Indeed, I expect that at higher levels of her company, one of the reasons she was even hired is due to the cheap money the Fed is pumping into banks. But her ignorance is not unusual. There is a general need in America to understand this mysterious thing called the economy. I hope to boil some complicated information down to easy to understand concepts so that more can realize the situation our economy is in.

So, let's start from the very beginning. A very good place to start. Because really, knowing these things should be as common as “Do, A Deer.” To keep things simple, let's start with understanding what we have. When I say what we have, I mean to analyze what we as Americans own. Because it's the most basic of economic wealth, I think it's appropriate to begin this week with the supply of American dollars in the world.

So I can set the standards as to what I know, I just this week studied the different types of money in the money supply. I understood some of this but did not now that we even had a simplified nomenclature for explaining the different types of money. This system was set up concurrently with the U.S. finishing its separation from the gold standard. We have three basic kinds of “money.” M1 – basically the cash in circulation, traveler's checks, and money in checking accounts; M2 – All of M1 plus savings accounts and Certificates of Deposit less than $100k. M3 – All of M2 plus “large time deposits, institutional money market funds, short-term repurchase and other larger liquid assets.”ⁱ If we know the M3 number, then we know how much money the United States has.

The November 2013 numbers, the latest released at the time of posting here, are M1-$2.61 trillion, M2-$10.93 trillionⁱⁱ. Understand the first number as the money in our wallets, and the second number as the money in both our bank accounts and wallets - cash. If we divide the total by an estimated 317 million persons living in the United States, that comes to about $34,400 per person. However, we are well aware that United States citizens aren't the only ones who own dollars. And, we also know that the majority of wealth is also owned by less than 10% of the population – don't be surprised if you have less cash than this. I certainly have much, MUCH less.

And now we should research the even larger number, M3. Look up the M3 number for the U.S. Dollar. You won't find it. The Fed stopped publishing those numbers in March 2006 and claimed that knowing this number doesn't give significantly more information about the money supply that the M2 number. I would have to respectfully and vehemently disagree with Ben Bernanke and the rest of the Fed's governors on this subject. M3 does not give information about what we currently have in terms of cash. But it certainly gives information about what we WILL have. Recalling that the M3 number is the long-term holdings of banks and large financial institutions, we realize that we have no information about how much money our banks have. Considering that most people deposit their money into banks, it seems fair that we should know how much money they have.

Let me take a brief tangent to make the argument that we own the banks. I say “we” to mean the people of these United States. We own them in two ways. Since all of the largest banks are public companies, their shares are owned by millions of Americans by both directly holding their stock and indirectly through mutual fund shares and IRAs. If the banks make money, we make money. On the flip side, those same banks' deposits are insured by FDIC insurance through the federal government. And, as we learned in 2008, when the banks get in real trouble, the federal government steps in and bails them out with huge amounts of cash. Where did the government get that cash? Well, from its citizens of course! Since we own the banks' profits and losses, one would think we have the right to know what they own. Indeed, so does the federal government, and banks are required to publish this information quarterly.

Ok, back to M3. The banks in fact do publish their assets, including long-term bond holdings. However, they are known to obfuscate the number by a little bit of cooking. Let's go to an article at CNN Money from February 11^th, 2013 by Stephen Gandal entitled “How Banks Could Get Blown Away By Bond Bubble”:

[In the summer of 2012], JPMorgan Chase CEO Jamie Dimon, in an effort to reassure Congress about the safety of his bank's investments in the wake of the London Whale trading loss, testified that the average duration of the the bonds in JPMorgan's portfolio was three years. Look at JPMorgan's books, however, and you might come away with a very different number.

In its third quarter securities filing, the last time the bank has updated investors on the matter, JPMorgan (JPM) said that it held nearly $200 billion in bonds that won't mature for 10 years or more, or nearly 56% of its overall portfolio. That would suggest JPMorgan's average duration is at least 10 years, perhaps more, and potentially a cause for concern.

The rub is the difference between the date the bonds come due, which is what JPMorgan's books are going by, and the so-called effective duration, which is a bank's guess as to when its bonds are likely to be paid off. The later figure is the one Dimon quoted Congress.ⁱⁱⁱ

So, Mr. Dimon wants to recast the 30-year mortgage as a 3 year mortgage in his books – yes, my portfolio would look much better on paper if I was getting my money 10x faster. Yes, people pay mortgages off early, when they buy a new house. But they don't just move out of their house onto the street. They typically move into a new house with a new mortgage, often of the “full” 30 year duration. Not always. Some people completely pay off their houses or buy a house with a shorter mortgage. But especially given the economy right now, most people have been “trading up,” to better houses rather than paying off the one they already had a mortgage on.

Know that I'm trying my best in this series to deal in facts, not in speculation. But we have evidence of two disturbing trends. One is the Federal Reserve's refusal to provide real data on the total amount of money in circulation, the M3 number. Long term bonds are the currency fueling the banks right now – QE3 is still going on and $85 billion of new money is going into the banks every month. The other trend is that banks are confusing the public on their assets and hence their value and long term security. Combine these two trends, and we have a very important data point that is a complete mystery to almost anyone on Earth. One wonders if the Fed could even calculate the number of dollars if it wanted to.

In my humble opinion, the Federal Reserve should recommence with publication of M3 data. This data is how those in the financial industry calculate inflation. Those numbers are then used by the rest of the general public to make plans for their own money.

I don't stand alone here. Former Representative Ron Paul of Texas felt the same way when he was in Congress, and many Americans more intelligent than I feel this information is essential for the United States to function. We should make public how many dollars are in circulation.

Anyway, we now have an idea of how much money we have: close to $11 trillion. Next week we'll get into something far more tangible and easier to count: real estate.

i Wikipedia.org, “Money Supply,” accessed January 4^th, 2014.

ii http://www.federalreserve.gov/releases/h6/current/, Accessed January 4^th, 2014, updated monthly

iii http://finance.fortune.cnn.com/2013/02/11/banks-bond-bubble/, Accessed January 4^th, 2014