The Broughton report

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You‘ve got to be able to do what is right - not what is politically viewed as right.” -Donald Broughton, managing director-equity analyst for transportation at Avondale Partners.


Listen to Donald Broughton‘s perspective on the state of the U.S. economy and you will NOT be bored, I guarantee you. Now, you may totally disagree with parts (maybe even all) of his analysis (summarized below from a presentation he gave at the 33rd annual Truck Blue Book workshop this week in Aspen CO) but you‘ll definitely get a whole lot of interesting information to chew on for a while - both in terms of what you can use in your business as well as general insight into the economy at large.


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Take J.P. Morgan Chase‘s acquisition of investment banking firm Bear Stearns back in March: “I want to be Jamie Dimon (J.P. Morgan Chase‘s CEO) when I grow up. He bought it for a song [some $1.1 billion or $10 a share when the month before its stock traded for over $133 per share] and did a ‘Heisman‘ on Bear‘s toxic third party subprime underwriting holdings - pushing that off to the government. You watch - he‘ll make billions on that buy in the coming years.”


Or why forbidding certain stocks to be “shorted” by hedge funds helped exacerbate the current financial sector crisis: “Look the way hedge funds deal with risk is to HEDGE - that‘s why they are called ‘hedge funds.‘ If they think a company is on the wrong track, they short the stock to cover that added risk. So when they put certain stocks off limits to shorting, the hedge funds naturally looked for other stocks to short sell - thus increasing short-selling across the stock market.”


Another bon mot details why mandatory reductions in the leverage ratios of financial firms upset the apple cart even further: “When you force everyone from a 10 to 1 ratio down to a 5 to 1 level, they must sell stuff. Not only does that mean they stop investing, they are all selling at the same time - depressing stock prices.”


Broughton also believes government should really get more blame for creating the current financial crisis than either political party is willing to admit. “I throw stones at both parties for this,” he said.


The Clinton Administration, in his view, got the ball rolling with two moves in 1999. The first came from pressuring Freddie Mac and Fannie Mae to buy more subprime mortgage loans as a way to expand home ownership. The second came with the repeal of the Glass-Steagal Act that year - allowing investment brokerages and commercial banks to be under the same roof. “The first move was just dumb - that lowered lending standards and increased risk. The second, though, was just stupid - they were separated by that Act in 1932 for actions that helped lead to the Great Depression,” he said.


The Bush Administration then made things worse in Dec. 2006 when the Office of Controller of the Currency declared that credit cards could no longer negatively amortize. “Before this the patient was sick - this move put it in the hospital,” Broughton said. “This wasn‘t phased in at all: it happened in one fell swoop. So now people who were struggling with their mortgage could not get credit - in Jan. 2007 they start enforcing it and by Aug. 2007 cracks in the home mortgage market appear.”


Letting Bear Stearns and Lehman Brothers fail pushed things over the edge in his opinion. “They were the largest underwriters of risk and then they are gone - off the table. So now who underwrites the risk? The taxpayer does. That heightened and extended the mess,” Broughton explained.


The political wrangling over fixing the financial sector mess then poured more fuel on the flame. “Look, it‘s not a bailout package; it‘s not socialism. Sometimes you need to just do what‘s right the fix a mess like this - not what is politically right,” Broughton said.


In his view, it comes down to readjusting government and people‘s expectations. “Look, let‘s take healthcare - it‘s now being called a ‘right‘ for people to have. We also have a right to eat what we want, live how we want, take lots of risks -- more than are prudent. And that is all OK - but should I, as your fellow taxpayer, pay for you to have an organ transplant because your liver failed due to your lifestyle?” Broughton said. Looked at another way, he said people should have incentives to do things that lower their personal risk and thus give them an opportunity to lower their healthcare costs.


“Most of all, we need to debate things like this - so for example, put a government run health care system up against what we have now and compare the two; what works, what doesn‘t, what makes the most economic sense,” he stressed.


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A final bone of worry to gnaw on, from Broughton‘s perspective, is the greater involvement of the federal government in financial markets: “The rate of growth of government authority into the financial sector is expanding unchecked. What does this mean? In financing, you must take prudent risks. Government and lawyers, however, don‘t take risks. Look at it this way: Fred Smith inherited $10 million in his mid-20s. While most of us would have tried to make that money as long as possible while enjoying ourselves, he went out and invested everything into this risky start up business he called Federal Express. That became more than making himself tens of millions richer - he ended up changing how the world works.”


That‘s the critical thing Broughton is worried about when he looks at the future - less risk can lead to less innovation, especially technological innovation. And that, he says, is what‘s really driving the U.S. economy.


“Take agriculture as an example. In the U.S., you‘ve got one farmer with land worth tens of thousands of dollars per acre, riding in a $250,000 tractor, using expensive seed and fertilizer to grow food,” he said. “His counterpart in Asia for the most part is planting rice by hand on cheap land. But which of the two is more productive and creating both greater wealth and food supplies? It‘s the U.S. farmer - and that‘s all due to technology.”


The problem is the U.S. right now, as Broughton sees it, is that no one is challenging the conventional wisdom - and that we are too quick to pull back when the economic waters get rough.


“The way out of this is through more trade - not protectionism,” he believes. “It‘s human nature though - we take a long time to establish trust, but yet are quick to panic. We were being pulled out of our slump by domestic manufacturing until this crisis hit - and that is what we‘ll go back to. The dollar will become weak again and export volumes will grow, just as they were from January through June this year.”


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He said that - through the first six months of 2008 - total U.S. export volume rose to $661.5 billion, with $473.3 billion coming from manufactured goods. Why? “Consumers in China, India, Vietnam, and other parts of the world want what we have - the lifestyle of the American consumer. That‘s what is driving this.”


As a result, more manufacturing is starting to flow back to the U.S. - which should boost domestic freight volume significantly. “We were stealing jobs from Germany, France, and Italy - now we‘re stealing jobs from Taiwan and South Korea,” Broughton said, pointing to a respective 55.9% and 38.6% surge in export volume to those Asian nations in the first half of the year.


“Put a plant here - like Volkswagen and Fiat are doing - and suddenly freight moves multiply. Instead of talking a car off the boat and moving it to a dealership lot, you are delivering raw materials and components to plants, and then finished products to dealerships. That‘s what‘s occurring now,” Broughton said. “That‘s where technology and capital can offset higher labor costs - by making that labor much more productive.”


It‘s interesting stuff all right - and if it‘s even partly true, the U.S. may be in a lot better shape than we think right now. Time, as they say, will tell.

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