Monthly Archives: August 2008

Economic indicators in pictures

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I struggled to find a decent data-set of past economic indicators off the web. I’m sure there’s an easier way, but I had to trawl the horrible formats of Stats-SA and the Reserve Bank to get the mangled data underlying this graph. Seems like Stats-SA is either deliberately obfuscating their data, or they’re working on systems from the late 80s.

The graphs cover:

  • Historical Consumer Price Index (CPI) inflation
  • Historical Producer Price Index (PPI) inflation
  • Historical CPIX, albeit for a much shorter period since this index was created in the late 1990s
  • Banks Prime rate of interest starting from 1980. This is the major interest rate that affects consumers through house and vehicle finance
  • The Reserve Bank’s REPO rate (rate for repurchase agreements with the banks) since inception in 1999.

Economic Indicators

More analysis to follow on this chart, but in the meantime some brief thoughts:

  • Real interest rates appear to be at close to their lowest ever. A period of negative real interest rates in the mid 80s was the last we were in this phase.
  • If one considers the rate of interest that most consumers will be able to earn (less than REPO) then it is hardly surprising that consumers choose to consume rather than save at a rate which erodes their capital in real terms every day.
  • The period of stable, low inflation for a few years in the middle of this decade appear barely more than a quick breath in amongst a turbulent ride over the past 20-odd years. I suspect the bumpy ride is more like what we should expect as the norm given our commodity-heavy and genearlly poorly diversified, small, emerging economy.
  • PPI doesn’t appear to lead CPI as much as some (including me) previously thought
  • But more worrying, PPI doesn’t stay much above CPI for most of history. In other words, the typical pattern is for producer costs to be passed on to consumers through price increases rather than through contracting margins or efficiency improvements. Our impressive PPI of 18.9% as measured (seasonally adjusted) in the year to end July 2008 is worrying for future CPI increases.

Of course, this chart tells us nothing about the causes of the cliff-climbing PPI and CPI (primarily oil and food as initial drivers) and how these might change abruptly given the pull-back in oil prices.

Don’t use Altman’s Z-score for managing a turnaround

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I attended workshop presented by the famous credit analyst and model builder, Professor Edward Altman. He is probably most famous for the invention of the seemingly immortal Z score, which is still in use 40 years after its creation in 1968.

During the workshop, Professor Altman recounted a story about how a company managed themselves out of near-failure using his Z score. I’m not denying the facts of the story, and I’m not even saying that use of the Z-score at this company (GTI Corporation) didn’t help the turnaround. I am proposing that using Altman’s Z-score to manage turnaround would be ill-advised.

Download the full Viewpoint below.

Don\'t use the Z-score to manage a turnaround

Fraud and statistics

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Like most power tools, statistics can be dangerous if left in the hands of the ill-trained or inebriated. Unlike rotary saws and industrial angle grinders, when you abuse statistics you don’t damage the tool but you do damage the result.

Fraud statistics

This is a general observation, but I was reminded of it recently when reading KPMG’s interesting Profile a Fraudster 2007 survey. In the survey, the authors analyse data from actual fraud investigations to better understand who commits fraud and under what circumstances. The survey presented the percentage of fraudsters between variables like gender, across age bands, across duration at the company, position within the firm and department.

While this makes interesting reading, it does very little to explain which types of people are most likely to commit fraud. Without knowing the make-up of the populations of fraudsters and honest employees, we cannot tell whether 36% of fraudsters had been with the company for between 2 and 5 years because this is when they are most likely to strike, or whether most employees, honest or dishonest have been at the company for between 2 and 5 years.

Unfortunately univariate

Employees in more senior positions are also more likely to commit fraud. This is expected since those entrusted with power are more able to commit fraud. However, given the analysis performed is univariate (considers variables one at a time) we cannot tell whether seniority in position makes a difference once the effect of the number of years at the firm has been removed.

70% of fraudsters are between the ages of 36 and 55, which probably represents about the distribution of all employees by age band. 85% of perpetrators were male – which does suggest that males are more likely to commit fraud. However, most companies will still employ more males than females. It’s unfortunate but still true that more males will be in position of power such that they can commit fraud. Maybe the representative baseline for comparison is only 60% rather than 50%, but maybe it is 70% or 75%, which tells a different story.

Selection effects and biases

Although there are more examples from this survey, I’ll finish with one last case. 91% of the cases examined in the survey involved more than 1 act of fraud or transaction. Again, this does suggest that fraudsters are likely to continue committing their crimes until discovered, and logical reasoning would also support this.

However, it is also very true that individual acts of fraud would be far more difficult to be picked up and investigated. If they were, it would be that much easier to defend it as a mistake rather than systematic fraud. The 91% figure reflects a significant selection bias, making intepretation of the real risks difficult.

The right answer

The KPMG survey makes interesting reading, and does include valuable information. However, if they had taken their data set and applied better statistical techniques, and applied them more carefully, the results could have been spectacular. In fairness, this would probably have required gathering more data about the honest employees than they had at their immediate disposal, but the results would have been worth it.

A Generalised Linear Model (GLM) could be fitted to estimate a probability of fraud for an individual employee based on their characteristics. It could also help predict points in their career where the risk increases sharply, perhaps providing a targeting opportunity for ethics training, peer review and improved controls.

The questions I’m left pondering are:

  1. Would you hire someone with a high “probability of committing fraud” based on a statistical model?
  2. Would you be allowed to discriminate on this basis?
  3. How might you manage this person differently if you had this additional information?

Pass me that nail would you

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A frequent comment about why “property prices will keep going up” is that:

  1. They aren’t making land any more
  2. Building costs keep going up
  3. Our population is growing

If these points are true, then this would provide a strong force to push property prices up. It still wouldn’t mean property prices couldn’t decline.

  • Citizens still need  funds and financing to purchase houses and may not have them
  • Property “consumption” can be reconfigured. That’s a fancy way of saying you can squeeze more people into the existing houses
  • Informal settlements can spring up relatively quickly. There is plenty of “land” in South Africa, it just doesn’t have services or proximity to employment opportunities.

What’s all this about a nail?

iAfrica has an article on declining building costs in Q2 2008. Wow, the cost of creating a new building is lower now than it was in the first quarter of 2008. This is while Producer Price Inflation (PPI) stood at 12.3% in June. PPI is a measure of the general costs of production and has been leading CPI and CPIX recently. (I think it will typically exceed CPIX due to efficiency gains in costs of production that are passed on to consumers through competitive pressure.)

Property prices are down (according to Standard Bank). If you ask ABSA, they still seem to suggest prices are rising. Decreasing building costs builds the case that Standard Bank’s index is telling the real story. This is another nail in the coffin of ever-increasing property prices.

Tail Wagging the Dog

So building costs are down, which suggests that there is less fundamental support for property prices. Property prices are likely to decline for a few months yet.

Could it be that rather than rising building costs driving up prices of existing houses, rising prices of existing homes increased the price of substitutes (new developments and thus building costs). The “support” that rising building prices were giving to property prices seems to be less real than many thought. What we experienced was rising profit margins for builders and developers.

The long, inevitable property cycle

Increases in the supply of raw materials and companies entering the profitable market didn’t have instantaneously. The delays in supply coming on stream  was part of the cause of the rising property prices. However, the delays in supply coming on stream also means that supply probably expanded more than necessary. New entrants, basing their decisions on the profit margins available at a point in time rather than considering what would happen to those profit margins when hundreds of other similar people were doing the same analysis and entering the market with the same goal in mind.

Plenty of existing builders and developers made money. Plenty of early entrants made money. Probably, given the length and extent of the property boom, plenty of later entrants made money. But the very late entrants probably aren’t going to make money. Worse, the over-supply affects the original suppliers, the early entrants and the late entrants as well. The market is over-supplied, profit margins will drop to below a fair economic return and builders and developers will leave the market.

They will leave, but only after they have completed their current contracts. Some will try to hang in, hoping that others will give in first and leave them a relatively lucrative market. In fairness, some will collapse and leave early with their half-completed developments in limbo. But the general trend will be for a slow demise, possibly with continued oversupply of the property market. Prices will continue to decrease and builders and developers will lose money.

The demand side of the story

Meanwhile, FNB is withdrawing approval for home loans on a large scale. Even as supply continues to grow, demand is declining. Every time any individual thinks hears bad news about property, he or she is that much less likely to want to buy “just at the moment”. This gearing effect on property is much like that created in commodities through ETFs.

What is a sustainable growth rate in property prices

Our economy grows at a certain rate. Careful, the numbers reported are “real numbers” which indicate how much the economy has grown if we keep prices the same. (Strictly speaking, a “GDP deflator” is used rather than CPI or PPI, but the principal is the same.)

Wages may sometimes grow at slightly more than real GDP, either due to productivity gains or efficiency of capital employed. Special fiscal spending on housing aside, I suggest that in the long-term, this should be a pretty close proxy for the sustainable growth in real property prices.

The first of many BEE deals drowning

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Moneyweb’s article on Barlow’s re-striking of BEE options echos my earlier post on the trouble of underwater incentive options.

The sense of the article is that this sets a bad precedent. Of course, the precedent has been set years ago – I’ve personally calculated the additional costs under IFRS2 for BEE deals in danger of expiring worthless because the share price didn’t perform as expected. I’ve also seen deals where performance conditions for BEE partners have been massively relaxed because the performance was massively below the original targets.

But more than that, what choice do companies have? I’ll quote my comments on the Moneyweb article below:

Company’s issue the share options in order to improve their black shareholding for BEE purposes. The cost of this was born by shareholders, presumably because the alternative was more costly. (One can argue “right” and “wrong” but here we are talking economics not politics.)

Now, if the options expire out of the money, then the company loses the BEE points. In that case, providing the cost of issuing new options is still less than the cost of not being appropriately BEE rated, then the rational choice is to issue new options. Re-striking existing options is just a pragmatic approach of achieving the same end.

IFRS2, the accounting standard that governs the measurement of the expenses of issuing share options to employees or BEE partners, will require the increase in the value of the options to be expensed. Thus, the economic cost of issuing the options will be recorded in the income statement as well as being a true economic cost.

If the BEE partners had been given shares rather than options, then there would be no chance of them expiring out of the money. They would then experience upside and downside just like ordinary shareholders. However, to achieve the same % black ownership, the expense incurred would have been greater.

The company took a gamble that the share price would rise, hoping to save a buck. Market turned against them, and now they have to dip back into their pockets to pay a little more. Does it make sense for a company to gamble on its own share price? Wouldn’t it be better to take the hit upfront, with no fuzzy option-like liabilities floating around, half-hidden on the balance sheet?

The really frustrating thing is that often the utility cost of the issue options (to the current shareholders) is greater than the utility benefit gained by the BEE partners due to the restrictions on sale and concerns around concentration of risk.

Share options issued by companies for various purposes have many hidden dangers. If you’re planning to use them, it might be worthwhile getting a second or third opinion on:

  1. How to structure it
  2. How much it will cost under a range of scenarios
  3. What impact it will have on the financial statements
  4. How much it will cost to be valued for each financial period as well as audited
  5. Whether it will incentivise the desired behaviour
  6. Whether the beneficiaries understand and appreciate the structure, so that utility discounts are limited
  7. How the costs and benefits of the chosen approach compare against alternatives

Each of these 7 points requires careful thought, experience and training. A little consideration and planning can give dramatically better results.

ETFs and gearing, and the property market

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Brief introduction to Exchange Traded Funds

An “ETF” is an “Exchange Traded Fund”. In it’s simplest form, it is:

  • a company…
  • with very specific assets (e.g. gold bullion or a portfolio of shares with the exact weights of a particular index)…
  • listed on (and traded on) and exchange
  • in which one can invest to get exposure to the underlying assets…
  • more easily, more cheaply, in smaller amounts and with higher liquidity than purchasing the underlying assets directly

The trick is that specific rules which allow market participants to “swap” appropriate portfolios of the underlying assets for new shares in the ETF, or redeem shares of the ETF for a proportionate share of the portfolio of underlying assets. This forces the price of the ETF very close to the fair value of the underlying assets. Arbitrage handles it.

This is a pretty simplistic descrition of ETFs, but it covers the major characteristics well enough to explain gearing in the context of ETFs and how this relates to the property market.

How ETFs can increase volatility in their chosen assets

ETFs have become very popular. The increasing gold price has meant that many investors want exposure to gold (since the price is going up at the moment, it will always go up, right?… right?). An easy way to get this exposure is to buy shares in the gold ETFs. This requires the ETF to issue new shares, and invest the cash in physical gold.

So the ETFs suddenly become significant purchasers of gold. Only a certain amount of gold enters the market every day. Some from raw production, some from recycling or sold jewellry, some from tightly held supplies with central banks or other investors. If we create a demand shock by introducing a new player (the gold bullion buying ETFs) on the demand side, the price will increase. The full price increase is mitigated through an increase in supply (think central banks in the short term, jewellry in the short to medium term, and gold production from new exporation and reopening of moth-balled mines in the medium to long term).

As the gold price rises, investors in ETFs tell their friends of their success.  More investors want exposure to gold (going up, always going up, can’t lose) and pile further into ETFs. The act of buying in such large amounts forces the prices up.

Hopefully this is sounding much like a bubble to you. And much like a bubble, two things are true:

  1. For a while, prices will continue to rise and there is money to be made selling on to greater fools
  2. Eventually the last fool will purchase and the bubble will deflate. Quickly.

Investors are a fickle bunch. Particularly individual investors who only piled into gold (to continue the example) ETFs because their Uncle Mike was doing so. As the price is on the way down, they sell their ETFs. The ETFs in turn sell gold and the geared effect unwinds in a hurry.

Prices move up more than they should due to feedback into the system and the inability of supply to increase instantaneously to meet demand. Prices move down for exactly the same reasons.

The price of eggs and property

FNB announced that they are withdrawing approvals for home loans on a large scale. This is on top of the banks existing moves to tighten lending criteria, and on top of higher interest rates, higher inflation, economic slowdown and both an increase in emmigration and a decrease in immigration.

So yes, demand for property is down. FNB’s move is both a result of declining property market and will become a driver of it.

The extensive expansion of credit financed a large part of the property boom. Credit expansion was profitable and low risk because “property prices are going up and will always go up”. Banks don’t really mind if you stop paying your home loan if you or they can sell your house easily for more than the outstanding loan balance. Once the sure-thing of rising property prices is found out to be the wolf wearing grandmother’s clothes, the party is over and the risks to lending institutions increase dramatically.

The greater fools have all gone.

Sounds like the sub-prime crisis in the US, doesn’t it? And we wonder why our banking shares are so “cheap”?

Didn’t expect this? Then you were foolish.

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FNB has confirmed that they will be pulling approvals for home loans on a large scale. Many seem to have been caught by surprise. Fools.

To an outsider, it appears that FNB made a mistake in underestimating the trouble in the property market when they first gave these approvals. Their estimates of property price growth, interest rates and overall affordability were sufficiently incorrect that they have been required to publicly back-track. This decision would not have been taken lightly and must reflect serious concerns on the part of FNB management around future recoveries on these approved loans. So we aren’t talk about slight optimism either.

But again, many are surprised that one of our four large banks would get to this stage. Fools.

The property market only goes up. It’s a sure thing. Maybe the market will be flat for a while, but overall you will always make money. Property market cycles are long, due to the slow nature of supply reacting to demand and banks reluctance to sacrifice market share for profits. Markets do strange things, stranger than this.

Few remember that life insurers cut bonuses, previously thought to be guaranteed set-in-stone never to be removed during the troubled markets of the late 1990s.

So, if a bank recognising that property prices are not heading up and borrowers on 100% loans will be in negative equity positions for several years, why would we not expect them to take appropriate action?

While I was snoozing

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A day behind the news

Talk about the wrong weekend to be struggling with upgrading wordpress. Turns out, we have all that is bad about governments around Africa, the worst bits of South America’s corrupt politicians and distinct flavours of mob-era Russia rotting from the head. I missed this story until this evening.

The Sunday Times shows that the arms deal was corrupt
And another, shorter article from the Sunday Times says so too

This is actually a good news story.

Should we just move on?

Alec Hogg from Moneyweb also wrote a piece outlining his views. For a while I was worried that he was saying let’s just do another Truth and Reconciliation Commission. You know, as long as we say we did bad it’s ok. Unconditional love and all that.

Turns out that even Mr Hogg now believes it is too late for fessing up. Reminds me a little of the late and still respected Hansie Cronje confessing and apologising for his mistakes, after he had vigorously denied the allegations. It’s amazing how being caught makes one sorry.

Of course, Mbeki still denies everything

The Sunday Times suggests a full investigation into the arms deal is required. Haven’t we had one of those already? How did that work out again?

So is it a pity party?

I don’t want this to be one of those dreary depressed South Africa complaints about how Everything Is Awful. Nobody seriously believed our government wasn’t corrupt. Too many stories, too much of the time. For crying out loud, our police commissioner wasn’t even the fish-smelling rotting head – that title is reserved for Thabo Mbeki (I will no longer be calling him “president” – he has treated the title with such disrespect after all). Uncovering evidence of what we already knew isn’t a reason to mope.

No, the real tragedy? The real tragedy is that our fundamentally flawed democracy will have another layer of paint brushed over the ever-widening cracks opening up in the foundations. Those who’s money was wasted on unnecessary arms, and lined the ANC’s coffers, who have been treated like ignorant peasants by the ANC, will vote them in to power again with a fierce majority in 2009.

What does this all mean for your organisation?

The ANC has been leaning towards popularism for several years now. Like or hate Jacob Zuma, a complaint that has few defenders is that he sways to the popular view. Albeit this view is usually provided to him by his political backers.

On the other hand, I would be surprised if major corruption at the senior level is viewed as more risky in the past. I’m not saying for an instant those with corrupt tendencies won’t want to cheat and steal just as much as before. We’ve just shifted the average risk aversion by showing the risks to be real.

So we end up with less displicined spending, less prudent monetary policy, no relaxing of exchange controls, no relaxing of labour laws, but marginally more honesty. Not sure whether honest and open foolish, destructive policies are better than relatively smart but self-serving and corrupt policies. I suspect that if business knows what the rules are, they will find a way to manage their operations for success.

The risks to the success of South Africa haven’t gone up in the last few days. They’ve gone down. The reality of corruption always existed, we just know a little more about it.  This might discourage corruption in future.

So this story was good news after all.