There is disagreement among economic observers regarding whether the economy is more likely to experience troubling inflation or deflation in the next couple of years.

Some who expect increased inflation reference current fiscal and monetary policies that, alone, are inflationary. Examples include recent government stimulus packages, historically low discount and federal funds rates, issuance of massive amounts of government and municipal debt, and expansion of the currency base, among other factors. Essentially, the more currency being created from nothing other than one’s good faith results in higher prices for goods and services (and a correspondingly lower value to said currency), ceteris paribus, to paraphrase my former economics professor. 

As is the case with most theories I’ve been taught while sitting in an ivory tower, ceteris paribus is noteworthy concerning whether theories are useful practically.

According to many who expect deflation, the rationale references value of assets and social psychology.  Regarding the former, we’ve experienced the effects of decoupling the price of an asset and its underlying secured cash value.  There are many thought experiments.  Think of houses: if everybody had to pay cash for a house, home prices would likely be a fraction of what they are today.  If municipalities could not issue bonds at reasonable interest rates or assess taxes beyond a moderate amount, then their cost structure (compensation, pensions, contracts) and prices would be lower.  These are just two of many examples, albeit presented in a simplistic manner.

What we have experienced in the past two years regarding some banks, companies and municipalities is that the price they paid for their assets exceeded the current and ongoing value of those assets: residential and commercial mortgages, stocks, credit default swaps, and tax receipt streams, for instance. 

As such, by printing more money and issuing more debt, inflation can be expected.  But, if debt of all kinds must be written down, some by 50% or even 100% (bankruptcy), then deflation is most likely to occur (prices of many goods and services decrease*).

So, the question to ask yourselves, Dear Loyal Readers, is “do you believe the current stated value of debt instruments and future obligations (on-and-off the balance sheets of companies and banks; derivatives; social security and pension funds; mortgages; credit card balances; sovereign and municipal bonds) accurately reflects reality?” 

If your answer is yes, then expect inflation.  Otherwise, expect near-term deflation.

--------------------
* In this scenario, falling prices are likely attributable to reduced spending and money supply contraction (e.g., reduced value of debt/liabilities more than offsets FED monetary expansion policies).  See The Anatomy of Deflation by Professor George Reisman for an expanded explanation of deflation.

A hat tip to the Immobilienblasen blog for the cartoon and observations:

"So this remains the Houdini rally — no jobs; no pricing power; no broad participation; and no volume."

Two reports about strategic M&A and private equity were released recently.  

Paul Weiss, a well-known corporate law firm, prepared a concise survey of the top 25 non-financial M&A transactions, highlighted at Research Recap here.  The report focuses on terms and characteristics.  However, a notable data-point is financial sponsors were nearly nonexistent (accounting for less than 3% of total value in the twelve-months ending July 2009).

The private equity summary was prepared by PitchBook, an independent private equity-focused research firm.  The report is updated quarterly and includes value, number, most active firms and sectors, among other criteria.

There were fewer and smaller transactions in comparison to peak 2006-2007 levels, with a reversion to activity during the last recession of 2001-2002.  For example, total number and value were down about 55% and 70%, respectively, from twelve-months ending June 2007 to same period of 2009.  Also, the median value for buyouts during 1H 2009 was $37 million, down from a 2007 high of $104 million.   

Still, private equity firms are originating and closing transactions, but some assert a competitive advantage has shifted to acquirers such as holding companies, strategic buyers, individual investor groups and fundless sponsors. 

The argument seems to reference smaller deal-sizes, less, if any, dependence on debt financing, longer-term investment horizons (some prefer to hold indefinitely), a focus on cultivating one or a few investments, and even a more personal approach with family-owned companies.

The implicit point to note about the ebb-and-flow of leveraged transaction volume is all that debt used to finance the record number of deals of yore (at premium valuations) comes due in the next 3-5 years. 

Ouch… 

For those interested in strategy, adapting to a changing environment, consumer behavioral trends, and, well, outright mismanagement, then analyzing the newspaper and print media industry provides a real-world, in-progress case study.

Although headlines of the death of the newspaper might be an exaggeration at the moment, there is clear and present danger.  The business model of newspapers depends on advertising revenue, which comprises about 80% of its total revenue.  In 2008, advertising revenue dropped 16.5%, according to the Newspaper Association of America.  Barclays Capital projects a 22.0% decline in advertising revenue in 2009 (see Mint.com below).  Startling, but also mirroring the economic recession.

Nonetheless, organizations that will most likely survive the economic challenges and thrive will create a new business model, with digital media being more prominent.  The extinction of the traditional daily is not likely in the near term, although it will probably play a more niche role.  Similar dynamics are occurring with telephones, internet connections, software, music and movies, to name a few.

Mint.com presents a concise one-page visual of key metrics of the top 25 U.S. newspapers.  Many others have written about the struggles of print media; Slate.com highlights the strategic and mismanagement aspects of this topic.

Well, that’s all for now, as I need to check my favorite news and entertainment blogs.

Say it ain’t so.  How many more obscure, undercapitalized financial institutions are lurking in the midst?  According to a New York Times investigative article, and summarized here, Customer Asset Protection Company (Capco), based in Burlington, Vermont, may be at risk.

Capco provides catastrophic insurance to wealthy clients in the event their brokerage firm collapses.  Basically, it provides coverage above the $500,000 offered by the Securities Investor Protection Corporation (SIPC).

The concern with Capco sounds eerily similar to the abuses regarding credit default swaps in which some firms, including AIG, sold protection without having adequate reserve capital.  In Capco’s case, the article indicates that it might have only $150 million of capital to support an estimated $11 billion of potential claims.

It is prudent for investors and customers to hedge their hedges.  One example is to retain a public company as a hedge provider and then create a hedge on that hedge-providing company via puts/calls, short position, or both.  

In a Wall Street Journal opinion article published last month, former high-yield corporate bond salesman and trader, Michael Milken, who has his share of detractors, penned an opinion titled Why Capital Structure Matters.  He commented on this theme previously, including in a Forbes cover story titled My Story (March 16, 1992). 

Milken stresses that an appropriate capital structure evolves and corporate leaders must consider various factors in managing it.  Likewise, he provides recent examples (Alcoa and Johnson Controls) that deleveraging the capital structure of companies with uneven revenue streams can positively affect a company’s valuation, contrary to conventional financial theory.

He describes market signals that may prompt a CFO to consider modifying the capital structure.  For instance, when equity market values surpass replacement value of assets, then deleveraging should occur, when practical.

According to the article, there were unwise modifications to the capital structures of AIG, Merrill Lynch, Washington Mutual, Home Depot and CBS, among others.  What was the alleged error?  They borrowed a lot of money to repurchase expensive common equity – some at peak 2007 values – equity that was more valuable than the underlying corporate assets. 

Shoestring Venture and Sramana Mitra provide related articles, among several others.  Nevertheless, as Milken states, “It doesn't matter whether a company is big or small. Capital structure matters. It always has and always will.”

As mentioned in our previous blog, there is an article in today’s New York Times Magazine titled My Personal Credit Crisis, summarized here, which relates to the topics discussed previously.  The subtext of the article touches upon universal themes of human nature, on a personal basis and within a corporate environment.

Given the number of recent business mishaps and mortgage foreclosures, several people might relate to the author’s circumstances.  The experiences he recounts demonstrate psychological elements relating to materialism and insatiability that contributed to the unwise use of liar loans, credit cards, and home equity advances. 

Yahoo! Finance's TechTicker dubbed the story a subprime borrowing nightmare.

Well, perhaps Yogi Berra can best summarize the financial and housing crisis: “We made too many wrong mistakes.”