Saturday, October 20, 2007
As a result, I've been thinking about this concept all week, too. Weighing what I know from nearly 30 years in the financial services sector, plus its history prior to that. Frankly, it sounds like a bad idea. Anytime that asset prices are artificially propped up or manipulated, it's ultimately, in the long run, a bad thing.
Dress it up any way you like, there are really only two alternatives to the immediate marking down of assets to current selling prices:
-delay the recognition of loss via re-pricing, or no pricing changes, in hopes that 'real' prices will, in time, rise, avoiding the current recognition of loss, or
-provide liquidity to avoid the need to sell the damaged assets, thus allowing them to be falsely marked at a higher price.
The other day, a Wall Street Journal piece noted that the Japanese led their economy into a decade-long depression by encouraging banks to keep bad loans on their books at falsely high prices.The piece, which I believe was in the Breakingviews column, noted that in 1907, J.P Morgan- the financier, not his company- saved the US financial markets by personally buying distressed assets, thus injecting capital into the system.
But he bought those assets at their lowered, market-making prices. Thus clearing the market of damaged assets, maintaining true values for assets, and providing liquidity.
I think doing so here, meaning retaining falsely-high asset values, by any means, is a mistake. It will almost certainly trigger Gresham's Law. That is, good assets won't be exchanged for suspect assets.
So much for the theory, and some history, behind my views. But let's take a little closer look at the actual mechanics involved in Treasury's scheme.
There are an assortment of SIVs- structured investment funds. You can think of these funds as similar to mutual funds, and, particularly, similar to the two Bear Stearns funds which cratered this summer, leading to the ouster of the CEO of that firm.
Basically, a financial services firm, such as Citigroup, which operates a handful of SIVs, solicits investors to contribute to the fund. The investment is levered, and CDOs and other structured financial instruments are bought, the yields on which are anticipated to exceed the interest paid on the commercial paper which the fund issues to complement its equity base.
Now, with the market for commercial paper 'seized up,' these funds can't easily re-fund their assets.
It's important to note that while, say, Citigroup may be the operating manager of the fund, reaping fee income, they do not have any equity nor asset interest. That is to say, although they clearly, and cleverly, imply that their moniker confers a quality image on the fund, they are not, technically, liable for anything except managerial diligence. Much like Bear Stearns' two erstwhile mutual funds, from which the latter firm desperately tried to distance itself, before capitulating to public opinion and making good with bailouts of the funds' investors.
So we have SIVs conceived and managed by Citigroup, and others, such as Gordian Knot, according to Thursday's Wall Street Journal article, scrambling to fund the assets of these SIVs, or face unwinding them.
If they have to unwind them, this means selling complex assets, in order to ratchet down the balance sheets and avoid re-issuance of commercial paper.
Here's where Treasury became concerned. A clutch of SIVs, all invested in CDOs, dumping even the best ones on the market, will cause prices to drop. Then all of the funds will be marking asset values down, causing asset-liability mismatches, equity losses, and further dumping.
Simplistically, Treasury, and some commercial bank CEOs, believe that raising a hundred billion dollars to buy the "higher quality" assets of these SIVs will forestall price declines, by effectively creating a private capital pool to fund the SIVs.
It's as if this special M-LEC, short for Master- Liquidity Enhancement Conduit, will swap, or engage in repo-style funding of the SIV balance sheets, rather buy commercial paper. The M-LEC would issue its own commercial paper, thus becoming a sort of stand-in for the actual CP market place.
In effect, the M-LEC is being touted as a clean, safe, Treasury-sanctioned joint bailout fund which will hopefully be trusted by investors, so that it may issue commercial paper that the untrustworthy SIVs cannot.
Two criticisms which I have read about this solution ring fairly true to me. One is that investors may just step back from the whole mess, realizing that, without an explicit Treasury guarantee, like Freddie Mac or Fannie Mae, this fund is still a risky counter party. Its assets are still the stuff that is mis-priced and suspect for defaults.
The other worry is that this fund will further starve even the better SIVs, becoming the preferred, lesser-risk investment to the actual SIVs.
It's tempting to want to support this M-LEC solution, in order to prevent the presumed demolition of prices of complex CDO-type fixed income assets with which SIV portfolios are chock full.
Let's consider what would happen if the M-LEC did not take off, and the SIVs had to wind down their investments.
Some very specious assets would be sold at fire sale prices. Investors in the SIVs would be substantially wiped out. Some creditors of the SIVs, holding commercial paper, would be stiffed, too.
So far, I don't see how this is different from the fixed-income equivalent of a severe downturn in the equities market. Investors buy assets, misjudge risk, and lose principal.
The banks are allegedly not involved in this. That is, they allegedly do not have to make good on any commercial paper borrowings, or asset price declines. They ostensibly lose fees. And probably never return to this business again, their reputations for doing this sort of thing besmirched for perhaps the next decade. Or as long as it takes one of today's junior traders to rise to be a managing partner of an investment bank some years hence.
True, there's a contraction of capital in the market. But there are no false prices. What's in the market, is correctly priced.
Using the M-LEC solution, there is, as my first condition of falsely pricing assets too high for a time stated, a suspension of reality regarding the prices of complex SIV-held assets. What is to be the condition under which the M-LEC would be unwound?
With a sort of false prop under the real commercial paper market, when would we know that it's safe to dissolve the M-LEC?
Or would it become a sort of permanent, anti-trust-violating super-asset management fund, with preferred commercial paper underwriting status?
I guess what I do not see, yet, is how, when, under what conditions, the M-LEC will terminate. Would that not have to be the condition that SIV assets become, once more, valued nearer par?
What would make that happen, if there's no 'real' market trading in them?
No, I think in the final analysis, the M-LEC is a false solution which will lead US financial markets dangerously close to catching the "Japanese disease" of holding bad assets in portfolio at par value.
Like it or not, the quickest, fairest way to solve the SIV problem is to let them go bankrupt, let their equity investors and creditors pay the price for their decisions, and flush the bad assets down to appropriate, market-clearing prices. Once assets are correctly priced, and capital is lost, then the remaining players, and their capital, can invest with confidence that publicly traded prices for all financial assets are 'real' prices.
Next, I'll have a few words to say on who is supporting the M-LEC thus far, and who is not.
Hint: I just wrote a post here about one supporter. His fellows share some troubling characteristics which I will discuss in the upcoming second post on this M-LEC topic.
Friday, October 19, 2007
Last Friday, I literally walked into a local retail branch of the Bank of America, sat down with an officer whom I know from a few prior transactions, and offered her the opportunity to take our options portfolio management business away from E*Trade.
Having experience in re-engineering the trust and custody businesses of Chase Manhattan Bank some years ago, as well as over a decade in asset management, I am well-versed in knowing what a diversified conglomerate financial institution like BofA should be able to offer my partner's and my business.
After spending about ten minutes explaining our business needs to the retail branch officer, she called one of her contacts in the private banking area. After they spoke briefly, she handed me the phone, and I repeated most of my earlier conversation with the branch officer.
I explained our problems with E*Trade, and precisely what we expected and wanted BofA to do for us.
Several times during my conversations with the two BofA officers, I said something like,
'I'm interested in seeing if Ken Lewis' universal bank model works. I'm a retail customer, offering you an opportunity to get several million dollars worth of institutional investment business.'
In my conversation with the private banking officer, I confirmed that BofA has institutional trust services, an asset management group, and a Wall Street brokerage presence. Later, I also recalled that they had bought US Trust from Charles Schwab, after the latter failed to make that acquisition fit with their discount brokerage business. So BofA has all the necessary pieces of our required, requested solution.
The result? Utter failure. As I write this, four and a half business days later, nobody has contacted me. Not the officer with whom I met. Not her colleague in private banking, with whom I spoke.Nobody.
As with UPS and EBay earlier this week, BofA demonstrated a lack of frontline, customer-contact skill. A new piece of business literally walked in the front door of one of its branches, and was summarily dropped from sight.
I know yesterday's horrendous earnings report from the bank was largely marred by trading and investment banking problems.
However, to me, the retail experience I had last week seems emblematic of the bank's sheer size as a feature which prohibits it from being competently managed.
As I discussed this experience, and post, with my old Chase friend and colleague, B, today, he related a truly horrific experience of his with Chase. They confused social securities numbers on accounts, and froze some of his assets for no cause.
As we discussed the treatment we had just received from two of the country's three largest banks, and watched the third, Citigroup, imploding from the managerial incompetence of its CEO, Chuck Prince, combined with the complexity of running the sprawling institution, B and I reaffirmed our belief that these financial juggernauts cannot long, if ever, consistently outperform the S&P500 anymore.
Reviewing the 2- and 5-year Yahoo-sourced charts above, you will not that BofA cannot manage to surpass the index over either timeframe on a simple basis, let alone consistently.
Between Lewis' corporate banking travails, and his retail bank's inept staffing, I don't think BofA will be giving anyone reason to prefer it to the S&P5oo as an investment anytime soon.
Thursday, October 18, 2007
Ken Lewis, your turn comes tomorrow.
Today, I want to discuss, in the first of two posts, how the overall mediocre performance of companies can sometimes be explained from simple, daily contact with those firms and their frontline employees.
Just as a river the size of the mighty Mississippi swells from countless tiny rivulets of drops which flow into one another, eventually comprising our nation's largest river, so, too, do millions of individual, small transactions at EBay, UPS and BankAmerica combine to form the companies' top line revenues.
Each of the three is an intensively retail operation. And, within the past three business days, each has failed miserably at some sale- or customer-service related task. With me.
I don't think my experiences are all that atypical. The nearby, Yahoo-sourced charts depict the failure of Whitman, Eskew and Lewis to lead their firms to outperform the S&P500 Index's total return over two years, and only Whitman to manage the task over five years. Even so, EBay clearly has been inconsistent, falling in value since early 2005, making it, in effect, a timing play, not a consistent long-term market outperformer.
My recent experience with EBay and UPS involves selling some sports equipment for one of my children. It is, in many ways, a simple story. But I now believe the ending foreshadows the obvious difficulties these companies are having in providing their shareholders with consistently superior returns.
I have bought items on EBay for years. As a buyer, it's a relatively simple process. Sign up for Paypal, and it's truly a snap.
But for sellers, who actually fund EBay, it's a totally different story. Last year, while selling various toys and electronic items for my children, I first encountered problems with shipping. On one irregularly-shaped item, we took a bath, due to the difficulty in quoting shipping costs to an unknown location. Neither the US Post Office, nor UPS, made it easy.
This year, one of my children had a leftover toy to sell, because the winner of its auction had never completed the payment process. We were left trying to sell the item too close to Christmas to get a buyer. The other item was a set of little-used sports equipment with a retail value of just under $200.
The sports equipment drew many browsers, some watchers, and several bids, resulting in a winning bid of around $50.
In EBay's profit model, sellers pay the bills. There are listing fees, auction completion fees, and Paypal fees. Though small, all those little droplets of revenue, $2, $3, $5 at a time, add up to EBay's top line, and, eventually, bottom line.
Shipping, as everyone knows, is expected to be paid by the buyer. But how to be sure of the shipping costs? This is why the US Post Office created those handy free boxes for Priority Mail. You get the box free, and pay a fixed rate to send it. It's very EBay-friendly. You list with a fixed shipping cost, and both buyer and seller bear no risk.
But the sports equipment we sold was irregularly sized. So I chose UPS. After experimenting with various zip codes, because UPS prices by distance, I found a 'shipping cost calculator' which EBay allows you to place on your auction. It even has UPS's name attached to it.
Long story short, the winning bidder's zip code, when plugged into the actual UPS shipping calculator, along with the weight and dimensions of the package, came to $11. And that is what EBay's invoice used, and the buyer paid.
Next, using EBay's allegedly sophisticated tools, I chose to pay for and print out the UPS shipping label on my computer's printer.
Upon entering the same exact package and destination information, Paypal charged my account $18, due UPS.
That's right! The actual shipping cost was $7 higher, on an $11 quote. A 64% mistake in UPS's favor.
Having already sent his payment via Paypal, the buyer was safe. My daughter had to eat the $7 error out of her profit on the equipment.
Are you with me so far? EBay and UPS have just conspired to treat me, as a seller, abysmally by giving me 'selling tools' which include malfunctioning shipping cost calculators that err on on the low side when I send the invoice for payment by the buyer.
Now it gets really good.
I contacted EBay to inquire about the malfunctioning calculator. First, I received an automated response essentially pointing me back to the calculator in their help pages. Next, I received this reply,
"Please understand that eBay can't guarantee the amounts given by the shipping calculator. We provide this information only as a free service to our members. Additional services, such as signature or delivery confirmation, may cost extra and are not included in the shipping calculation. In addition, if the seller accidentally selects the incorrect weight or package size, the calculated amount will be incorrect.
eBay does try and be as accurate as possible. As such, eBay works with Pitney Bowes to validate the eBay Shipping Calculator calculations monthly.
In future we suggest that you confirm the shipping charges from your shipping provider and then list them as a flat shipping rate on your item listing. "
Translation: We never actually guaranteed that the tools we give you will work. We don't stand behind them. Further, you're probably either a liar or a moron, and have entered incomparable shipping information for the invoice and the shipping label. Finally, while we provided the shipping calculator in full recognition that UPS prices by distance, we recommend you just wing it and risk getting underpaid by quoting some single 'average' shipping cost.
Who treats their customers like this and expects repeat business? Sellers drive the actual profitability of EBay, and it's no wonder they are now beating the bushes to try to lure back one-time customers, as the company's sales growth has flattened.
As for me, I'm not sure I'll ever sell on the site again. Buy, yes. Sell, probably not. If I do, it will be in some convoluted form stipulating that I determine the shipping price before sending an invoice. Either way, it's horrendously inconvenient.
So much for EBay's service management and provision, and customer "service" function.
Now to UPS.
When I dropped the package off this morning for shipping, I asked the service agent about my EBay experience. Her first response was,
"I'm not really with UPS. We're just an agent. But I can give you a main phone number to call."
OK. Off to a tepid start with Big Brown.
Then the woman says,
"Do you mean charge back? A lot of EBay shippers tell me that happens."
At first, this is incomprehensible to me. Then, after a few minutes of conversation, the truth emerges. A stunning proportion of EBay shippers using UPS have this happen to them, as well. The calculators under-estimate the shipping, forcing the sellers to eat the overage from their profits.
But, wait. The Big Brown tale isn't over yet. I go home and call the number with which the service agent provided me. After several bounces to and from a front-line telephone agent, I finally get a "manager."
Upon beginning to explain my question, the manager, Sandra, cuts me off, saying,
"You probably want customer service. Let me transfer you....."
At this point, my frustration building, I reply,
"No, Sandra. I really don't want customer service. I've run out of patience. So I'm going to tell you what the problem is, and you can relay it. I've spent minutes bouncing back and forth with your agent. This is something UPS should know about and fix, if you still want to work for a company with future revenue growth....."
As I pause to breathe, I hear music.....Sandra has dropped me back into the service queue.
Maybe it's just me, but I think Meg Whitman and Mike Eskew are in for a rough ride. One has services wrongly represented to her paying customers as useful, accurate and reliable. The other has service managers who deliberately ignore their customers' questions.
Do these sound like enterprises in which you would invest? No, they don't, do they?
And, as it happens, neither has been selected by my equity portfolio selection process in years. EBay was in the portfolio long ago. UPS never has been. Small wonder.
I cannot help but think that my idiosyncratic, tiny customer experience with each firm, EBay and UPS, is emblematic of their performance problems. I imagine my experience occurs daily for the two firms, multiplied a thousand times over.
You can use other auction sites. You can ship via USPS or FedEx.
Neither EBay nor UPS has a lock on their business anymore. Certainly not so firmly as to deliberately mistreat and cheat their customers, and behave as if nothing untoward has occurred.
Tomorrow, I share with you my recent challenge to Ken Lewis' frontline troops at BankAmerica to propose a solution to my partner's and my options investing needs.
Care to guess how the financial titan will fare with my request? Tune in tomorrow.....
Wednesday, October 17, 2007
Tuesday, October 16, 2007
This bill, pushed by Florida Democratic Representative Ron Klein would, according to the Journal editorial,
"force the U.S. Treasury to issue below-market loans to state-insurance programs, while also creating a kind of Fannie Mae of disaster reinsurance, a federally chartered organization called the "National Catastrophe Risk Consortium."
According to Treasury Assistant Secretary Phillip Swagel, "Taxpayers nationwide would subsidize insurance rates in high-risk areas, which would be both costly and unfair."
I wrote about this trend early on in this blog, in a post here, and more recently here.
Honestly, I don't know whether to laugh, or cry about what the Floridians are attempting with this bill.
Basically, we have the following series of events.
Over years of benign hurricane seasons, people flock to the Southern Atlantic and Gulf Coasts, putting homes and businesses in harm's way. Then the hurricanes begin to return, and the losses mount.
As private insurers left the oceanfront markets, state governments, albeit foolishly, stepped in with their own funds.
Of course, if you know anything about insurance, you immediately realize that a state such as Florida, tapping its own resources, cannot self-insure against its hurricane risk. The very storms that are to be insured against by the state's taxpayers will damage the state's economic ability to generate income to....pay for that damage, via insurance claims.
So, having established an under-funded state insurance program, the state is now turning to the rest of us Americans, via federal legislation.
This means that even though you may not enjoy an ocean view from Key Biscayne, the other Keys, or the Florida Gulf Coast, you're going to paying for one soon.
There are several aspects to this story that should frighten all of us.
First, there's one state's attempt to force the rest of the country to subsidize their citizen's inability to afford insurance for the area in which they have chosen to build homes and businesses. Perhaps if they had to pay full freight, they would have located elsewhere, mitigating the entire problem.
Second, there's the unwise federalization of what has historically been a private insurance market. What business activity has the federal government ever performed better than the private sector that it replaced?
As I noted in the earlier linked post,
"The net effect of today's mess of homeowners insurance in hurricane areas is to make all Americans ultimately pay the tab for the difference between what local politicians feel they can ask their ocean-front-dwelling homeowners to pay for insurance, and what private insurers would actually demand for those risks. So you and I, if you don't have a beachfront home somewhere between North Carolina and Texas, pay a form of rent to those who do, but we never get to enjoy their view.
Common sense says that if it's too expensive for a person to afford privately-offered insurance to replace the value of a home built so near the ocean in hurricane territory, then the home shouldn't be built. Not that 'someone else' should step in and pay to make it affordable. How long can we, as a nation, afford this sort of economic idiocy?
This sort of market price signal distortion, on such a grand scale, is bound to come a cropper at some point. It's a good argument for simplifying the insurance market to become a national one, rather than 50 local ones, each hostage to local political appointees who try to beggar their neighbors by capping risk prices in their own states, and attempting to force the insurers to recover the true risk premiums 'somewhere else.'
The way things are looking, this would seem to cast doubt on the wisdom of investing in property and casualty firms anytime soon, if one expects consistently superior total returns."
Third, since the legislation intends to make the Federal loans to the state insurance funds 'forgivable,' you know what this means. Through the Federal treasury, we will all be subsidizing ever-riskier building in a variety of natural disaster zones, since there will be no check on the activity.
So there you have it. One state's dissatisfaction with the reasonable reaction of the private, publicly-owned insurers to their citizen's risky home- and business-building in the path of hurricanes has led us to this. A bill to replace the astute risk pricing and rationed capital with the boundless debt capacity and more (endlessly) forgiving insurance practices of the Federal government.
The only positive about this story is that it might warn one off investing in property and casualty insurers until this matter has been settled, one way or another.
Monday, October 15, 2007
In discussing the term with her, I quickly realized that it is used so differently, in so many technical contexts, that she probably has no clear idea just how complex the topic has become.
In an attempt to return to some simpler expression of the term, I sought a definition. On Wikipedia, which is not usually one of my first choices, I found this information,
"Risk vs. uncertainty
In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction between risk and uncertainty.
“... Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. ... The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. ... It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We ... accordingly restrict the term "uncertainty" to cases of the non-quantitative type." "
Since it's a quote attributed to Frank Knight, I felt it worthy of presentation here. And, additionally from Wikipedia,
"In finance, risk is the probability that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.
In finance, risk has no one definition, but some theorists, notably Ron Dembo, have defined quite general methods to assess risk as an expected after-the-fact level of regret. Such methods have been uniquely successful in limiting interest rate risk in financial markets. Financial markets are considered to be a proving ground for general methods of risk assessment."
As a general meaning, I think this is not far from the mark.
To me, risk is the probability, typically expressed via some variant of standard deviation, that actual returns or profits will be less than expected. It is an asymmetric concept, in my opinion.
To use symmetric measures, such as beta, or full, bi-directional standard deviations, is incorrect. Upside variance or deviation is good and, therefore, not 'risk' as we mean it here.
That said, my discussions with others has brought an agreement that the various technical meanings of risk tend to differ because of context.
For instance, I began to describe to the young woman in question, a college student, four different contexts in which one could measure risk: fixed income rating; loan underwriting for portfolio holding; equity investment management, and; institutional trading.
All four scenarios have risk which must be expressed quantitatively and managed.
Rating agencies like S&P, Moody's and Fitch want to minimize unexpected, quick downgrades of their prior ratings. Loan originators and portfolio lenders want to limit negative surprises which cause downgrades of their loans, and the loss of principal. Equity portfolio investors want to minimize the likelihood that a firm's future performance during the expected holding period will be worse than expected. The same is true for traders, although their timeframe is the shortest of the group.
Essentially, risk in its various contexts requires measurement of downside variance of actual from expected returns over different time horizons. Risks which a trader would not accept, may be, and often are, completely acceptable to me, as a longer-term equity portfolio manager.
For me, after choosing the appropriate time over which to calculate downside standard deviations of historic actual from expected returns, these may be used to adjust the actual returns. No matter what the context or duration of holding period, the concept of measurable downside variance, with which to adjust nominal returns, seems to be a valid and transferable approach to describing, measuring and managing risk.