Friday, October 26, 2007

More on The M-LEC and SIVs

A Wednesday Wall Street Journal article in the Money & Investing section, entitled "SIV Situation: Will Rescuers Arrive in Time?" confirms my understanding and diagnosis of the SIV situation, as I described in a post here recently.

According to the Journal piece,

"SIVs need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings."

Thus the targeted $100B size of the M-LEC fund proposed by the Treasury. The article further reports that SIVs have some $350B of assets, mostly in mortgage-backed structured finance paper.

Echoing my post of last week, in which I wrote,

"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,"

The Journal opines,

"Besides tapping the superfund (M-LEC), SIVs are likely to re-structure their debt, wind down, or, in a worst-case scenario, become a dead SIV that can't pay debt investors."

Contrary to my friend's contention, in a conversation I reported here last weekend, that SIVs are levered 3-4:1, the Journal article says that most have only a 5% equity-like investment in 'Capital -notes.' This makes the leverage 19:1.

The Journal pieces continues,

"Capital-notes holders face two options: risk losing money if the SIV sells assets to the banks' fund at a loss, or try to keep the SIV going by buying more of its debt. In recent days, SIVs have been trying to persuade capital-notes holders to buy medium-term notes to fund the SIVs and protect their investments, people familiar with the matter say. Some capital-notes holders -- and SIVs -- say they are skeptical about the banks' plan, because selling assets at today's prices will require the SIV and the notes holders to recognize a loss on those investments.

The lead banks have provided little public guidance on their plans for the fund, leaving themselves open to criticism. Executives working on the fund see it not as a silver bullet but as one of several options open to SIV operators, according to a person familiar with the effort.

The plan would benefit a lead participant, Citigroup, because it is a large operator of SIVs. The SIV industry has become a key part of the U.S. economy, because the funds buy securities backed by mortgage loans to U.S. home buyers. The industry, at its peak earlier this year, totaled about 30 funds with $400 billion in assets.

The three banks have many issues to work out, according to people familiar with the situation. They need to figure out how participating banks would divide any profits or shoulder losses when the rescue fund is wound down, according to people familiar with the plan. They need to decide if participating banks will be ranked based on how much funding they provide, just as banks take lead and supporting roles in stock offerings."

These are some of the issues which I mentioned in my initial piece on this topic last week, providing more reinforcement for my views on this evolving financial services issue.

As a former Chase Manhattan corporate strategist, I can't but help muse about how these events have been triggered by the last decade's evolutions in commercial banking roles. As I wrote here, last month, concerning another article appearing in the Wall Street Journal,

"But a larger issue struck me in this piece. Maybe credit markets went too far in their evolution to total market pricing of credit and debt.

Commercial banks seem, after all, to have a few advantages that were unapparent in a consistently up-market.

Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?

It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.

Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.

It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"

The passage in Wednesday's Journal article citing the importance of the SIV sector, "at its peak....about 30 funds....$400 billion in assets," causes me to ponder how the three largest commercial banks- Citigroup, Chase, and BofA- and perhaps a few more, would have managed the mortgage assets on their own balance sheets a decade ago.

Back then, the largest banks built or bought large mortgage origination businesses, feeding into the banks' own large lending portfolios. The rise of securitization, with its liquidity and market-based risk pricing, made it economically feasible and sensible for the commercial banks to cede the portfolio lending business to a market of CMOs and, now, CDOs.

If the commercial banks had remained portfolio lenders, would this current SIV sector have reached $400B in assets? Or would the risk management functions of the banks have slowed as the mortgages began to decline in quality, hitting the sub-prime market? For example, one-time high-flying manufactured housing lender Green Tree Financial was rescued by an Indiana-based insurer, not a commercial bank.

As inept and stodgy as commercial banks can be, including their own prior mortgage lending problems which helped lead to the RTC creation to clean up the last housing finance mess, I think they perhaps exercise a bit more focused risk oversight than a widespread free market in CDOs.

While free financial markets more accurately price risk over time, they are prone, naturally, to excesses, as they swing from birth, to growth, to excessive growth, to default and contraction.

Hopefully, the long term response to this latest housing finance cycle won't be Congressional legislation which hamstrings the market with excessive and clumsy regulation. Given some time, it's likely that the market will provide its own blended solution of a return to portfolio lending by commercial banks, mixed with a modest re-emergence, in time, of securitized residential mortgage paper. And, next time, it's likely that investors will be more wary, and rating agencies will be more sanguine in the development and operation of their loss prediction models.

Microsoft's Banner Day

The business/financial news programs were going crazy over Microsoft's post-close of market earnings report. In after hours trading, the stock is up roughly 10.5%, after closing at $31.99.

This will probably be front page news tomorrow in the Wall Street Journal, occupying the first or second paragraph in the left "What's News" column.

To give some perspective, I went to Yahoo and downloaded daily adjusted closing prices for Microsoft from 1986 until yesterday, then added the 10.5% gain as today's price. Then I constructed a daily return series from the daily closing prices, sorted by returns in descending order, then selected the top 50 days.

After removing all days prior to 1990, the nearby table of 18 entries resulted. You may click on it to see a larger version.

Prior to after-hours yesterday, which I have labelled as "10/26/2007," the last time MSFT had a top-18 day gain for the last 17 years was May 8, 1002. That's over five years ago.

Before that, there were five days in 2001.

Of course, this is only half of the story. For the other half, I performed the same sort of analysis

for the worst daily returns for MSFT since 1986. That table is nearby this text.

As the table shows, MSFT had an -11.4% daily return as recently as April 28 of last year. A 'greater,' but still negative, daily return of -7.9% was posted nearly four years ago to the day, on October 24, 2003.

Since 1990, of MSFT's 21 worst daily returns, 5 have occurred since the beginning of 2002.

Thus, when you view both extreme daily gains, and losses, for MSFT in the past five calendar years, it's clear that the more frequent result of holding the stock is to experience an outsized loss.
Further, you'd have experienced a total return of -43% from the most extreme negative MSFT returns since the beginning of 2002, vs. +22% from the total of the most extreme positive MSFT returns over the same period.

Why all of this analysis?

Well, just in the brief after-market comments I heard on CNBC this afternoon, it sounded like one quarter's earnings, and the after-market stock price rise, confirms a new era for Microsoft. But the truth is, for the last roughly 1,250 market days, the stock has had only two days ,like this. And many more of similar magnitude, but a negative direction.
Today's performance is more like a rogue wave than a steadily rising tide of excellent peformance.

It's all well and good to be impressed by a 10% gain in the after-market on the strength of one quarterly earnings report from a company that has been moribund for over five years. But, as the accompanying Yahoo five-year price chart shows, you'd have been far better off buying and holding the S&P500 Index for the past five years than you would have been holding MSFT.
Thus, an astute investor wouldn't be in MSFT today to capture the tsunami-like one day 10% gain. Performances like this are near-worthless for anyone but a complete speculator. And certainly not for an investor interested in consistently superior total return performance.

Thursday, October 25, 2007

Investment Banking's Continuing Fallout: BofA and Merrill Lynch

Today's Wall Street Journal editions features two significant stories involving BofA's capital markets restructuring, personnel reshuffling and recent losses, and Merrill Lynch's Stan O'Neal's woeful and inept risk management oversight.

In light of the BofA pull back from capital markets my recent post, here, seems almost uncanny.

Truth be told, BofA's pretension to be a capital markets power, as the Journal article cites,

"The top-to-bottom assessment of the investment bank, coming less than a week after the company reported $1.45 billion in third-quarter trading losses that caused its overall profits to tumble 32%, is the strongest indication yet that the nation's largest consumer bank may face insurmountable hurdles in its quest to compete against giants such as Goldman Sachs Group Inc. and Merrill Lynch & Co. on Wall Street,"

has always been somewhat delusional. And, personally, I take issue with even lumping Merrill Lynch with Goldman Sachs.

Anyone who has been close to the investment banking sector, knows professionals in it, etc., will probably agree that the sector's roots in smallish partnerships is an important distinguishing characteristic. That BofA could have ever seriously entertained the notion of becoming a competitive force among investment banks is, honestly, laughable.

Investment banks like Goldman, Morgan Stanley, Bear Stearns, and Lehman, are, essentially quasi-organized bands of financial market buccaneers. You need look no further than the classic boardroom battle at the original Lehman Brothers, between Pete Petersen and Lew Glucksman, to understand this, and the golden rule of investment banking, he who has the gold, rules.

And it's a lot of gold. That's why the very best financially-applied minds skip commercial banks, and go to investment banks. I wrote a bit about this recently, here.

So the conundrum for any commercial bank- Chase, Citigroup, BofA- is one of living with a foreign virus called 'investment bankers,' and the risks the freewheeling trading and deal making styles they bring, or accepting the expensive luxury of a smallish, uncompetitive, second-rate investment banking unit which can never truly rival their peers at pure investment banks.

The largest three US money center banks' strengths involved far-flung international networks, a broad presence across deposit, fee and lending businesses, and, long ago, credit ratings superior or equal to those of their customers. They were never known for attracting the best minds. Those people headed for the far more profitable territory of investment bank partnerships. And, even after the last of these, Goldman, went public, it still offers compensation levels far in excess of those even the very highest levels of commercial banks.

If you don't believe me, go check out the recent compensation data for Ms. Amy Woods Brinkley, BofA's (soon to be former?) Global Risk Executive. According to the company's profile on Yahoo Finance, she earned a total of just under $8MM in cash and exercised options last year.

Maybe the gang from Charlotte never really understood that merely appropriating the BofA name didn't grant them entree into the innermost sanctum of American capitalism, trading and investment banking. Judging by the $675MM spent on hiring traders and bankers, and the 'deep into the red' trading losses this year, according to the Journal article, Lewis and his team badly misjudged just what it would take for their expensive dreams to pay off.

The same can't really be said of Stan O'Neal, Merrill's hapless CEO. According to Forbes, O'Neal was paid some $22MM last year, and more than $50MM over the past five years. Capping his career at the retail securities giant, he became CEO in 2003, thus owning the current team and decisions leading to yesterday's admission of a larger writedown than had been acknowledged just a few weeks ago, here.

A conversation yesterday with a friend who is a former Merrill employee confirmed that O'Neal had replaced senior fixed income executives in recent years with his own choices.

Of course, O'Neal reportedly has one more line of Praetorian guards to shove between him and the his board's indignation: President and COO Ahmaas Fakahany and CFO Jeff Edwards.

Yesterday, on CNBC's morning SquawkBox program, former GE CEO Jack Welch, when challenged to comment on the horrendous losses at Merrill Lynch this quarter, opined that the company's CEO, Stan O'Neal, should 'be accountable.' However, upon being grilled as to whether that meant O'Neal should be fired, he backpedaled with astonishing alacrity. SquawkBox co-anchor Joe Kernen chided him for being an "old boy" and reserving judgment on fellow CEOs. Welch just sat there and remained silent.

So much for Jack giving it to you "from the gut."

But, surely the Merrill board of directors, enumerated here, will be calling someone to account for this $8B loss of shareholder value? Hopefully O'Neal and his management team.

So here we have two CEOs, Ken Lewis and Stan O'Neal, of two investment bank-wannabe firms, BankAmerica and Merrill Lynch, losing a combined $9B so far this year from playing in the sandbox of their more skilled rivals, Goldman Sachs and Morgan Stanley.

If this sort of experience and result doesn't help people distinguish between the cultures, risk management and performances of investment banks, retail securities firms, and commercial banks, I honestly don't know what will.

Running Scared: CNBC vs. Fox Business Channel

It's week two of Fox's Business Channel, and I still haven't seen it. My Comcast system doesn't carry the channel yet. I guess Roger Ailes was right when he remarked in a Wall Street Journal interview, about which I wrote here, that FBC would debut in only a sliver of the market that CNBC reaches.

Still, CNBC's recent format changes show how it's running scared from the implied threat of, if not the actual new Fox Business Channel.

Watching or listening to the dominant cable financial news network has become like watching someone on speed. It's so frenetic you can barely digest what guests or reporters are saying.

Every other segment is a business version of the Brady Bunch- a group of bobbing heads, often all screaming at once to be heard. You know that the producers think a topic is big or deep when

they assemble a Task Force!

That's the cue for that screen full of moving heads that begin screaming at the anchor or other guests. For the next 120 seconds or so, you get this furious assault on your ears of sound bites representing the various headline positions on the issue du jour.

Justifiably worried that Fox will begin to erode CNBC's market share, the latter's producers have gone for a hectic, frenzied pace that virtually eliminates thoughtful consideration of business news developments.

The anchors are very full of themselves now, in a way they didn't use to be, and espouse this sort of puffed-up camaraderie, as if they, themselves, are the fonts of business knowledge and news.

As if.

The other morning, while Jack Welch engaged in meaningless chit-chat on a phone link with Warren Buffett, who was traveling with CNBC co-anchor Becky Quick, the network displayed a banner on the bottom of the screen reading something like,

'Jack and Warren Talking ONLY On CNBC'

I guess one might describe CNBC's new strategy as "All Business Celebrities, All The Time."

They clearly are attempting to literally corner the market on CEOs and other presumed business (g)literari. Too bad that the average CEO is, well, so average. Hardly a font of global business wisdom, actually.

Here's another indicator of CNBC's level of concern. I belong to their online panel, CNBC XChange, or somesuch named focus group. Last week, they sent me a very quick, three-page survey. It consisted of essentially three questions:

-have I heard of Fox Business Channel?
-can I get it on my cable system yet?
-whether or not I can get it, do/would I watch FBC vs. CNBC 100/80/60/50/40/30/20/0% of the time. Or some set of splits reflecting relative time spent with the two networks' programming.

Pretty focused on FBC, eh?

Look, I give the CNBC producers credit for having the good sense to take their former boss, Roger Ailes, seriously. And if they didn't, you know I'd be writing about their hubris and stodginess, to be stuck in neutral while a new competitor came at them like a pair of pruning shears.

Yet, somehow CNBC's response is so...... shallow. It smacks of aiming for a cheap, vapid, entertainment-style treatment of financial markets and related news.

When they could have shifted to a more in-depth, reasoned and value-creating approach, the dominant cable business channel instead intensified its attempt to reduce everything about financial markets to its most frequently uttered phrase,

"So, what's the trade?"

Because, on CNBC, despite years of good academic research to the contrary, they believe that their viewers, institutional and retail alike, should be constantly trading on whatever they have just seen on CNBC, rather than implementing a considered 'buy and hold' strategy.

Perhaps the good news is that the more reasoned, reflective approach to interpreting financial and general business news remains open to the new Fox Business Channel.

Now, all I have to do is get a chance to actually see it.....

Wednesday, October 24, 2007

Who Cares What Julian Roberston Thinks Anymore?

This post really covers two topics. The first involves CNBC's repositioning of late, in order to prepare for competition from the new Fox Business Channel. As a case in point of that topic, I find myself commenting on the reappearance of failed hedge fund manager Julian Robertson.

Julian Robertson was interviewed by Erin Burnett on CNBC last week. As part of the network's attempt to push its ability to feature long interviews with financial personae, present or long past, they trotted out segments of a recent interview with the one-time manager of the Tiger Funds.

Really, who cares? Didn't Robertson blow up his hedge funds up ten years ago? Failed, closed the funds and got out of the business?

Is CNBC so desperate for guests that they need to resurrect this guy? Who's next, Michael Steinhardt, John Meriwether and Bob Vesco? Well, I guess Steinhardt's busy with his new ETF business, so he's perhaps less available, if more current.

When Googling Robertson, I initially found this piece in US News&World Report three years ago this month,

"Julian Robertson, the legendary hedge-fund manager whose steadfast refusal to be a part of the Internet stock craze essentially ended his investing career in 2000, has run into a new obstacle, this time on the other side of the globe....Since his Tiger Management fund group returned its money to investors--it still exists to manage Robertson's $850 million fortune and advise other fund managers, among other things--"

What's curious is that the USN&WR omits any mention of Robertson's egregious losses in the last year of his funds. More on that later in this post.

This entry from "Investopedia" alleges,

"Year after year of brilliant returns turned a reported $8 million investment in 1980 into $7.2 billion in 1996. During the later part of this period, Robertson was the reigning titan of the world's hedge funds. At his peak, no one could best him for sheer stock-picking acumen. Investors, at a required minimum initial investment of $5 million, flocked into his six hedge funds.

In the late 1990s, Robertson agonized over the tech-stock craze and, while avoiding what he considered to be "irrational" investing, the TMG funds missed out on any participation on the big gains of the sector. The gradual demise of Tiger from 1998 to 2000, when all its funds were closed, was reflected in the plunge in assets under management from a high of $23 billion to a closing value of $6 billion. Poor stock picking and large, misplaced bets on risky market trades are usually cited as the cause of Robertson's downfall. However, it is felt by many objective observers that high-level executive defections from TMG's management, as well as Robertson's autocratic managerial style and notorious temper, eventually took their toll on the firm's performance.

And this, from a CNBC interview in 2005,

"I am more disturbed than I have ever been in my investment life."

He believes the U.S. consumer is all but exhausted (see yesterday's comments on the same subject) , that the effort will be made to "inflate our way out."
He notes a soft landing is possible, but ala Japan, it could involve years of flat or no growth.

Of course, there was no catastrophic recession in 2005...or 2006....or 2007.......

Another Google search result was this column, from August of 2005. It contends, in part,

"Julian Robertson is a loser. But he doesn’t lose his own money. He only loses Other People’s Money (OPM). When Julian Robertson was forced to shut down his Tiger Management Group of 6 hedge funds in 2000, according to the Sunday Times of London (April 2, 2000), he readily admitted, “We are in a market I really don’t understand.” Robertson’s record of failure is a testament to his ineptitude.

In an interview with Institutional Investor, International Edition (December 2002), he was asked, “So who do you blame for the stock market bubble?” Robertson answered --“Mr. Greenspan. He and all the other politicians and Fed chiefs. Their objective was, ‘Let’s not let anything bad happen on my watch.’ They were not letting normal business corrections happen, setting us up for a doozy.”

Then when asked, ‘What about the situation today?’ Robertson answered, “This can’t go on forever. The little guy is doing it, but now he can’t spend anymore. He’s tapped out. So the economy will collapse like a house of cards.’”

“Collapse like a house of cards”? It should be noted that in the interim, the Dow has rallied some 3,000 points while “the little guy,” as he puts it, keeps increasing debt levels and refinancing his house to maintain consumer spending. And, sad but true, once again, Mr. Robertson has missed a dynamic bull market!

When asked if America’s economy is going to be as bad as Japan’s, Robertson answered, “We Americans are set up for a very tough time for a very long period of time… The economy will fail ‘when the little guy can’t make the monthly mortgage payment on his mortgage.’” Robertson reiterated this belief in his recent interview on CNBC that he was worried about what was going to happen when Americans started losing their homes.

When Robertson was asked, “How do we get out of this mess?” He answered, “I don’t know how to get out of it. It could be a rough 10-year period for us. I see no way of getting out of it.” That interview was conducted in 2002.

For the record, Julian Robertson was the fund manager of Tiger Management Group, which had $23 billion at its peak and $6 billion when it was rolled up. Robertson has admitted that he doesn’t understand the markets and thus missed one of the most dynamic bull periods in the market (1998-2000) and then again missed a second bull market move from 2002-present. Nevertheless he now wishes to form yet another hedge fund.

Continuing with Julian Robertson’s record of failure, the Financial Times of London (November 6, 2004) writes that his investment management record deteriorated “when Russia defaulted on its debts in 1998. By this stage, he was looking in some very strange places for advice.” According to Strachman, author of A Tiger in the Land of Bulls and Bears, “Robertson had looked to guidance from Margaret Thatcher and Bob Dole. Both had asserted a default was impossible.”

Then Robertson’s desperation led him to try to recoup losses by investing in dangerously unstable but extremely high-yielding debt. It was essentially a gamble. And his investors lost.

“Robertson was remembered less kindly for losing $200 million in 1996 with a bet on U.S. Treasuries that went wrong… Investors withdrew money from his funds he wound down in 2000 when it had fallen to $6 billion. He has been since running his own foundation. His net worth has been estimated at more than $400 million.”

Business Week (April 17, 2000, called the collapse of Robertson’s Tiger fund “the biggest hedge-fund collapse in history.” And it didn’t get a government/ central bank bailout like the geniuses at Long Term Capital either.

How Robertson dealt with it, according to Business Week, was however a “stroke of genius. And the press largely swallowed it whole…He released a 2-page letter to his investors portraying himself as a champion of rock-solid value investing. This sound philosophy was made impossible by ‘an irrational market’ that he likened to a Ponzi scheme destined for collapse.”

Robertson should have known by then the very first rule of investing: Never fight the trend. Instead he calls the entire market a “Ponzi scheme.” "

Why would anyone now care about his views now on economics, inflation, etc. ?

For what it's worth, I can attest to the version of Robertson's fund collapses as being attributed to excessively-risky bets.

Sometime during 1999-2000, I accompanied my then-partners in a hedge fund, for which I sub-advised, on a trip to Santa Barbara, California. At a dinner party there, I spoke with a successful, retired investor who sat on several institutional investment committees, including that of a prominent California university.

That university had invested in one of Robertson's Tiger funds. As such, it merited a personal visit by him to explain the fund's demise. Thus, this anecdote comes directly from someone in the room as Robertson described his fund's losses.

Essentially, according to my conversation partner, Robertson let several traders in one of his Asian locations get heavily invested in hedge trades which Robertson confessed were more complex than he could understand. They resulted in serious losses- the losses which ultimately triggered his funds' closings. I distinctly recall this man's shock in learning, directly from Robertson, that he had essentially abandoned risk management, or even making sure he at least understood the ramifications of the hedged positions being put on by his traders.

With this as a background, I find it bordering on reckless for CNBC to be treating Julian Robertson as some sort of font of business and investing wisdom for the ages.

There are a host of ways in which the network could position itself to compete with the new Fox Business Channel. It's sad that their chosen method is to go for celebrity name interviews, rather than solid, reasoned analysis of business news.

More on this in a subsequent post.

The M-LEC Silk Purse

As I inquire about, and listen to comments concerning, the M-LEC structure being touted by the Treasury department, I hear similar responses to mine, about which I wrote earlier this week, here.

Last night, while working out at my fitness club, I ran into an old colleague from my days at Chase Manhattan Bank. Bill was a savvy, up and coming IT guy with a lot of business sense. Always well grounded amidst the false sense of grandeur that Chase still espoused in those days, he would frequently lampoon the senior management's "big cigahs and motorcahs.'

These days, Bill heads the American arm of a mid-sized European bank. He hasn't lost his sense of humor, as evinced by this exchange,

Me: Hey Bill, want to buy some structured finance instruments?
Bill: No thanks, I already have a bunch.
Me: Well, how about we each sell each other some troubled structured instruments at falsely-high prices, like Mike Milken used to arrange among his high yield customers at Drexel?
Bill: *Nods his heads and laughs heartily*

Funny, when you think about it, isn't it? What Milken was excoriated for allegedly doing twenty years ago is now being advanced by our Treasury as the way to alleviate the current SIV liquidity dilemma. What is frowned upon as securities market manipulation when done by an investment bank is considered proper when the Federal government sponsors the same behavior.

I don't actually think my friend's bank has much exposure to structured instruments. But when I asked what he thought of the M-LEC concept to save the SIVs, he agreed that it would make real market price discovery very difficult. And make it hard to know when 'normal' market conditions had returned for them, allowing the wind-down of the M-LEC.

Then he chortled, noting that, ironically, Bear Stearns, which triggered the whole mess with its two crippled mortgage-instrument hedge funds this past summer, has actually come out clean in the subsequent act two of this financial drama.

Then, this morning, on CNBC's Squawk Box program, guest host Jack Welch, when asked what he thought about the M-LEC idea, replied, to paraphrase the former GE CEO,

'You can wrap up this pig, but it's still going to be a pig.'

Just so.

He also, tellingly, referred to the 'three banks' which are now identified with the fund. Make that three commercial banks. As I wrote here, recently, it's evident that the investment banks are steering clear of buying into the master SIV concept.

One of the CNBC reporters mentioned that he had spoken recently with Larry Fink, of Blackrock, the now-partially-public private equity firm, concerning the M-LEC. He stated that Fink noted how market bottoms require written-down prices of damaged financial instruments. Without that market-clearing action, the market can't resume its growth.

The reporter went on to opine,

'And that's what this master SIV will do. It will allow these instruments to be marked down.'

But that's not true. The stated intent of the M-LEC is to allow crippled SIVs to exchange high quality instruments for cash, thus functioning as a stand-in to supply commercial-paper sourced liquidity to SIVs which can no longer access that market. Nobody, to my knowledge, nor according to the articles I've read, believes that the worst paper will be sold, at true, open market prices, to the M-LEC.

Tuesday, October 23, 2007

Jamie Dimon's Chase: "Time To Grin?" Not So Fast.......

Last Thursday's Wall Street Journal's Money & Investing section featured a glowing, fawning article on Jamie Dimon, CEO of JP Morgan Chase, entitled "J.P. Morgan's Time To Grin." Dimon's smirking mug is prominently displayed next to a stock price chart showing Chase having a 97% rise, compared with Citi's 27%, since Dimon's "arrival" at Chase.

If you only read the article, you'll think Dimon walks on water and has miraculously led Chase to financial success while his old outfit, Citigroup, stumbles under Chuck Prince's mismanagement.

However, the Journal article contains, in my opinion, several errors in reasoning and fact. And investors are not limited to just these two choices in the equity marketplace.

From my proprietary research on equity performance, I have observed certain relationships between key variables and the ability of a company to sustain superior total return performance.

The nearby chart presents some of that information for Chase, from 2001 to the quarterly information available as of the end of last month. The table which is its source appears a little further on in this post. Both may be viewed as larger images by clicking on them.

The Journal article contends that,

"J.P. Morgan Chase & Co.'s record third-quarter earnings showed that the financial-conglomerate strategy can work.

A three-year crusade by J.P. Morgan Chief Executive James Dimon to relentlessly slash costs and invest heavily in technology and core businesses appears to pay off amid a global credit crunch that has roiled Wall Street."

First, one quarter does not a successful performance make. It certainly does not 'show that the financial conglomerate strategy can work,' over time. Merely that in one quarter, it out-earned a crippled rival.

And, by the way, commercial banks are not "Wall Street." This is a mistake no investment banker would ever make. Per my post yesterday, here, I would suggest that simply by virtue of being a commercial bank CEO, Dimon is not a Wall Street executive. He's a commercial banker. Period.

The Journal article further states,

"J.P. Morgan's financial results underscored the potential of the so-called universal bank, a model that Mr. Dimon helped create under the wing of legendary deal maker Sanford Weill at Citigroup. Yet it also shows how the corporate strategy, in which assorted financial businesses are brought under one roof to balance out a bank's performance in tough times, requires a strong and nimble management in order to prosper."

I think it is far from clear that Jamie Dimon "helped create" the "so-called universal bank" under Sandy Weill. James Robinson, Weill's one-time boss, at American Express, failed with the 'financial supermarket' model in the 1970s and '80s. Buying ShearsonLehmanBrothers was one of the steps that disproved the model. Renaming it a 'so-called universal bank' doesn't really change much about it.

The original idea, which Weill also subsequently borrowed from Robinson, was to unite all financial service businesses under one 'umbrella,' pun intended, i.e., the old red Travelers Insurance umbrella logo that Weill so loved. Cross-selling to hopefully capitalize on presumed brand loyalty of financial service customers has been the real driving force of financial services diversification. And it's never worked yet. Not even the purer European 'universal banks' were able to sustain profitable growth, neither prior to their US appearances, nor subsequently.

Thus, I find myself in disagreement with the Journal article's authors regarding Chase's imminent prospects.

To the contrary, I believe that the trends displayed in the chart, drawn from original Compustat data, depict a bank already in a financial performance stall.

Look at growth in revenues and NIAT. Annual revenue growth has been declining since its peak of 50.5% in 2005. It is now down to 18.5%. Similarly, annual NIAT growth declined by more than half in 2007, from 70% in 2006.

Both of these trends are not indicative of long-term consistently superior total return performance.

Over the past five years, Chase has outperformed the S&P, 28.5% to 15.4% per annum. Yet it has not done so consistently. The bank has bettered the index in three of the past five years, but its annual returns oscillate wildly from a high of 90% to a low of -11%.

This leads us to examine the volatility of those total returns. Over the past five years, Chase's return standard deviation is 40%, versus the S&P's 5%. It's common knowledge that holding just one stock will expose you to far more volatility than holding the market, via an index such as the S&P. That said, a simple adjustment of dividing Chase's and the S&P's five-year average total returns by a denominator of one plus their standard deviations yields risk-adjusted total returns only 3 percentage points apart.

What I believe has occurred at Chase is an initial reduction of discretionary and, then, core expenses by Dimon soon after his arrival at the bank. This temporarily swelled operating margins, as revenue growth crested against a lower expense base. As revenue growth has been affected by the cost-cutting, it has slowed.

NIAT growth, as a function of the temporary margin expansion, swelled in 2005 and 2006, only to fall precipitously this past year.

If you are familiar with Dimon's mentor, Sandy Weill's origins, then none of this should surprise you. Weill was the original low-cost consolidator of the brokerage industry wire houses in the 1970s and '80s. He was never an investment banker. Rather, his specialty was combining commodity-like retail brokers, combining back offices, sometimes improving technology, and reaping the improved margins. Eventually, he ran out of wire houses to buy and consolidate, so he sold out to American Express.

By the time he was ousted from Citigroup, Weill had demonstrated that he had learned no new tricks since he lost control of ShearsonLehmanBrothers to Amex. Citi's topsy-turvy growth and increased complexity resulted in serious lapses in risk management and attention to business details. Significant growth was not something Citi achieved, sans acquisition, under Weill.

Personally, I doubt that Dimon knows much that he did not learn from Weill. His signal achievement since being tossed out of Citigroup consisted of giving BancOne the "Weill treatment." It is not yet clear he's done anything more at Chase, nor that he is capable of more, either.

It would take at least four years of consistently strong revenue growth at Chase, with corresponding NIAT growth, before I would believe that Dimon is capable of leading a financial services conglomerate to consistently superior performance, either fundamentally or technically.

Monday, October 22, 2007

Reinforcement for My M-LEC & SIV Comments

In this recent post, I discussed the wisdom of the proposed M-LEC fund, to alleviate the difficulties in the commercial paper markets resulting from the much-feared, possibly imminent defaults of various SIV funds.

On Saturday, I happened upon a friend at my fitness club. He manages some fairly sizable institutional funds for a large, diversified financial services firm which resulted from the acquisitions of his old company.

In discussing the M-LEC and SIV situation, he agreed with my assessment of the situation, as well as my questions regarding the difficulty of exiting the M-LEC solution.

To that, he added that nobody knows what is the nominal value of the bad SIV assets. Thus, the time involved to either write down the assets 'safely,' or declare their return to nominal value, is unknowable.

He didn't find fault with my analysis of the need for market-clearing prices. Only that nobody knows how badly equity markets could be damaged, for a time, by the loss of capital in the fixed income markets, as commercial paper is in default and CDO losses are realized.

Which is to say, another seasoned professional, looking at the same situation, sees essentially the same picture. And expresses doubts that anyone really knows how large the problem may be, nor just what will occur if/when we see the true marking-to-market of the complex instruments which triggered this entire situation.

Some Blog Stats

A few quick pieces of information.

After being essentially a private business observation journal for most of the two years I have written this blog, it's recently begun to attract attention.

Thanks to the Wall Street Journal's new policy of linking its online stories to blogs which mention them, I am routinely seeing traffic from the paper's online site. Some days, there will be as many as three Journal pieces linked to my blog posts.

That, combined with Google's search, thus resulted in numerous visits this weekend to read part one of my posts on SIVs and the proposed M-LEC.

With Sitemeter's traffic counter, and its javascript, I get a fair amount of detailed information about who visits.

For instance, beginning recently, the consulting firm for which I was the first Director of Research, Oliver Wyman, now the financial services consulting arm of Mercer Management Consulting, has begun to visit the blog. From the details of the first site visit that I noted, it seems to be a daily scan of the blog.

While I'm flattered that they still care about my insights, perhaps one could conjecture that they now get those insights for free.

But the real value would be in the insights that drive the options investment strategy I co-manage with my business partner. And that's a proprietary strategy for proprietary money.

Additionally, Sitemeter has informed me that employees at Bank of America in Charlotte, Philadelphia, and Jonesboro have visited roughly 10 times, in total, to read my recent posts about SIVs and my dismal experience with the frontline officers at the bank.

Do you think there's a chance that a copy of that latter post, or this post , written earlier today, will get to Ken Lewis?

Folks at Bloomberg, the US House of Representatives, and the Candian Trade Ministry have been reading posts as well. My piece on Florida Governor Charlie Crist's attempt to get the taxpayers of the country's other 49 states to pay for his voters' property insurance got a ton of readership last week.

The blog is now registering around 20 visits per day, with an average of 2 pages read per visitor. Add the uncounted visits via LexisNexis, via my business partner's Newstex operation, and there may well be as many as 50 readers per day now.

I hope these new readers continue to find topics of interest, and comments of value, when they visit.

On The M-LEC Master SIV Fund: Part Two- Commercial Bank CEOs

On Saturday, I wrote this post, discussing the mechanics of the US Treasury's proposed financial sector M-LEC, or Master- Liquidity Enhancement Conduit- a fund to be owned by a consortium of US financial sector firms. Having thus treated structural aspect of the current SIV problem, and a proposed solution, in this post, I want to discuss who is "in," and who is still "out" on subscribing to this "solution."

Thursday's Wall Street Journal featured a fawning piece on Chase CEO Jamie Dimon, including this passage,

"Mr. Dimon defended the bank's decision to join Citigroup and Bank of America Corp. in forming a massive investment fund that is aimed at shoring up sputtering credit markets. J.P. Morgan, (i.e., Chase) doesn't own any of the structured-investment vehicles that are in trouble, leading some analysts to question why it is participating in a rescue plan. "It's very reasonable for J.P. Morgan to play a role in trying to help the system, and that's what this is," he said in a conference call. "

Thus, we see that the three largest US commercial banks, by asset size, are supporters of the M-LEC.

Late last week, I saw an interview on CNBC with John Mack, CEO of Morgan Stanley. He expressed reservations on just how the M-LEC would help the credit situation. I do not notice Goldman Sachs signing up, either.

So, conspicuously absent from the M-LEC list thus far, are large investment banks.

Why is this? Let me opine. In brief, it's a combination of commercial bank CEO experiences and talent, combined with a confusion of most bank CEOs regarding their priorities- shareholder returns versus financial system protection at shareholder expense.

Quite simply, as a group, US commercial bank CEOs are typically less-broadly experienced and, frankly, less 'smart,' in a business sense, than their investment banking CEO counterparts. Stretching back to the 1970s, I think only David Rockefeller and Walter Wriston were, among commercial bank CEOs, possibly on a par with their investment bank peers in terms of vision and business acumen. Even then, these two were encumbered by the inherent obligation, as leaders of large US banks, to act to protect the banking system, rather than focus primarily on their shareholders' interests.

A look at the nearby Yahoo-sourced price chart since the early 1990s for Goldman Sachs (public since 1999), Morgan Stanley, Chase, Citigroup, Wells Fargo, BofA, Wachovia and the S&P500 confirms this.

Back in the early 1980s, as a Chase Manhattan officer, I watched Chase, Citibank and BofA (California- the original one, run by Sam Armacost) all take huge write-downs for billions of dollars of bad loans which were the eventual result of petro-dollar recycling from the oil crisis of the mid-late 1970s.

Several of us in the Corporate Planning & Development group, all exclusively non-bankers hired by SVP Gerry Weiss, former senior strategic planner at GE, observed that, smart as Wriston and Rockefeller had been in cutting their banks in on this massive dollar flow in the form of loans to developing nations, they forgot to take a healthy risk premium off the top for Chase's and Citi's risks. We paid the price in the 1980s. Thus was spawned the following joke,

Q: How do you create a good regional bank?
A: Start with a money center bank and shrink it with loan write-offs.

Think I'm wrong? Look at the current five largest US commercial banks.

Citigroup is the ailing, mismanaged hodgepodge of acquisitions resulting from non-banker Sandy Weill's grab for the commercial bank's assets. More on this in a future post. For now, note that Weill never ran an investment bank, either. He was seen as a sort of financial version of a Seventh Avenue rag merchant, combining and running retail 'wire houses.' He took ShearsonLehman in and out of American Express, but had to buy Salomon Brothers to actually get an investment bank.

Chase is the result of several mega-mergers of the other mediocre New York money center banks- Manufacturers Hanover, Chemical, JP Morgan- and struggling midwest banks that had once been, separately, BancOne, First Bank of Chicago and, I believe, National Bank of Detroit.

Bank of America is the name appropriated for itself when the one-time North Carolina National Bank, a/k/a NCNB, then Nationsbank, gobbled up the weakened San Francisco financial giant.

Wachovia, the other surviving North Carolina regional bank of the 1980-90s, took over the third North Carolina one-time regional, First Union.

Finally, Wells Fargo is the name taken by a Minnesota bank conglomerate, resulting from the takeover of the crippled Norwest by First Bank System, when that combine grabbed the remaining west coast commercial bank.

The original leaders of all of the large US commercial banks of the 1990s lost their companies to acquirers. The US regional banks which avoided the devastating effects of the LDC loan losses of the late 1980s, plus the real estate development problems of the early 1990s, consolidated the sector and took the marquee names of US commercial banking. So we now have the same names, but with a different CEO lineage. Mostly CEOs supplied by regional banks or second-tier securities trading firms.

It's my contention that the commercial banks are backing the M-LEC because they simply aren't as good a group of CEOs as the investment banks. They will obligingly put their shareholders' capital at risk because they feel they must, as part of the 'bargain' for having access to the Fed discount window.

You can't accuse that bunch of being broad-minded, nor good at capitalizing on financial opportunity. In my opinion, they are just too narrowly experienced. Here, for example, are the company biographies of the CEOs of America's five largest commercial banks.

Ken Lewis, BofA CEO

Lewis has been chief executive officer since 2001. He joined North Carolina National Bank (NCNB, predecessor to NationsBank and Bank of America) in 1969 as a credit analyst in Charlotte and served as corporate banking officer and Western Area director in the U.S. Department before being named manager of NCNB’s International Banking Corporation in New York in 1977.

He was named Middle Market Group executive in 1983 when the group was created and was responsible for expanding and improving service to middle market companies throughout the Southeast. He led the bank’s operations in Florida and Texas in the 1980s, served as president of Consumer and Commercial Banking and chief operating officer in the 1990s, and was named chairman, chief executive officer and president of Bank of America in April of 2001.

Lewis was born April 9, 1947, in Meridian, Mississippi. He earned a bachelor’s degree in finance from Georgia State University, and is a graduate of the Executive Program at Stanford University.

To prove my point, Ken Lewis, on his investment banking 'experience' of this past summer, was quoted in Friday's Wall Street Journal as saying he,

"had all the fun I can stand in investment banking at the moment."

BofA had reported something like a 90% drop in quarter-over-year-ago-quarter in investment and corporate banking income. You almost feel sorry for Lewis. He's so over-matched when he attempts to use the bank's enormous balance sheet to try to muscle into the rough-and-tumble capital markets. Maybe the Countrywide move of this summer will work out. Maybe not.

Chuck Prince, Citigroup CEO-

Mr. Prince began his career in 1975 as an attorney at U.S. Steel Corporation and in 1979 joined Commercial Credit Company (a predecessor company to Citi). He was named Executive Vice President in early 1996. Mr. Prince was made Chief Administrative Officer of Citi in early 2000 and Chief Operating Officer in early 2001. He was named Chairman and CEO of the Markets & Banking in 2002, became CEO of Citi in 2003, and was named Chairman in 2006.

Jamie Dimon, JP Morgan Chase CEO

Mr. Dimon became Chairman of the Board on December 31, 2006, and has been Chief Executive Officer and President of JPMorgan Chase since December 31, 2005. He had been President and Chief Operating Officer since JPMorgan Chase ’s merger with Bank One Corporation in July 2004. At Bank One he had been Chairman and Chief Executive Officer since March 2000. Prior to Bank One, he had held various senior executive positions at Citigroup Inc., its subsidiary, Salomon Smith Barney, and its predecessor company, Travelers Group, Inc. Mr. Dimon is a graduate of Tufts University and received an MBA from Harvard Business School.

Interestingly, after Dimon's ejection from Citigroup, he didn't head for an investment bank, did he? No, he chose a sleepy, down-on-the-heels commercial bank in the midwest.
John Stumpf, Wells Fargo CEO

John Stumpf was named Chief Executive Officer in June 2007, elected to Wells Fargo’s Board of Directors in June 2006, and has been President since August 2005. A 25-year veteran of the company, he joined the former Norwest Corporation (predecessor of Wells Fargo) in 1982 in the loan administration department and then became senior vice president and chief credit officer for Norwest Bank, N.A., Minneapolis. He held a number of management positions at Norwest Bank Minneapolis and Norwest Bank Minnesota before assuming responsibility for Norwest Bank Arizona in 1989. He was named regional president for Norwest Banks in Colorado/Arizona in 1991. From 1994 to 1998, he was regional president for Norwest Bank Texas. During his four years in that position, he led Norwest’s acquisition of 30 Texas banks with total assets of more than $13 billion. In 1998, with the merger of Norwest Corporation and Wells Fargo & Company, he became head of the Southwestern Banking Group (Arizona, New Mexico and Texas). Two years later he became head of the new Western Banking Group (Arizona, Colorado, Idaho, Nevada, New Mexico, Oregon, Texas, Utah, Washington and Wyoming). In 2000, he led the integration of Wells Fargo’s acquisition of the $23 billion First Security Corporation, based in Salt Lake City. In May 2002, he was named Group EVP of Community Banking.

G. Kennedy Thompson, Wachovia Corporation CEO.

Joined the company: 1976
In current position since: 2000
Previous positions at the company: Head of Global Capital Markets; president of Florida banking operations; head of Human Resources; various other management positions

Education: B.A. in American Studies, University of North Carolina-Chapel Hill; M.B.A., Wake Forest University

So, there you have it. Lewis, Prince, Dimon, Stumpf and Thompson. The five largest US commercial bank CEOs. Most have careers almost entirely with their current employer. Prince was an attorney at a steel company, then a loan company bought by his current employer. Dimon was apprenticed to a wire house bottom-fisher, Sandy Weill, until Sandy fused the modern Citigroup together, causing massive infighting between four cultures- insurance, investment banking, commercial banking, and retail securities. Then Dimon got himself ousted and headed for the relative safety of an ailing, once-acquisitive midwest bank.

Former heads of Goldman Sachs or Morgan Stanley have become Treasury Secretaries or State Department officials. Sometimes they depart to found or join private equity firms or hedge funds, such as Pete Petersen, Larry Fink, et. al.

Even now, as Citi's Chuck Prince's future is in doubt, the newest rising star at the firm is an asset management czar hired from.... Morgan Stanley!

As I consider the M-LEC and its supporters, I can't help but see it as essentially an attempt by the less-savvy commercial bank CEOs to stave off a fire sale of fixed income assets which they abetted by their operation of various SIVs. Meanwhile, the savvier investment bank, hedge fund and private equity CEOs circle, like sharks in the water, waiting for the inevitable disgorgement of SIV assets to begin. They will wait for near-bottom prices, buy and hold and, eventually, realize tremendous profits for their risk taking.

The mere fact that the commercial bank chiefs back the M-LEC is almost enough, on its own, to convince me it's a bad idea.

In keeping with the overall theme of this blog, perhaps the concluding observation is that you can short commercial bank stocks, and buy publicly-traded investment banks. Even a handful of private equity groups.