Saturday, November 03, 2007

Citigroup's CEO Chuck Prince To Resign

This mornings weekend edition of the Wall Street Journal carries a lead story that Chuck Prince will resign his position as CEO of Citigroup at a meeting of the firm's board tomorrow.

Back in January of this year, I wrote two posts, here and here, contending that it was already time for Prince to leave Citigroup.

To be fair, it's unlikely that much of the recent financial damage Citi has sustained would have been much less if Prince had been fired nine months ago.

However, the real damage has been occurring, continually, for nearly four years under Prince. As the nearby Yahoo-sourced price chart for Citigroup and the S&P500 Index shows, the bank has treaded water since late 2003 under Prince's mismanagement.

Originally handling the regulatory mess that Sandy Weill left for him, Prince foundered as soon as that phase of Citi's troubles were behind him.

Don't you wonder why Citigroup's board allowed Chuck Prince to run the firm with such lackluster, market-underperforming results for so long? According to this piece on the Forbes website, Prince has been paid, through last year, just over $49MM as CEO. Just over $15MM per year of failure to best an index whose performance can be purchased through Vanguard for about .2 cents/dollar.
The Journal article alleges that Prince, who, like Merrill's Stan O'Neal, incomprehensibly worked sans contract, may leave Citi with as much as $31MM. How much of this amount was counted in the Forbes compensation is not clear to me, but I'm willing to bet that at least half of the amount reflects new payments upon his exit.

Citigroup's board, which is listed here, would seem to be ultimately culpable for allowing this long, slow slide into mediocrity of the country's largest commercial bank. Despite the Journal's reporting that either Bob Rubin or Dick Parsons might be considered to move from board member to interim chairman, it's hard for me to see how members of this already tainted group could be candidates to correct the situation.
And isn't it odd that, along with his longer term management failures, Prince allowed the seven SIVs which Citigroup operates, reputedly worth some $80B of purchased asset value, to be created? Of all the functional skills a CEO would need to understand whether, and how much, risk Citigroup ultimately has from these entities, a lawyer would seem most capable.
Didn't Prince understand that the SIVs were simply off-balance sheet tactics to imply that Citi stood behind the entities, while carefully avoiding explicitly leaving a paper trail as such?
Isn't this the type of regulatory corner-cutting Prince was supposed to have avoided? Didn't his board wonder, as these SIVs were created, precisely where the risk went? Especially Rubin, a onetime co-head of Goldman, Sachs, and Secretary of the US Treasury?
Call me a broken record, but as I opined regarding Merrill, here, I think Citigroup, too, should be dismantled upon Prince's departure. It's not as if a long string of stellar years of performance were briefly interrupted under Prince's tenure.
The truth is, ever since Sandy Weill fused his insurance-asset management conglomerate with Citicorp some years ago, the firm has had trouble consistently outperforming the market for its shareholders. The diversified financial giant has proven too unwieldy and complex for anyone to run profitably to shareholders' lasting benefit, as measured against the less risky step of simply buying the S&P500 Index.
Most of Citigroup's businesses don't really positively affect each other. Oversight obviously continues to be a problem, both regulatorily, and for risk management purposes.
With the board having collaborated with Prince in allowing these omissions to fester and grow for four more years, after Weill, I'd suggest that the biggest favor the Citi board can grant its shareholders is, at least, to break up the company into separate, manageable units, spun back as separate equities to current Citigroup owners. Perhaps, in a few cases, buyers can be found for the units. It's unlikely that the old commercial bank unit could merge with another bank. But various asset management, investment banking and other non-core commercial banking units could be sold or split off.
Look at it another way. The company has suffered under two successive CEOs, and the board that allowed the pain to continue. Should anyone connected so far with this travesty have a hand in improving it within the same framework, going forward?
I don't think so. That way probably lies more failure and loss for shareholders.

Friday, November 02, 2007

Back To Basics: SIVs, CDOs, Banks and Valuing Securities

As the financial markets fallout of sub-prime mortgage lending continues to affect both equity and fixed income markets, it may be instructive and useful to return to some basics about these markets, the institutions in them, investors, and rules about valuation.

Back in the 1980s, as a strategist at Chase Manhattan Bank, I had the occasion to be involved in a project regarding increasing our presence in the mortgage origination business. As part of this, I attended a few conferences on CMOs. These were the original, private-labeled securitizations of mortgages by the likes of Salomon Brothers, First Boston and Kidder Peabody. Names like Lew Ranieri, Dexter Senft and Larry Fink (yes, that Larry Fink) predominated the burgeoning sector's conferences.

The conferences were held by these investment banks in order to facilitate the sale of securitization services to S&L executives. After we all listened to long talks by investment bankers about the mechanics of CMOs, the usual forgettable conference lunch was served.

I spoke with an S&L executive at my table regarding the complexity of issuing CMOs. Yes, he said, they sure were complex. That's why he needed the likes of Kidder, Salomon,, to know how to create and price them to sell.

I then asked him if his S&L also bought CMOs.

"Of course," he replied.

"Well, if they are complicated to price for sale, and you need help for that, how do you know at what price to buy them from these same investment bankers," I asked him?

Rather than answer, he turned away to the man on his other side, and engaged him in conversation, instead.

Nothing has really changed in twenty years. Structured finance instruments have always begged the question of valuation and, thus, the ability to presume true 'market' conditions. That is, continuously priced, and a seller always available for every buyer, and vice versa.

Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?

Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.

So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?

You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.

They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances.

With regard to the SIVs, the question that is troubling credit markets is, essentially,

"Will the SIVs have to sell their structured finance assets to pay off their commercial paper liabilities, what will be the (very low) prices of those assets, and will there be resulting commercial paper defaults?"

It's the uncertainty of the answers to these questions that is 'seizing up' credit markets. Lenders don't lend to counterparties whose financial conditions they do not, for certain, know, without collateral.

Citigroup, BankAmerica and Merrill Lynch have just taken very public, large writedowns summing to roughly $15B over the past month, all attributed, except perhaps BofA's, directly or indirectly, to capital markets activity involving mortgage-related CDOs.

Until holders of suspect CDOs either explain the (presumedly lower) values at which they are marking these instruments, counterparties, including those in traded fixed income markets, will not be showing up to lend money or buy paper.

The banks and related financial entities have only themselves to blame for this 'seizure' of fixed income markets. If they would be forthcoming about valuations, then their true financial condition would be known, risks could be assessed, instruments priced, etc.

Rick Santelli, CNBC's Chicago-based fixed income expert, said it best this morning when he likened the banks' situation to what he would face if he had lost money on assets in a margin account. He'd have to make the margin call, or lose his collateral.

He questioned why banks should be 'different,' and be allowed to delay valuation of CDOs, or be given special license to create the M-LEC to buy more time.

Here's a novel idea. If banks and other entities truly believe that the securities involved should not be marked down as fire sale items, why don't they simply buy the putative owners/losers out of their positions, at face value, and hold the suspect securities themselves?

By doing so, they would literally put their money where their collective mouths are, indicating they believe values will rise in the future, making ownership of the troubled structured finance instruments a benefit, not a loss.

As I observed in this recent post, that's what the legendary financier, J. Pierpont Morgan, did to halt the panic of 1907. Of course, he was the one buying at fire sale prices. In our current situation, this is precisely what banks are trying to avoid- the writedown.

It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing.

Or, the banks can make good on the alleged implicit guarantees, take back the commercial paper and senior notes at some artificially high price, and hold the associated assets, absorbing losses into their investment accounts over the next few years.

Either way, the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.

If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track.

I think that anytime someone 'structures' financial instruments in such a way as to prevent their easy valuation and market maintenance, they better be ready to hold them as if they were a painting, real estate, or some other lumpy, illiquid asset.

Because, in truth, that's what they are.

Thursday, November 01, 2007

SIVs Remain In The News

SIVs, a/k/a "structured investment vehicles," continue to make headlines in the business press. With Merrill Lynch, they seem to be dominating this week's headlines and columns.

I wrote four posts about them between the 20th and 26th of October, found here, here, here, and here.

Yesterday's Wall Street Journal featured two prominent pieces on SIVs. One was Holman Jenkins' very clear and forceful editorial portraying the M-LEC SIV rescue fund as a way of simply aiding some inept financial firms, not actually saving our economy or financial system.

In his piece, he writes,

"A bit of bumf came across your desk recently from economist Donald Luskin, who says that though some banks may be in trouble, "other investment banks such as Goldman Sachs have thrived on the recent chaos and have emerged in superior competitive positions, poised to accelerate their profit growth. We're seeing not the impairment of a sector, but rather the realignment of the competitive landscape -- which is usually a healthy thing."

He makes a valid point. If contributing to the superfund were a patriotic and profitable duty to help protect the broader economy, that's one thing. But contributing just to save a few banks from having to own up to their slippery dealings with a few SIVs?"

Jenkins also echoes my own prior comments with this passage,

"The Ugly: Banks are supposed to know better than to borrow short and lend long, which can be profitable as heck until short-term rates skyrocket or short-term lenders disappear altogether. No, banks didn't commit this folly directly. They set up off-balance-sheet SIVs to borrow short and lend long, while shifting some of the proceeds back to the bank sponsors as fat "fees." Citigroup, for one, collected $24 million last year from its biggest SIV, equivalent to about 38% of the profits funneled to outside investors.

But weren't the outside investors supposed to bear any loss? Otherwise the banks were obliged to recognize the SIVs on their own balance sheets with suitable reserves. Yet now you hear murmurs that banks offered informal guarantees and staked their "reputational capital" to lure investor cash into the SIVs. Some say that contributing to the superfund would be contributing to "moral hazard," i.e., encouraging bad behavior."

Exactly. You can't help but believe that commercial banks tried to get the best of both worlds- imply their backing of the SIVs, but carefully avoiding legal, technical ownership of any of the assets, the better to keep them as off-balance sheet entities.

Now that the SIVs are imploding, the banks are weighing the long term risk to their market reputations by letting them fail, versus the immediate hit to their balance sheets by taking responsibility and making good on the about-to-default commercial paper which these leveraged entities issued.

Luskin's comments strongly reinforce my initial comments that only the commercial banks are behind the M-LEC 'solution' to the SIV situation. The investment banks are playing the other side, waiting to profit from judiciously timed investment in distressed financial instruments.

Meanwhile, yesterday's Journal's lead article in the Money & Investing section was entitled, "For Citi, Stakes Get Higher." The graphic accompanying the article details the role the M-LEC would play in buying time and liquidity for the commercial banks caught in the above-mentioned dilemma between long-term reputational and short-term balance sheet risk.

That article states,

"Accounting groups have raised the question of whether Citigroup and other managers of the SIVs should account for the funds, many of which face potential losses, on their own balance sheets.

The funds still owe money to commercial-paper holders. If they can't raise money by selling new commercial paper, they could be forced to unload the securities at fire-sale prices.

If it doesn't work, Citigroup and other SIV managers could find themselves in a bind that could force them to take financial hits.

If the rescue plan failed and buyers continued to stay away from the commercial-paper market, the bank might feel pressure to pony up cash to backstop the SIVs to preserve its reputation with the vehicles' investors, who would otherwise incur the bulk of the losses. But that prospect has raised the issue among accounting professionals about whether the bank shares in potential losses to such an extent that it should consolidate the SIVs onto its own books."

As I stated in my initial piece on this topic,

"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."

Suspending the usual, well-known rules for valuing assets, paying financial claims due the holders of commercial paper, etc., should be enforced. Let the investors who unwisely took excessive risks by trying to earn outsized yields on questionable commercial paper take their lumps.

To suddenly change the rules for these banks and the investors they hoodwinked is to invite more morally hazardous behavior going forward in our financial markets.

Economic Misconceptions: Amercian Homes are "ATM Machines"

Am I the only person who has become tired of hearing one guest/host after another on CNBC mouth this baseless platitude- that Americans have been borrowing their rising home equity to fuel the recent years' economic expansion? So, now that mortgage lending is tight, the economy must fall into recession?

Jack Welch, Robert Reich and numerous others, including politicians and non-economists, to the contrary, Americans are not using their homes as "ATM machines."

In a post which I wrote in August, found here, I quoted frequent CNBC guest, David Malpas, in a passage from a Wall Street Journal editorial of early August of this year, wrote,

"The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.

Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007."

Malpas' logic and data are compelling. The income effects of continued employment of Americans drives the economy, and overshadows the presumed 'wealth effect' of falling home prices.

And, "no," Americans have not used their homes as 'ATM machines.' Home equity Withdrawals up, household financial assets up, consumption unchanged. Where's the support for the 'ATM machine' allegation? Nowhere.

So next time you hear that tired phrase about Americans borrowing on their home equity like it was an ATM machine, you'll know it's wrong. And that the speaker knows not of what s/he speaks.

Wednesday, October 31, 2007

Merrill Remains In The Media Glare

This seems to be the unofficial Merrill Lynch/Stan O'Neal week in business media. The attention just won't stop.

First it was the $5B of CDO writedowns early this month. Then last week's disclosure of another $3B worth of losses. Then the weekend's rumors of Merrill CEO Stan O'Neal's imminent firing.

Now, we learn from one of the several Wall Street Journal articles about Merrill and O'Neal this morning, that he retired from Merrill. He wasn't fired.

Thanks for the hair-splitting distinction. Yet another reason for Merrill board members to either resign, change their names, or do anything else to hide their identities as this pathetic example of corporate governance continues at the stricken financial services giant.

The back page of today's Journal, C14, contains this line from the fluff,

"Directors can rectify that when naming a successor with a more tightly-worded employment contract- one that actually penalizes the boss financially if the firm posts losses."

That's comforting to read. It echoes my own thoughts in this post, yesterday,

"However, as I watched CNBC report on the two-day long travail at Merrill, while the board ostensibly negotiated with O'Neal on some sort of monetary compromise that would allow the former to appear to be prudent trustees of their shareholders' interests, another idea occurred to me.

Why didn't Merrill's board, and, for that matter, the board of any publicly-held, financial services sector company, require a new CEO to sign an agreement which states performance and event conditions under which the CEO is eligible to lose all but an agreed minimum amount of money if s/he is dismissed from, or resigns, the CEO post?

Honestly, this seems like a pretty obvious clause, now that I see how badly O'Neal damaged Merrill. Think about that.

The truth is, the nature of financial service firms is such that a CEO, or, as I've written recently, here, any senior executive, can play the 'heads I win, tails you lose' game all too easily by risking the shareholders' equity.

In this regard, financial service companies are a bit different than those in most other sectors. Pumping growth at a financial services firm often leads to simply taking more risk.

In order to help a CEO own the responsibility for not allowing this to happen, why not simply make all deferred CEO compensation over an amount with which the board would not be embarrassed to have a loss-inducing CEO leave, subject to revocation and loss, in the event of certain conditions.

These conditions could include the occurrence of loss, as reported on financial statements, exceeding, either annually or cumulatively, a stated amount. Or perhaps a percentage decline in total return, adjusted for the S&P500 Index.

By making a new CEO aware that extreme losses and failure would not result in loss of the post with substantial financial rewards, such a candidate would probably be more cautious when running the company."

So the Journal's piece reinforced my own idea, but with none of the detailed thought my post provided. I think I'm on to something. As I said to my partner at lunch today,

"How long will it be before we read that Heidrich & Struggles has advised Morgan Stanley or Lehman to add such a clause into their new CEO's employment contract?"

Of course, there's much speculation on who will succeed Stan O'Neal as Merrill's CEO. By now, it's pretty clear that Larry Fink passed on the privilege of trying to run Merrill.

I've pasted the Yahoo-sourced five-year chart of Merrill's and the S&P500's prices nearby. It's clear that Merrill has barely outperformed the index over the entire period, and only briefly outpaced it, in late 2003 and parts of 2006. Then it began falling in the early months of this year. You can see by optical inspection that just in the price series alone, never mind the total returns, Merrill's stock has had quite a bit more volatility over the period, for not much more return than the S&P.

As my partner and I discussed the Merrill situation, I offered this analysis. Were I to be invited to a Merrill board meeting to review the company's options, I would offer this recommendation:

It's time to break Merrill up, return what cash or equity can be gained for a sale of the parts to the shareholders. Quite simply, Merrill no longer needs to exist, in an economic sense.

Question: What is the (one) innovation for which Merrill Lynch is most famous, when did it occur, and who chaired the firm when it occurred?

I won't divulge the answer right away. It's at the end of this post. However, let me give you a clue- it's been quite some time since this event.

And that is sort of my point. Merrill hasn't been consistently superior to the Index for a long time.
As the nearby Yahoo-sourced price chart of the S&P500 Index and Merrill since 1977 depicts, Merrill has outperformed the index, but fitfully so. Merrill lost all its advantage from 1977 to about 1991. Then, if you draw a line along the bottoms of the troughs in Merrill's stock price, you see that its effective rise over the index was much less steep than it appears for the 1990s. It gave back quite a bit in 1998, and then in the early years of this decade.
As we used to do back at AT&T when assessing the attractiveness of our businesses, and Warren Buffett similarly approaches investments, ask yourself the following question:
"If someone left me $20B, would I start a Merrill Lynch from scratch now?"
Doubtful. Merrill is the only remaining independent retail 'wire house,' or brokerage firm, from before the Big Bang. Shearson, Paine Webber, Bache, Dean Witter, EF Hutton, are all gone. Merged, consumed by banks, or defunct.
It's a fair question to ask just what unique value or skill set Merrill now possesses. It bought its investment banking parts, and they remain second-rate, compared to the 'white shoe' firms.
I don't know of anyone who has an active Merrill retail account who isn't basically old or unsophisticated. It's not a growth market.
Here's another perspective. Stan O'Neal began to pump his fixed income group for growth soon after rising to the top of Merrill. He behaved dismissively toward the brokerage head, McCann, while replacing the existing bond executives and growing that business.

Why? We have to assume that O'Neal believed that the necessary growth would not come from Merrill's vaunted retail brokerage corps. Instead, he felt obliged to undertake a riskier strategy involving origination, securitization, trading and holding of increasingly-lower-quality mortgage securities.
If that doesn't tell you something about Merrill's supposed unique "strength," nothing will.
No, I think if I were advising the Merrill board now, I'd advocate selling the brokerage unit to one firm, and the capital markets piece to another. Perhaps spin the asset management unit back to shareholders as a standalone unit, from which BlackRock could buy the remaining 49%, if it so chose.
And, finally, we come to the page 2 Wall Street Journal article entitled, "Is There a Second Act for O'Neal After Merrill?"
George Anders begins his column by comparing O'Neal to Abraham Lincoln and Richard Nixon.
That's an insult to the two former Presidents.
Lincoln only lost a Senate race. He didn't blow out a major company, nor hold and lose a major office.
Nixon was an accomplished foreign policy wizard and political survivor before his fall from grace. He merely waited, plying his foreign policy craft, for time to pass and his credentials to bring him back out of disfavor.
Even Bob Nardelli, whom Anders mentions, only failed to profitably grow Home Depot. He didn't seriously torpedo the place with billion dollar losses. And Nardelli is credited with actually creating value at GE for years prior to that.
Stan O'Neal seems, from the reports I've read, to have been mostly a politically astute executive who accomplished more by adroit maneuver at Merrill than he did by stellar solo performance. Other than a few brief years of profit growth, now tarnished by the ensuing risk and losses of that growth, there hasn't been a lot for people to point to in O'Neal's defense.
While Anders contends that it's just rich white males who merit a second chance, I don't think that's necessarily true, either. My own ex-CEO at Chase, Bill Butcher, never really rose again after being knifed by his lieutenant, Tom Labrecque, and tossed overboard for the LDC losses. Bill was given the American Enterprise Institute over which to notionally preside, but nobody ever accused him of being an especially insightful or standout businessman to start with. Good natured and well-intentioned? Sure. But at best, an organizational man of his era, more suited to administer a mature corporate loan business than provide vision to a large commercial bank during times of radical change.
Stan O'Neal reminds me of Butcher in that regard. Capable of administering internal businesses and climbing the Merrill ladder, but unequal to the task of leading the firm to consistently superior performance, once installed as CEO.
Even though he may have $160MM to bring to the table, I'm not sure O'Neal will find many offers to join private equity or hedge fund firms. More likely, he may just bankroll himself as a targeted private investor and shun the spotlight for a few years.
By the way, here's the answer to my earlier question regarding Merrill's innovation.

Answer: The Cash Management Account, or CMA, in 1978. Don Regan was chairman of Merrill Lynch at the time, just prior to his departure to serve as Ronald Reagan's Treasury Secretary.

Nissan and The Art of The Small Car

Yesterday's Wall Street Journal featured an article concerning GM's IT chief, Ralph Szygenda. As he detailed his accomplishments in reducing GM's tech expenditures, he mused, in summary,

"the IT department can't save an automotive company, but it can accelerate the efforts. This is a fashion business. The best processes in the world don't matter if you don't have the best cars."

Just so. And to see how far GM has to go, one need look no further than the Journal's story on Nissan, which appeared last week, on Monday, October 22nd. The piece depicts the incredible focus of CarlosGhosn's engineer, Carlos Taveras, on designing and manufacturing superior entry-level, small cars. The Journal pieces notes,

"In 1998 Mr. Ghosn, then Renault's head of manufacturing and engineering, put Mr. Tavares in charge of Renault's most crucial line of compact cars, the Mégane and Scénic series. ... The engineer had demonstrated his small-car savvy while working on Renault's tiny Clio II subcompact and other models. Under his leadership, the Mégane and Scénic got sportier, aerodynamic grills and curvier trunks, and became Renault's most popular line, accounting for more than a third of the company's auto revenues in 2002. In 2004, Mr. Ghosn sent Mr. Tavares to work on midsize cars at Nissan, where he soon became an executive vice president and a member of the board of directors.

This past April, he effectively became Mr. Ghosn's No. 2 in Tokyo -- just after the company reported its profit decline. Mr. Tavares concluded that Nissan should focus a lot more on emerging markets to boost stagnating world-wide sales. But competition was already heating up."

What this article showed me is how challenging it is, and to what lengths Nissan and Mr. Ghosn will go, to engineer a profitable, attractive small car for the emerging drivers of Africa, Asia and the India subcontinent. For instance,

"On a visit to a factory in Thailand last year, Mr. Tavares noticed that the complex shape of the Tiida's door panels meant that half as many Tiida doors as Logan doors could be stacked in a shipping container. His product planners said the higher-priced Tiida needs more complex doors than the Logan, he recounted, but "I told them, 'Let's be serious,'" Mr. Tavares says. He told them to start "making sure, when you design a part, that they can be piled together."

Finding cost cuts on the Tiida has helped product planners apply the change in thinking to new models, he says; they are focusing on details such as how much a certain kind of speedometer or door handle will add to production costs. Japanese auto makers also have been in a heated race to build the roomiest small cars, and Nissan engineers are working on ways to comfortably fit luggage and five passengers without making the car bigger and heavier overall."

Tavares' intensity and attention to detail seems to outstrip anything I've read about his counterparts at GM or Ford. But Tavares isn't just a production-oriented engineer. No, he's far more potent- he has an understanding of the use of engineering for marketing, as illustrated in this passage from the article,

"Nissan also is moving production to low-cost areas and using more local suppliers in place of longtime Japanese suppliers. This year at its Thailand plant, Nissan cut its parts imported from Japan from an already-low 30% to 10%. It also is soliciting more local staff and input instead of relying on designers and engineers in Japan: Nissan and Renault plan a joint business center in Chennai, India, in early 2008. Mr. Tavares says he hopes local input will help designers cut costs and generate sales by offering only features consumers want in each country."

Reading this article reminded me of something in a Journal article about Alan Mulally's early experiences at Ford. He had described how he brought Boeing engineers in to explain the engineering of a Boeing plane. Further, Mulally provided examples from the various Fords he drove, as CEO, showing how small, seemingly-insignificant parts, like windshield wipers, differed from car to car. Tavares is like Mulally on steroids. Plus, he's already integrated into his firm.

Whereas Mulally is trying to teach Ford engineers as an outsider, Tavares is firmly linked to Nissan's CEO, and has years among the constituent companies of the alliance.

I wouldn't even know where to begin to imagine how far behind these two firms is GM. As the opening quote from the company's IT czar illustrated, he only feels he can facilitate a turnaround- someone else will have to actually pull it off by designing better cars.

What this article about Nissan, and Mr. Tavares, demonstrated to me is just how hard it will be for auto makers to make money on the smaller cars they are counting on to comprise the growth in the sector for the next decade. And how small a chance I'd give to GM, Ford and Chrysler at pulling off such intense, integrated design, development, engineering and marketing for small cars sold offshore.

Tuesday, October 30, 2007

Merrill's Latest Embarrassment: Stan O'Neal's Outgoing Compensation

So, now we know. Stan O'Neal, the CEO who presided over $8B+ in losses at Merrill Lynch this year, is officially out.

Some combination of insiders are temporary co-presidents, or co-CEOs, or some such.

But the real news this morning is poor Merrill's board's continuing embarrassment vis a vis O'Neal's outgoing pay package.

Today's Wall Street Journal mentioned a total figure of some $160MM, which was separately mentioned on CNBC this morning, as well. The Journal piece provides detailed breakdown of that amount, citing various retirement benefits, options, and deferred compensation.

It is stated that O'Neal had no contract with the firm, and, thus, receives no formal severance.

By late this afternoon, or perhaps tomorrow morning, we should expect to hear from the corporate governance and executive compensation crowd regarding O'Neal's lush "parting gifts," as he leaves the firm he so recently torpedoed with his aloof, casual "oversight" of Merrill's mortgage-related businesses.

It has to be galling for Merrill's board members to realize that they will be perceived as both a laughing stock, and pernicious in their own right, for allowing Stan O'Neal to retain so much money after nearly ruining the firm of which he was CEO for five years.

I've written on this topic many times before in this blog. You may find those posts by clicking on the labels 'executive compensation,' and/or 'corporate governance,' or by searching the blog on those terms. My personal favorite on this topic, from November of 2005, may be found here.

However, as I watched CNBC report on the two-day long travail at Merrill, while the board ostensibly negotiated with O'Neal on some sort of monetary compromise that would allow the former to appear to be prudent trustees of their shareholders' interests, another idea occurred to me.

Why didn't Merrill's board, and, for that matter, the board of any publicly-held, financial services sector company, require a new CEO to sign an agreement which states performance and event conditions under which the CEO is eligible to lose all but an agreed minimum amount of money if s/he is dismissed from, or resigns, the CEO post?

Honestly, this seems like a pretty obvious clause, now that I see how badly O'Neal damaged Merrill. Think about that.

Here's a guy who presided over, and abetted, the loss of more than $8 BILLION this year, and he still walks with $160MM.

I don't care how that $160MM was earned, or over what time period. The truth is, the nature of financial service firms is such that a CEO, or, as I've written recently, here, any senior executive, can play the 'heads I win, tails you lose' game all too easily by risking the shareholders' equity.

In this regard, financial service companies are a bit different than those in most other sectors. Pumping growth at a financial services firm often leads to simply taking more risk.

In order to help a CEO own the responsibility for not allowing this to happen, why not simply make all deferred CEO compensation over an amount with which the board would not be embarrassed to have a loss-inducing CEO leave, subject to revocation and loss, in the event of certain conditions.

These conditions could include the occurrence of loss, as reported on financial statements, exceeding, either annually or cumulatively, a stated amount. Or perhaps a percentage decline in total return, adjusted for the S&P500 Index.

By making a new CEO aware that extreme losses and failure would not result in loss of the post with substantial financial rewards, such a candidate would probably be more cautious when running the company.

Now, you may ask, would a company like Merrill be able to attract a seasoned, talented executive such as Larry Fink, with such conditions?

Why not? After all, the board should be attracting CEO candidates who genuinely believe in their abilities to improve and sustain shareholder return performance during their tenure. If they aren't willing to bet a substantial portion of their compensation on that, why would you hire them?

In the case of a Larry Fink, Merrill would probably have to pay him for any unvested deferred compensation that he lost when leaving BlackRock, if the had to leave that firm. This money would be Fink's, not subject to the conditioned agreement.

Then, if the board would honestly be fine with letting Fink fail, and preside over spectacular losses, yet still leave with tens of millions of dollars, then they don't need such an agreement.

However, as the Merrill board now understands, being in the moment of such embarrassment is very chastening. You can bet they would pay plenty right now to simply not have the appearance of compensating the guy who just put Merrill's stability in jeopardy, after losing a huge chunk of shareholder value this year.

In a way, think of my idea as a sort of board of directors risk management. It's a tool to provide for capping financial risk and embarrassment at the CEO level. It removes the asymmetry with which most CEOs are allowed to operate- they are paid lushly for success, and pretty well for failure, too.

While still an enormous sum of money to the average American, limiting a failed CEO to, say, just $5MM of any deferred compensation or severance, no matter how it had been 'earned,' would be reasonably palatable for a board to explain. Five or ten million dollars, while a pittance among CEOs, would be sufficient to claim that the board was providing a fair minimum guaranteed final payment to a CEO, even if s/he failed utterly and lost huge sums of shareholder value.

If a CEO candidate could not understand the need for a board to provide this insurance to shareholders against CEO ineptitude, why would a board hire her/him?

Monday, October 29, 2007

O'Neal, Merrill Lynch & Its Search For a New CEO

This morning's Wall Street Journal's Money & Investing section has, as its lead story, a handicapping of contenders for the top job at Merrill Lynch, now that Stan O'Neal has been cashiered for incompetence.

Despite the stories circulating about his call to the CEO of Wachovia about a possible merger, it seems far more believable that O'Neal is going simply because he proved himself unable to appropriately manage Merrill's growth without incurring disastrous risks which have resulted in losses of $8B so far this year. And it's only the end of October.

Among the putative replacements for O'Neal, the Journal article mentions,

"A dream pick would be Mr. Thain, CEO of NYSE Euronext.....However, people close to him have thrown cold water on the speculation he may throw his hat in the ring for the Merrill job. One reason: he may be holding out for a bigger job, possibly the top spot at Citigroup, Inc., although it currently isn't open.

Gary Cohn and Jon Winkelried, co-president and chief operating officers of Goldman, Sachs, could be wild cards in the race."

Geez....dream pick, indeed. Does anyone, besides Susanne Craig, who authored the Wall Street Journal piece, really think Goldman executive among the top three managers of the firm, past or present, would really be interested in running Merrill?

Merrill represents the last of an otherwise dead model, the retail wire house. Sure, Merrill bought and grafted on investment banking in the past decade. But it hasn't internalized the risk management skills which seem to have prevented Goldman Sachs, Morgan Stanley, and Blackstone from suffering the same losses during this year's financial crises.

As for Citigroup, it's the worst example of the hydra-headed model now known as a 'universal bank,' the former moniker, 'financial supermarket,' evidently being dropped sometime in the past decade.

Neither Merrill, nor Citigroup, has a reputation for attracting and retaining the best financial minds. Nor, for that matter, do any other large US commercial banks.

Why would a senior executive who has run part or all of Goldman Sachs need to prove himself running a less-robust financial services business model with less talented personnel?

For Larry Fink, on the other hand, it would represent an opportunity to run a larger, more complex operation than he has had to date. If the inherent problems in Merrill's structure, including the dying retail brokerage business, don't cause him to think twice.

Should be interesting to see who wants the top job at Merrill. An insider, such as McCann or Fleming, is understandable- the move would be a natural accession and bring more money. For an experienced, capable outsider, though, the job might ultimately hold more risk than opportunity.

Perhaps the most interesting aspect of O'Neal's departure is whether it speeds Chuck Prince's outster at nearby Citigroup.

Jeffrey Larson's Sowood Capital: A Lesson In Risk Mis-Management

The weekend Wall Street Journal carried an amazing story concerning Jeffrey Larson, once a member of the Harvard University endowment's management team, now ex-partner of his failed hedge fund group, Sowood Capital Management LP.

As an asset manager with experience managing both my own and other people's money, and having clear memories of market shocks all the way back to 1987, I am a firm believer in the weakness of so-called 'dynamic' hedges, or cross-instrument hedges. Next, I learned first-hand, watching a hedge fund, for which I sub-advised some money with my own equity strategy, come a cropper on 3:1 leveraged money in 1990. The crux of the Sowood article proves my personal contention, as Larson's big losses came via complex, cross-instrument hedges, the risks of which were accentuated with highly leveraged money.

Thus, Larson's Sowood did two things my partner and I won't do. That could be why my large-cap equity strategy currently has a 33% YTD return, and our related options strategy has a return in the 60% range after only roughly six months of operation. Both are comparatively simple, single-instrument strategies using no leverage. We would prefer that customers, if and when we choose to open our strategies beyond their current proprietary nature, bring their own borrowed money, if any is to be used.

Perhaps the fundamental moral of the Sowood, and other, similar stories, comes from this paragraph in the Journal article,

"The $35 billion Harvard endowment would have been able to absorb Mr. Larson's losses. But like many traders who have recently left large organizations to start their own funds, Mr. Larson found he didn't have any leeway in times of crisis."

Another lesson I observed from my one-time colleagues who ran a stat-arb hedge fund in the late 1990s was that often, a strategy will work in the long term, but fail to sustain itself amidst losses and redemptions in the short term. In Sowood's case, Larson sold his portfolio to another hedge fund, Citadel Investments. The Journal piece notes,

"...Mr. Larson has told investors he'd like to resume his trading career. He said he wasn't reckless, and that his investments eventually would have led to profits. On this point, few would dispute: Citadel has made big gains on the investments, according to people familiar with the situation."

This is quite believable, as highly-leveraged trading/investing strategies often take losses which wipe out the sliver of equity supporting the total asset position, for a time, before rebounding after whatever financial crisis caused the unexpected reversal of the hedged positions' values.

It seems that some managers are incapable of understanding lessons which they have not personally experienced. For instance, it's fairly obvious now that the correlations upon which many cross-instrument hedges are based can rapidly and easily evaporate in times of unexpected financial crises. And the crises are typically things which nobody foresaw, or for which low probabilities were generally assigned- the Russian sovereign debt default, LTCM's massive hedging losses affecting even equities, or the recent large-scale seizure of 'markets' for structured finance instruments.

Years of respectable, if not out sized portfolio returns can be dwarfed by losses in a crisis lasting only weeks or months. Leverage and the need to provide margin funding can quickly consume the relatively small amount of equity in a leveraged portfolio. And, last of all, the worst time to try to trade one's way out of trouble is typically in the midst of a crisis in which prices, if they exist at all, may be fleeting or ultimately unknown with certainty for some time.

It's a fine line between confidence in a successful asset management strategy, and hubris that nothing can go wrong with it- ever. It seems to me that avoiding crippling, lethal losses on the downside is more important than attaining the maximal possible returns to a strategy on the upside.

Sunday, October 28, 2007

EBay & UPS's Shipping Charges Calculation Errors: The EBay Response

Earlier this month, I wrote this post, detailing EBay's provision of a misleading and, ultimately, flawed UPS shipping charge calculator. Bordering on fraud, the two companies conspire to allege that, with this calculator, a bidder may ascertain their UPS charges, unique to the package's dimensions, weight and beginning and destination zip codes. However, as I wrote in that post,

"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,

"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."

Upon actually dropping off the package at the local UPS store, the agent told me, in response to my query concerning the difference between quoted and actual UPS shipping charges,

"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."

This past week, I received this belated email from EBay, containing their official reply to my query as to why their UPS-labelled shipping charge calculator provided shipping charges so different from the actual charges levied by UPS,

Dear Charles,

Thank you for writing eBay in regard to the variation in the shipping charges while printing the shipping label and in the calculator.

I apologize for the amount of time it has taken us to get back to you on this issue.

To help you as quickly and efficiently as possible, I've forwarded your email directly to a PayPal representative.

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.

Also please make sure that you contact the shipping companies.

To learn more about USPS services, go to:

To learn more about UPS services, go to:

It is my pleasure to assist you. Thank you for choosing eBay.


Penny A. eBay
Customer Support

In case you didn't visit the link to my prior post on this topic, this second email response is the same core text as the first semi-automated response of several weeks ago.

Maybe "Penny A." exists, and maybe she doesn't. Perhaps she's simply a stand-in for all of the dissembling, misleading customer service mis-representatives at EBay. Either way, EBay once again essentially accused me of either lying, trying to cheat UPS, or simply being a moron who is incapable of measuring and weight a package correctly.

The Yahoo-sourced price chart of the S&P500 and EBay which appears nearby confirms that, even with the recent jump in EBay's share price from their recent, single-quarter positive earnings surprise, the stock still underperforms the index for the past two years. Good work Meg.

In conclusion, though, I would merely write to EBay CEO Meg Whitman,

"Well done, Meg. You've motivated me to only use USPS, if I ever sell anything on your site again. Which I probably won't, since I now would like to avoid paying you as little as even one dime in the future. I may have over 100 confirmed positive purchase ratings, but I'm going to try to never sell again on your site."