Friday, November 16, 2007

Mixed Signals From US Government On Oil Policy

This past Monday's Wall Street Journal contained a 'green' section, in which an article entitled, "One Step Forward, One Step Back,' focusing on US governmental policies with respect to oil, was featured.

The crux of the article was to describe the back-and-forth nature of our government's attitude toward the development of onshore oil and oil refining projects. In part, the piece stated,

"In its efforts to set the U.S. on the road toward energy independence, Congress may be constructing a detour.

The House and Senate have passed separate energy bills and are now working on combining the two into final legislation that could come up for a vote by the end of the year.

Both bills are designed to lessen American reliance on foreign oil, in part by mandating far greater use of corn-based ethanol and so-called cellulosic ethanol, which is made from biomass like grasses and wood chips. The Senate bill also calls for higher fuel-economy standards.

Here's the catch: Anything that creates uncertainty about demand for gasoline over the long term means less incentive for refiners in the U.S. to expand their capacity. And that means greater reliance on gasoline imports in the near term, at least until ethanol becomes a mainstream fuel. And that, of course, is the opposite of energy independence."

This is no small matter. Remember when, in the wake of hurricane Katrina, just a little over two years ago, the great hue and cry from Congress was,

'Why hasn't the oil industry built (us) a new refinery in over 30 years?'

The Journal piece continues,

Critics also question whether the country can supply the 15 billion gallons a year of corn-based ethanol that the Senate bill mandates by 2015 without substantially raising the cost of food -- or whether the supply can be relied on in drought years.

Not long ago, at hearings and press conferences, lawmakers called on refining companies to increase capacity in the U.S., after the devastating hurricanes of 2005 hobbled a number of Gulf Coast refineries and sent pump prices soaring. And there remains some support in Congress for such an expansion.

"We're going to become dependent on foreign refineries," Sen. Orrin Hatch, a Utah Republican, warned at a Finance Committee hearing earlier this year. "If we can't refine oil, others will do it for us, and it's foolish if we don't wean ourselves off imports."

But refiners see the political winds shifting. "If you want to add refining capacity here, how can you have the president advocating reduced consumption?" says Greg King, president of Valero Energy Corp., the largest independent refiner in the U.S. "It's a mixed message."

Mr. King says he is concerned that incentives to encourage expansion are in jeopardy. The House version of the energy bill doesn't extend beyond 2008 a provision from the Energy Policy Act of 2005 that grants refiners tax savings on 50% of the costs of investments that increase capacity by at least 5% at any one refinery. The bill also would take away from refiners a tax deduction granted to other U.S. manufacturers.

Meanwhile, refiners in other countries are forging ahead. Saudi Arabia is gearing up to start four refineries, each able to process 400,000 barrels of crude oil a day. Kuwait has approved plans for a 615,000-barrel-a-day plant, and a 580,000-barrel-a-day facility will soon be processing in India.

"It will be difficult to build a new refinery in the United States," says Lehman's Mr. Robinson. "There are significant investments coming on line in the world that will, in addition to this whole ethanol craze, continue to de-incentivize building new refineries in the U.S."

This, I think, is the key point. Only two years after suffering gasoline supply disruptions and rising prices due to inadequate onshore oil refining capacity, Congress is behaving in a manner which injects uncertainty into decisions to expand US refining capacity, even as foreign projects near completion, making the onshore investments look less profitable with each passing month.

Recently, US presidential candidate and Democratic Senator Hillary Clinton has called for the ending of tax breaks for oil companies, saying,

'They don't need them anymore.'

Great, Hillary. Just when oil companies require more certainty to underpin the requests/pleas they have received from the US government to add more refining capacity, Clinton threatens to remove incentives for them to do so. And supporting ethanol just adds to the confusion.

Despite their current, temporary profit increases from the global oil demand and supply situation, US oil majors aren't guaranteed a continued flow of those profits, as the sovereignization of oil deposits has changed the world in which they must compete.

Then we have this passage from the Journal article,

"Bill Wicker is a spokesman for Sen. Jeff Bingaman, the New Mexico Democrat who chairs the Senate Energy and Natural Resources Committee and is one of the chief proponents of the proposed biofuels mandate. Mr. Wicker concedes that the energy policies in the Senate bill might increase gasoline imports if cellulosic-ethanol technology doesn't produce on schedule the billions of gallons the mandate requires. But he urges the energy industry to join the effort to steer the country away from oil-based fuels.

"There are big oil companies that are also looking at investing in ethanol refineries," Mr. Wicker notes. "They are energy companies, not oil companies, and if the market is trending towards domestic grown or produced energy, I certainly hope that the industry sees that and acts accordingly." "

Thanks, Bill. Here, we have a rather faceless spokesman for yet another Senator of dubious expertise in the field telling us that oil companies are, in fact, energy companies now.

I hope Bill Wicker called ExxonMobil CEO Rex Tillerson to break the news to him. Lee Raymond, the firm's just-retired CEO, famous for refocusing Exxon on oil, to the exclusion of alternative energy forms, must have lost his breakfast when he read that quote.

I recently wrote this post comparing BP to the ill-fated, defunct Penn Central Railroad. In my opinion, Penn Central's experience illustrates what can happen when a company unwisely broadens its focus and wrongly loses sight of its narrower expertise.

Both that example, and financial theory with respect to diversification, suggest that capital markets and venture capital are more than up to the task of funding promising startups in alternative energy sectors, such as ethanol, wind, solar, etc. None of which seem to share much with oil in terms of business models.

Who do you think will most rapidly and successfully exploit a new energy source: a startup devoted to that energy, or some new division of a large oil company, whose fate is still largely invested in petroleum-based energy provision?

If government truly wants other energy forms, it should provide a stable, certain regulatory environment, within which all competitors may function. Arbitrarily recasting ExxonMobil, Chevron,, as energy companies, when they are, in fact, merely very large oil companies, is a recipe for weakening the largest producers of energy, in the form of refined oil products, for our country's transportation needs.

Thursday, November 15, 2007

Merrill Lynch's New CEO: John Thain

Beginning yesterday afternoon, the biggest story in the US financial sector was John Thain's departure from the job of CEO at the NYSE, to take the same position at troubled retail brokerage giant Merrill Lynch.

You can read or hear any number of accolades for Thain today in the business media. And everyone, except, apparently, Dan Tully, a Merrill ex-CEO, seems to believe Merrill is lucky to have retained Thain for the job.
I think the more interesting question is,
Where will Thain take Merrill Lynch, and what will the firm look like when he's finished?
In over ten years of using my quantitative, S&P500-beating equity management strategy, Merrill Lynch has only appeared in a portfolio once. Goldman Sachs, on the other hand, has been a periodic member since a year ago, most recently with increasing frequency.
Were Thain to attempt to take Merrill to the same heights of consistently superior shareholder return performance that Goldman has enjoyed, he'll be taking it somewhere it's really never been.
For example, simply comparing Merrill's stock price to that of the S&P500 since 1978 shows that Merrill has bettered the index, but not consistently.
The brokerage firm was no better than the index, in totality, for the first 12 years of the period. It had some brief runs of superior performance in the early 1990s, then sagged, doing so again in the latter half of the decade. Since 2000, Merrill's return has been fairly flat, though volatile, while the S&P has dipped, then risen steadily.
What kind of financial firm will Thain create from the wreckage of Merrill Lynch? Well, he is on record in the past 24 hours as saying the problems are with the mortgage finance area, in which he has substantial experience.
While that may be true, that doesn't mean he'll simply repair that unit and continue to manage the rest as he finds it.
My partner and I discussed Thain's move into the Merrill CEO job last night, and agreed that he probably took the job because it will allow him to build something himself. He inherited a senior management post at the already-smoothly functioning Goldman. He transformed the NYSE, but, again, from an already-powerful position.
Perhaps at Merrill, he feels he can retool a company and be credited with the entire value creation job.
I wrote here, recently, that I thought there was no chance Thain would be interested in the Merrill job. I was dead wrong when I wrote,

"Does anyone, besides Susanne Craig, who authored the Wall Street Journal piece, really think (any) Goldman executive among the top three managers of the firm, past or present, would really be interested in running Merrill?"
Evidently, at least Thain thought otherwise.
However, in the same post, I also observed,
"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."
I wrote in another post that Stan O'Neal was forced to turn to a risky bet on mortgage finance in part because his brokerage operation wasn't going to get the job done when it came to consistent, profitable growth at Merrill. That has not changed.
Thain's experience at Goldman involves heavy doses of risk management, capital commitment, and modeling with a workforce of the truly 'best and brightest.' None of that is true of Merrill Lynch.
I think everyone, including my partner and me, expect Thain to begin importing talent he knows from Goldman, and, probably, various private equity groups and hedge funds around Wall Street. Surely he has some favorite 'number twos' elsewhere who would be happy to come to Merrill to run one of its businesses for him.
As my partner and I realized, Thain is in the position to effectively implement an idea I first put forth in this post, this past February,
"Suppose private equity firm partners offered their services to a publicly-held company. Would they not, in effect, take board positions, in exchange for options to own much of the firm, or be paid a percentage of the value they created over, say, a function of the firm's prior total returns, relative to the S&P500? In effect, like my idea, they'd commit their financial fortunes to, and align them with those of the firm's. But what mechanism exists for shareholders to do this? None.
It would, in fact, be a sort of return to the days of the original form of shareholder capitalism. A few wealthy, skilled owners running the boards of large companies. Since, instead, many boards are infested with lesser lights, faded failures of other boards (look at Microsoft for a great example of this tendency), or "politically correct" members with absolutely no business skills, corporate performances are often appallingly bad, while CEOs and board members are still handsomely compensated."
We see Thain about to bring a band of corporate buccaneers aboard Merrill, and be compensated for the value they create.
But among all the talk about Thain's ascension to the Merrill CEO post is that lingering doubt about his ability to win over, lead, and otherwise develop cultural commonality with the vaunted 16,000 strong band of Merrill retail reps.
My own prediction is likely to be seen as nonsensical. But, here it is. I think there's a significant probability that Thain will simply sell the brokerage business to another firm. Perhaps Wachovia. He could sell it to Citigroup, if it finds a new CEO and can afford the price.
But I think Thain will consider it. First, it doesn't involve firing anyone- simply divesting Merrill of a dead-end business. As I've written elsewhere in this column, who trades with full-price, full-service brokers anymore except older, and/or less sophisticated clients? It's not a business with a future. There's a reason Merrill is the only surviving predominantly retail wire house.
As the Yahoo-sourced chart nearby shows, the stock prices of investment-type banks, such as Goldman Sachs, Lehman and even Bear Stearns have outperformed the hapless Merrill over the past five years. Only Morgan Stanley, beset by various organizational woes in the past, and, more recently, its own fixed income losses, has underperformed the retail firm.
Looking over a longer timeframe, the result is similar. All of the firms outperformed the S&P500 since 1994, but Goldman and Lehman have steeper curves in the past five years.
In short, Merrill's distinguishing feature as a business model, a large retail brokerage sales force, seems to be related to its inability to outperform other non-commercial banks.
Thain is used to managing highly intellectual, risk-oriented businesses. Merrill's retail side leans heavily to the old backslapping, ingratiating model of entertaining clients more than serving them.
In a world with Fidelity Investments, Vanguard, E*Trade, Scott Trade and Schwab, how many observers of this sector believe that full-service, personal retail brokerage is a business with a profitable, growth-generating future?
I was wrong about Thain taking the Merrill job. But he's a very smart, seasoned, tough manager. I don't think he believes he can take Merrill to where Goldman has been without throwing the retail business over the side.
My partner and I believe that Thain sees an opportunity to recruit top talent to join him in building the next Goldman Sachs or Blackstone. Coming from the NYSE, rather than directly from Goldman, he's probably not operating under any sort of agreement not to poach Goldman employees. None of them, nor Thain, has managed retail brokerage, nor has needed it to become the best-performing investment bank in recent years.

Wednesday, November 14, 2007

Some Additional Thoughts On Large Financial Conglomerates & Regulation

Yesterday, I wrote this post concerning Henry Kaufman's editorial piece in Tuesday's Wall Street Journal on the same topic.

That post discussed to what extent regulation, per se, is really possible, or even desirable, in the current context of our financial system.

Other passages in Kaufman's thought-provoking editorial include these,

"As a result, in an age when "transparency" is the business watchword, financial markets have become increasingly opaque. This in turn has fostered doubts and fears about the underlying strength of markets and their institutions. Compared with a generation or even a decade ago, financial markets today are much more complex, an order of magnitude larger, and filigreed with new and often arcane credit instruments. Risk taking -- driven by the mystique of quantitative risk modeling -- has become more aggressive. And these structural changes, many of which were initiated in the U.S., are rapidly gaining acceptance in other major financial centers around the globe.

But the destruction of financial silos that once separated brokerage, commercial banking, investment banking, insurance, mutual funds, and other financial businesses has made fragmented state and federal regulation obsolete.

The Federal Reserve System comes closest to performing the role of financial system guardian. Its central mission is to implement policy that will encourage sustained economic growth. But its monetary tactics are asymmetrical. Leading Fed officials periodically acknowledge that the central bank knows what to do when a financial bubble bursts (ease monetary policy), yet it lacks the analytical capacity to identify a credit bubble in the making. How, then, can the Federal Reserve hold inflation in check in order to encourage economic growth while at the same time restraining financial markets within prudent limits?

Oversight of the 10 to 20 largest financial conglomerates would fill the much-needed regulatory void, given the vast reach of those dominant players. The 15 largest institutions in the U.S., for example, have combined assets of $13 trillion. They dominate many key areas of trading, underwriting, and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that have grown so rapidly in the past decade."

While he doesn't explicitly state it, I get the sense from Kaufman's remarks that he believes the integration of the 'silos' of financial activities such as brokerage, commercial banking, investment banking, insurance and mutual funds to have perhaps been not an unalloyed good thing for our financial system.

Whether or not Kaufman meant to imply this, or really believes it, isn't material to my point. I'd like to explore it for its own sake.

It seems to me that two salient differences between our financial system circa, say, 1960, and 2007, are: provision of more financial services to more consumers, and; provision of more instruments which allow risk to be bought and sold, at prices determined by freely-operating markets, among sophisticated, vetted parties.

Think back to the world of 1960, and my first contention is obvious. Credit cards, apart from retail store charge cards, were the exception, rather than the rule. Investing directly in equities or fixed income securities was expensive, the former enjoying (for brokerages) a 7% fixed commission structure. Capital, at the retail level, in the form of savings, was sticky, rather than liquid. Financial performance information was scarce, if not virtually unavailable.

Now, the changes in retail brokerage alone has resulted in massive changes in investment flows. Information abounds, for free, about equities, mutual funds, and all manner of investment vehicles. Trading and investment is much cheaper, and includes direct, electronic access via trading one's own money at costs which were totally unforeseen in 1960.

The process of buying a home is now cheaper and faster than it was 47 years ago.

In the process of their evolution, various financial systems came to increasingly on technology. This reliance, as it has in other industries, drove two important structural changes. First, the rising costs of technology made size profitable, driving consolidation in businesses such as credit card issuance and processing, as well as mortgage loan origination and servicing. Second, concurrent with this consolidation came lower fees for the same services.

In business after business, save, perhaps, for boutique services such as high-end private banking and investment banking M&A activities, scale has become important for driving costs down and making financial services ubiquitous to those who need them, be they retail consumers, investors, or institutional investors or credit customers.

Along the path to 2007, substantial businesses were built by standalone companies in asset management, credit card lending, mortgage banking, and various capital markets activities.

As recently as 1996, when I was Research Director for then-independent financial services consultant Oliver, Wyman & Co., which is now the financial consulting division of Mercer Management Consulting, there were five independent credit card issuers (First Card, MBNA, Advanta, and two others whose names now elude me), a number of mutual fund companies, and several mortgage banks (Countrywide & Golden West, to name two), and retail discount brokers (Schwab, Quick & Reilly).

In the decade since, commercial banks, contrary to accepted financial theory that an investor can diversify his/her own holdings better than a company can do it for him/her, sought these types of businesses to attenuate variation in their reported earnings, as well as pursue the mythical 'cross sell' opportunity amongst various retail businesses.

The results have not been impressive, as I noted in this post two months ago. Thus, Kaufman's concern regarding money center bank opaqueness to regulatory scrutiny may be only a passing issue. Even now, there are calls for Citigroup, the most diverse of the money center banks, to begin unraveling itself into more manageable, standalone units. The financial supermarket model originally pioneered by Jim Robinson III at American Express has never outperformed the S&P500, anywhere, for very long.

Consumer behavior remains stubbornly resistant to profitable cross-selling of financial services, while their provision by giant, diversified financial entities results in difficult-to-manage, loss-making financial companies which never seem to function smoothly for very long. For more on that, read these posts, here, and here.

And, contrary to Kaufman's typical gloomy outlook, perhaps, as I observed here, in a post echoing an article appearing in the Wall Street Journal just this past September, we are observing a pendulum of credit creation that is swinging between securitzation and portfolio lending. Right now, it's swung far to the securitization pole, but appears heading back toward the center, and, probably, beyond.

My point is that, over time, financial conglomeration does not, in fact, lead to consistently superior shareholder total returns. In fact, the only currently, or, for that matter, historically frequently-appearing large financial institution in my equity portfolio is Goldman Sachs. It's not a widely-diversified financial services company. Rather, it tends to specialize in two areas- institutional businesses, such as underwriting and trading, in which superior knowledge, modeling and risk management matter, and asset management, which shares the same salient characteristics.

The price that US consumers have paid for financial services innovation and cost reductions over the past five decades has been the concentration of many financial services into fewer, larger entities, which concentration has increased risks to the banking and credit system.

Failures such as First Pennsylvania Bank, Continental Bank, SeaFirst, and numerous banks weakened by loan losses, which were acquired during the 1980s and '90s, such as BofA, Shawmut, First Interstate, and a clutch of Texas energy-lending dependent banks, provide examples.

Perhaps the most serious threat to the US financial system in the past decade was the 1998 collapse of Long Term Capital Management, a Connecticut-based hedge fund founded by former Salomon Brothers partners, led by John Meriwether. However, that entity doesn't fit Kaufman's warning of a diversified financial conglomerate bringing down our system through complex, opaque dealings among its many tentacle-like businesses.

No, LTCM managed to do that with just one business- asset management. It complied with then-existing hedge fund regulations. No problem with concentration of financial service businesses and risk in that case. Yet, it is generally regarded as the worst single-firm example of excess in recent memory.

The US financial system weathered the LTCM situation, and the prior crises involving various insolvent banks.

So, in conclusion, I'm not at all certain that Kaufman's warnings are even correct. Most of our financial system's largest failures have been committed by non-diversified banks or financial services companies.

In fact, one of the few benefits, besides technological innovation, that recent consolidation affords is larger capital bases with which to absorb the effects of mistakes.

Looking back over nearly 50 years of US financial system innovation and evolution, I think one could fairly say that the benefits we have enjoyed have far outweighed the realized risks that have accompanied such changes.

Tuesday, November 13, 2007

Henry Kaufman On Large Financial Conglomerate Regulation

Henry Kaufman wrote an editorial in today's Wall Street Journal entitled, "Who's Watching the Big Banks?"

Kaufman writes, in part, in his piece,

"The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses. They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades. As a result, in an age when "transparency" is the business watchword, financial markets have become increasingly opaque. This in turn has fostered doubts and fears about the underlying strength of markets and their institutions. Compared with a generation or even a decade ago, financial markets today are much more complex, an order of magnitude larger, and filigreed with new and often arcane credit instruments. Risk taking -- driven by the mystique of quantitative risk modeling -- has become more aggressive. And these structural changes, many of which were initiated in the U.S., are rapidly gaining acceptance in other major financial centers around the globe.

This new, highly securitized financial regime can work well only if securities are priced accurately. Stated differently, weaknesses and failures in securities pricing are wreaking havoc in financial markets. Traders and investors are learning the hard way that not all assets are the same when it comes to pricing. There is a sharp difference between marking-to-market U.S. government securities or large high-quality private-sector issues versus lower quality issues for which pricing is done off a model or matrix."

Kaufman covers a lot of ground in just these two paragraphs. His first statement is a contention worth pondering at length,

"The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses."

Is it? Is this actually what we wish these entities to do? Are the Fed and Treasury primarily in place to limit future financial excesses? More on this a little later in this post.

Kaufman's second contention, following the first, is,

"They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades."

This statement is, I believe, easier with which to agree. And, on the face of it, true, in terms of the two entities, the Fed and Treasury, having the ability to do much about these new forms of credit monetization.

Later in his thoughtful piece, Kaufman proposes,

"What is urgently needed is a new kind of institution that I will provisionally call the Federal Financial Oversight Authority. This regulatory body would oversee only the largest U.S.-based financial institutions -- the giant conglomerates engaged in a broad range of on- and off-balance-sheet activities that I noted above. The new authority would monitor and supervise these huge financial conglomerates -- assessing the adequacy of their capital, the soundness of their trading practices, their vulnerability to conflicts of interest, and other measures of their stability and competitiveness.

I am not proposing comprehensive supervision of most or all financial institutions. Oversight of the 10 to 20 largest financial conglomerates would fill the much-needed regulatory void, given the vast reach of those dominant players. The 15 largest institutions in the U.S., for example, have combined assets of $13 trillion. They dominate many key areas of trading, underwriting, and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that have grown so rapidly in the past decade.

This is not to say that other financial institutions should be allowed to do what they please. For them the current official regulatory and supervisory authorities should remain in place. But insuring the safety and soundness of the dominant firms would go a long way toward assuring the smooth functioning of financial markets, even if smaller institutions occasionally failed.

The new Federal Financial Oversight Authority should function under the auspices of the Federal Reserve because its insights into market developments would fill the present-day void in central bank deliberations on monetary policy. To underscore the importance of the new Authority's mission, it should be required to submit annual reports to Congress on the safety and soundness of the financial institutions under its purview. And in light of the increasing globalization of financial institutions, other leading economies throughout the world should consider a similar approach. There, too, relatively few institutions would come under supervision, because financial conglomerates dominate throughout the leading nations of the European Union as well as Canada and Japan as they do in the U.S."

I confess to not being swayed by Henry Kaufman's plea for yet another, albeit, super financial regulatory agency. Underscoring its importance by reporting to Congress means nothing. It only assures us that the appropriate head of said agency would cover his/her ass equally appropriately and carefully, knowing full well that any subsequent burp by the financial markets would immediately be charged to that official and, by extension, directly to the sitting Secretary of the Treasury and the President.

To me, the more interesting and relevant questions are those in my set following the first quotes from Kaufman's article.

Do we indeed want the Fed and Treasury to be the lead in limiting future financial excesses?

This itself presupposes another important question- Can we, in any meaningful capacity which does not infringe on individual rights, limit future financial excesses?

I'm not at all sure that each of us, individually or, collectively as a corporation, does not have the right to engage in financial excess.

I don't think any government agency will ever succeed in limiting or preventing financial excess. The post-Depression fixes of Glass-Steagal and unitary, single-state banking laws only lasted a comparatively brief 70 years. Global trading, differing sovereign regulatory environments, and technology proved too much for them to handle.

Between the invention of Eurobonds in the 1960s, ubiquitous credit cards, Merrill Lynch's CMA account, commercial paper, etc., the financial regulatory framework of the US circa 1933 became totally overwhelmed. Upon that contention, I agree with Kaufman.

But he misses the fundamental lesson of this current reality. Whatever rules, agencies, etc., are devised, intelligent, greedy minds on Wall Street and, in imitative fashion, among commercial bankers, will find ways which exploit the clear, well-defined and, thus, self-limiting language of such regulations.

To me, the more interesting and important point is how our financial market participants have liquified heretofore untradeable risks.

For instance, the creation of 'money' via private issuance of credit instruments, culminating in private equity firms going 'public,' pretty much has ended any hope of Treasury and the Fed rigorously controlling dollar-denominated money creation as it could back in the late 1950s. Nobody seriously thinks about DDA account limitations or credit card regulation anymore.

We've seen 40+ years of vibrant, constant financial innovation in US markets, since those first offshore Eurobonds were issued to avoid a Treasury-mandated holding tax in the early 1960s.

How do we expect anyone inspecting the books and records of various large US financial entities to actually preclude a financial crisis? Until defaults and credit freeze-ups occur, who can say what is good, and what is bad? Further, do we want any governmental bean-counter to blow a whistle and declare the legal actions of any large US financial institution to be wrong and dangerous?

Who among us believes that anyone working for Federal government scale is qualified and motivated to make that decision correctly?

No, I don't think any governmental regulatory initiative, even that proposed by Kaufman in his Journal editorial, can pre-empt painful financial excesses.

The best I think we can hope for is to limit the damage of financial excesses.

Today, this is generally done via careful counterparty trading vetting. Most large entities won't trade with entities which have not gained access to trading systems without the assurance of sufficient liquid assets, or collateral, to settle their obligations. We don't need to 'belt and suspender' this area. We can trust private parties to generally police each other with regard to settlement risk.

It seems that the major new risk we have encountered is the inability of various parties, some of whom are large, diversified US financial institutions, to distinguish between listed, truly liquid financial instruments, and structured financial instruments.

Hmmm. Funny, how that name is so prominent, isn't it? instrument.

To paraphrase the currently, seemingly endlessly-running New York Times 'Weekender' ad concerning the word 'weekend,'

"the word alone makes me suspicious."

There are liquid markets for a wide variety of financial instruments: small, medium and large-cap equities, corporate bonds, corporate and bank commercial paper, US Treasuries and bonds, listed options and futures, commodities, commodity futures.

All of these tend to be self-explanatory, and require either full payment, or some carefully regulated, collateralized situation to exist in order to trade.

To my knowledge, nobody, i.e., financial institution, has ever stepped forward and pledged to be a 'market maker' of structured financial instruments.

My friend B, a longtime business colleague, sometime business partner, and creator of one of Wall Street's larger mortgage businesses, had an interesting take on this whole question some years ago.

He opined that perhaps the basic business of deposit-taking should be, once again, a la Glass-Steagal, separated from all other activities. To safeguard the basic banking system, he thought that making it into a sort of simple, financial utility, capable of taking consumer deposits, insuring them, and investing in only the safest financial instruments, would go a long way toward quelling many fears of financial excess damaging our basic credit and banking systems.

In today's world, I'd add that such utilities would be forbidden to invest in any structured instruments. That, to qualify for FDIC insurance, they could only invest in instruments that were AAA rated and unstructured. A sleepy business, to be sure. Such deposits, of course, would earn the lowest rates available in the financial markets, because there would be absolutely no possibility of the financial utility to take extra risk with the deposits and make a larger spread.

Anyone wishing more return would, of course, be obliged to take more risk.

But even B's suggestion doesn't really address Kaufman's central question. Or, more properly, the central question which has occurred to me, in light of Kaufman's thought-provoking piece in the Journal today.

Do we actually want to limit financial excess? That is, financial innovation and technological advances? Or do we simply want to limit the damage of financial excesses, gone wrong, to those who knew the risks, and had already been vetted as capable of withstanding the losses thereto?

In the final analysis, I don't believe Kaufman's focus is correct, nor his solution probably effective to actually preclude the next financial excess. It's just the nature of our financial system.

People stand to reap handsome rewards from intelligent, well-managed financial innovations. Structures like private equity, hedge funds, mono-line mortgage banks and credit card companies come to mind. Even the original, residential-finance-only CMOs probably constituted a reasonable advance in housing finance.

But mixed-asset CDOs crossed a threshhold of ability to be easily priced and to assume a continuous market for the instruments. And, to my knowledge, thus far, the only victims are the sophisticated purveyors of these instruments, and their sophisticated institutional investors/buyers.

It may be financial excess, but I still seriously doubt it's either preventable, nor desirable to create significant new regulatory structures to attempt such prevention.

Monday, November 12, 2007

Another Note On SIV Ownership

As I discussed recently in this post, it appears that the money center banks which created the SIVs which hold so much of the questionably-valued CDO assets, do not own those SIVs.

As structured, it appears that some 'senior note holders' stand as equity participants in the vehicles, by virtue of their reaping the gains, net of financing costs and management fees, accruing to the entities.

One thing I neglected to cover in my prior SIV-related posts (found by reading the posts under the 'SIV' label located on the right side of the page) is why commercial banks, or other entities managing an SIV which they created, are unlikely to assume the SIV liabilities, i.e., take back the commercial paper issued to fund the SIVs.

If a commercial bank, such as Citigroup, were to voluntarily offer to take back the commercial paper issued by an SIV which it created and operates, or simply absorb the SIV's balance sheet onto its own balance sheet, thus bringing it 'on balance sheet,' it could well be subject to lawsuits by some of its institutional investors.

By having structured SIVs as separate entities, companies like Citigroup specifically and legally sidestepped ownership of liabilities connected with the SIVs. To now assume those liabilities, which might default if left alone on an SIV's balance sheet, would be effectively assume an obligation with no adequate offsetting benefit.

It's hard to believe a major commercial bank's institutional investors would stand by silently while a company in which they hold substantial positions engages in such foolish use of its capital.

I think that's why the M-LEC structure is being used, with cover from the Treasury's blessing.

Participating in the M-LEC isn't technically taking back and/or owning any of the SIVs' commercial paper. But it is supposed to, under ideal conditions, liquify the SIVs' assets, in order to provide them with cash with which to pay commercial paper holders. By investing in the M-LEC, banks in effect issue commercial paper through this entity, to replace the individual SIV commercial paper, without, per se, owning the latter.

If the M-LEC can somehow manage to not lose money on the same 'borrow short, lend long' basis that the SIVs employed, but, instead, borrow short and lend short, by effectively doing repurchase agreements on the better quality SIV assets, then the commercial banks might be able to mitigate the losses of commercial paper holders of the SIVs which the same commercial banks created and operated.

I think, in retrospect, that the M-LEC structure was originally conceived in part to avoid the legal problems of the relevant banks attempting to take ownership of SIVs which would only saddle them with more liabilities than assets, at this time.

It remains to be seen, however, whether the M-LEC will actually be created, and whether it will avoid some of the challenges predicted for it, and cited in some of my prior posts on the topic.

Sunday, November 11, 2007

US Economy Ranked Most Competitive- CNBC Disagrees!

A WSJ article two Thursdays ago noted that the United States is now ranked 'most competitive' among nations. CNBC also carried the story, but with a different spin.

CNBC immediately panned the pick in a live discussion of the news.

C. Fred Bergsten, the ultra-liberal economist, was the 'expert' of choice for Maria Bartiromo, herself never accused of any economic knowledge. His Peterson Institute bio reads, in part,

It's curious that CNBC chose C. Fred. Here are some excerpts from his bio on the website of the Petersen Institute,

Dr. Bergsten was assistant secretary for international affairs of the US Treasury during 1977–81. He also functioned as undersecretary for monetary affairs during 1980–81,

He was also chairman of the Competitiveness Policy Council created by the Congress from 1991 through 1995;

Dr. Bergsten was born in 1941. He received MA, MALD, and PhD degrees from the Fletcher School of Law and Diplomacy and a BA magna cum laude and honorary Doctor of Humane Letters from Central Methodist College.

From his academic information, it doesn't appear that he is even an economist by training! He's a lawyer, or a diplomat.

With so many decent economists available on CNBC- Larry Kudlow, David Malpass and Brian Wesbury, to name just three- why select C. Fred, who isn't even a trained one?

The World Economic Forum, which brings you the Davos summit each year, is responsible for the rankings. According to the Journal,

"However, the U.S.'s sharp climb was due to a change in methodology that gives more weight to market-related factors in the survey, relative to macroeconomic criteria on which the U.S. is weak. Under the new methodology, the U.S. would have topped the rankings last year, too.

"The U.S. does amazingly well on innovation and markets, but on the macroeconomic-stability pillar it ranks 75th" out of 131 countries included in the survey, said Jennifer Blanke, the forum's chief economist and a co-author of the report. "This still reflects a very serious problem that could hurt the U.S. in the future."

The U.S. scores badly for high levels of government debt and deficits and a low savings rate that reflects overextension among U.S. households. The recent credit crunch, triggered by problems in the subprime-mortgage market, is an example of the risks these weaknesses hold for the U.S. and global economies, according to the survey's authors.

The forum's annual competitiveness report covers 12 criteria that range from business sophistication to health and primary education, polling 11,000 business leaders around the world. The goal is to identify the potential of economies to raise productivity and prosperity, measured as gross domestic product per capita."

Upon the receipt of this news at CNBC, C. Fred and Bartiromo launched into a savage critique of the US economy. Bartiromo insisted that because of our financial system's SIV-related challenges, and a recently-weaker dollar, our economy can't possibly be ranked most competitive.

C. Fred chimed in to reinforce Bartiromo's unquestioned views, and added that 'our deficit is spiraling out of control,' or something like that.

Except it isn't, C. Fred. It's shrinking. It's on track to be gone in two years, unless the free-spending, ear-mark-happy Democrats derails us from that accomplishment.

Last month, the Journal reported,

"for fiscal 2007, the Federal deficit had declined to $162.8B, from $248B in 2006. This was a 34% reduction in the annual deficit."

So much for the popular notion that our deficit is large and growing. It's now down to just a few percent of our annual GDP.

As I read the WEF ranking article, I couldn't help but recall this post, in January of this year, describing Nobel-winning economist Edward Prescott's analysis of our nation's economic situation. I wrote,

"Mr. Prescott observes that "privately held interest-bearing debt relative to income" is at levels comparable to those of the 1960s. So he also judges our governmental debt level to not be "too big."Perhaps the most interesting myth is the fifth one. It's a sort of product of the third and fourth myths, with a little emotional zing tossed in about the next generation's inherited liabilities.

Here, Mr. Prescott refers to some prior research, stating,

"Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. This assumes 1% population growth, 2% productivity growth, 4% real after-tax return on investments, and that people work to age 63 and live to age 85. Currently, privately held public debt is about .3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt."

Mr. Prescott actually make the point, subsequently, that government debt is a necessity if one has a long-lived population that is not growing rapidly. In effect, the more older, non-working people a society has, the more productive assets it needs with which to generate wealth in order to pay for those retired people. It's the reverse of how most economists present this situation."

Thus, it's quite possible that the WEF's macroeconomic criteria are not sensitive to the unique mix of population growth, age, and productivity. It makes sense that, when weighting innovation and markets, the US dominates. And, as Prescott indicates, it makes sense to feed the world's most productive economy by using debt finance. Especially when that economy belongs to the world's most free, stable government.

Our deficit isn't a problem, and neither is our current, short-term problem with losses in various structured finance instruments. They constitute a short-term loss of investment capital, not a long-term burden on the economy.

But leave it to CNBC to look for the dark cloud surrounding an economic silver lining. A view on the country's global economic supremacy, as judged by the WEF, brought to you by two non-economists.