Saturday, December 01, 2007

Citigroup-Chase Merger: An Idiotic Idea

Thursday's Wall Street Journal carried a short piece about this idiotic notion in its 'breakingviews' column. Article authors Rob Cox and Robery Cyran float the absurd notion that two of the countries three largest banks could easily merge, and, further, there would not be regulatory and Congressional outcry.

Apparently, according to Messrs. Cox and Cyran, the mere fact that Citi currently lacks a CEO, and Chase does not, is worthy of advancing the idea of this merger. Further, they are obviously enamored of Dimon, Chase's CEO, writing,

"Not only did Mr. Dimon spend more than a decade carrying Sandy Weill's bags on the shopping spree that build Citigroup, he also has made the financial-supermarket model work for his current investors. Citi shares are down 31% in the past four years, J.P. Morgan's are up 24%."

As I wrote in this post in late October,

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

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

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

Dimon has in no way yet proved he can grow Chase and deliver sustained, consistently superior total returns for his shareholders. To say he carried bags for Sandy Weill is no compliment, given the fate of Weill's spawn, Citigroup.
In this recent post, I noted, using this same chart as appears nearby,
"Even Chase's price curve indicates that the basis of its current five-year outperformance of the market is due largely to a few months in mid-2003. Which was prior to Dimon's arrival at Chase as CEO. Since then, it's performance has been somewhat flat, and not materially better than the index's, overall, with a significant period of falling returns, from early 2004 to late 2005."

But, beyond Dimon and Chase, the chronic underperformance of the S&P500 Index by our nation's money center banks is widespread. As I wrote in that prior post,j
"Commercial banking, in general, among the remaining money centers, isn't a good bet to beat the S&P500 anyway. It's not just Citi's problem.As the nearby, Yahoo-sourced price chart for Citi, Chase, BofA, Wachovia and the S&P500 for the past two years shows, none of the banks has outperformed the index. Citi is the worst, by far, Chase the best of the mediocre lot."
As my old boss and Chase Manhattan Bank Chief Planning Officer used to say,
'All you get by merging two or more mediocre money center banks is one great big mediocre money center bank.'
And probably even less than that. If you think Citi's been a mess so far, try doubling its asset size via a merger with Chase and see what happens. It'll be an unmitigated disaster.
The putative savings Cox and Cyrman ascribe to such a merger, 15% of noninterest expenses, or some $93B, is rather similar to those static models that the CBO runs when analyzing the effects of tax cuts. They assume ceteris paribus, when that won't be true.
My guess is that the the 15% estimate comes from mergers of much smaller, simpler banking unions. Chase and Citi have, between them, a wide variety of businesses, many of them the backbone transactions and clearing functions which have made money center banks so special over time.
To even suggest that Dimon, whose banking background is actually quite limited, compared to his extensive time at Weill's feet during the wire house rollups, could even come near pulling off such an integration is simply laughable.
And then, honestly, who is stupid enough to think the Fed and other regulators would simply let two of the nation's largest five commercial banks, in the same city, merge?

This piece was about the wackiest I think I've seen in the Journal in ages. Don't they have better uses for their space?

Friday, November 30, 2007

Henry Kaufman Turns 80 On CNBC Yesterday: Who Cares?

An old, retired guy named Henry K. shows up on a cable news channel. He talks about a recent editorial he wrote for a prominent national newspaper. The program's anchor gushes admiringly over Henry's every word, despite the famous guest's accent.

Henry Kissinger? No, not that still-lucid foreign policy veteran. Instead, it was second-tier economist and perennial market bear, Salomon Brothers' Henry Kaufman.

Kaufman appeared on CNBC yesterday, the occasion of his 80th birthday, to stump for his recently proposed plan of increased regulation of large US diversified financial institutions. I wrote posts about his plan two weeks ago, and his assumptions, here and here.

Kaufman didn't say much yesterday that went beyond his Wall Street Journal editorial of earlier this month. The most salient thoughts I had, in summary, about Kaufman's idea were these,

"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."

But something else struck me about Kaufman's appearance yesterday on CNBC. As I watched the program's co-anchor, Bill Griffith, fawn over Kaufman, the latter's track record began to come back to me.

Kaufman was once Salomon Brothers' chief economist, and, as befits a fixed income house, usually a market bear. Then he left Salomon to become a money manager. But, as I recall, he foundered. Salomon didn't participate in his firm, and I believe he failed to attract sufficient funds to make in the razor-thin margin world of fixed income management.

Come to think of it, does anyone else know of a successful institutional investment manager who came out of Salomon and went on to consistent success?

The only name that comes to my mind, of course, is John Meriwether. But Long Term Capital Management, as mentioned in my quoted passage, hardly constituted a successful example of consistently superior investment management.

Most of the better institutional managers about whom one hears, if they have an investment bank pedigree, more often than not, seem to be Goldman, Sachs alumni.

Could it be Salomon's fixed income heritage somehow biased its managers?

Take the longer term view. Salomon isn't even independent anymore. It was rocked by the Treasury bid-rigging scandal some years ago, which required Warren Buffett to step in temporarily as acting Chairman. Then it was acquired by Sandy Weill in 1997. So it hasn't even been a separate investment bank for over a decade.

Goldman, on the other hand, prospered continuously for the past several decades, culminating in its own public offering.

Given the rather checkered history of Salomon, Kaufman's early departure to a rather forgettable career thereafter, as his one-time employer stumbled and was acquired, why does anyone take Henry's views seriously anymore?

Why didn't Griffith ask Kaufman on what basis, with what credentials, he is qualified to propose refashioning US financial markets regulatory mechanisms?

Honestly, in Kaufman, I see little besides disgruntlement at lack of accurate calls when he was an economist for Salomon. And, subsequently, reason to call into question his presumption that Salomon now counts for much when weighing in on this topic.

Perhaps his appearance simply reflected CNBC's indiscriminate need to fill air time on a weekday afternoon.

On Boards of Directors of Diversified Financial Firms

Yesterday's Wall Street Journal featured an excellent editorial by Peter Hahn, entitled "Blame the Bank Boards." The article's byline describes Mr. Hahn as "a fellow at the Sir John Cass Business School in London and was Citigroup's senior corporate finance officer for the U.K."

Echoing my own sentiments regarding the boards of diversified financial giants such as Merrill Lynch and Citigroup, appearing here, here, and here, Hahn characterizes the board members of such firms thusly,

"Most bank boards consist principally of leading clients, ex-politicos and community leaders. Notably absent among them is any sophisticated understanding of banking and risk, let alone stuff like derivatives. But the contemporary banking business is about risk management, risk trading and systems integration -- and has been for years. German banks speculate in the U.S. mortgage market; a regional British savings and loan (Northern Rock) becomes the ninth largest bank in U.K. buying mortgages from brokers and selling interests in them to U.S. investors; the largest bank in the U.S. with assets in 100 countries (Citi) finds itself with $50 billion in securities that it can't value. And we haven't even talked about what could happen with all the private equity positions these guys own. As far as boards are concerned, in other words, we're not just talking about sophisticated risk management -- we're talking about basic oversight.

One common denominator with many of the bank boards I've looked at is that very few bank directors actually have full-time jobs. To be blunt, many of the biggest bank boards resemble retirement clubs. Without current corporate, banking or risk expertise, it's hard to see what these directors are adding, save a few more deal contacts."

My own thoughts included these, in one of the linked posts above,

"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.

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?

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.

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."

Another post quoted various outside observers laying much of the blame for Citigroup's current situation at the feet of Rubin and his fellow board members.

Hahn has this to say about Citi's board,

"Citigroup's board reportedly fought for two years to get Sandy Weill to name a successor. But looking at Citi's business structure, it's clear they didn't have much overall success overseeing the company's banking integration efforts -- let alone risk management. And they still haven't figured out succession planning.

The average tenure of the Citi board member is over 10 years. Much has been made of the fact that many of Citi's outside directors were not associated with stellar business performances elsewhere. But with the scale of Citi's bad positions, investors must be wondering -- if not succession planning, or business oversight, or risk oversight -- what were they doing for the last decade at Citi?"

Hahn makes great points regarding the inappropriate makeup of most financial services company boards. They still cling to old notions of involving a broad array of community and political leaders, along with luminaries from other fields. But, as Hahn notes, banking today is much more involved with sophisticated understanding of abstruse risk management. Chemists and community activists hardly qualify as capable of overseeing such financial activities.

While we skewer various CEOs- Spector of Bear Stearns, Prince of the Citi, O'Neal of Merrill Lynch, and, just today, Morgan Stanley Co-President Zoe Cruz- let's not forget the sleeping morons on the boards which let these executives take such appalling losses for their firms.

Thursday, November 29, 2007

Another Fed Rate Cut Next Month?

The past two days have seen CNBC's on-air staff going typically nuts discussing the possibility of a rate cut at the next Fed meeting.

Yestday morning, Rick Santelli, CNBC's Chicago Merc-based reporter, shared an opinion with Brian Wesbury that another Fed cut won't fix real credit problems.

In the midst of an argument with the as-always clueless, usually wrong Steve Liesman, Santelli correctly blurted out that financial concerns are now 'worries over collateral,' not rate levels.

After a few more rounds with Liesman, Santelli chuckled something like,

'You ought to try making a living trading,'

implying that Liesman dreams up all sorts of interpretations for interest rate moves, without understanding the basics of what drives futures traders in the Chicago pits.

Today, the two were at it again, with Liesman crying,

'It's not just some Wal-Mart we're talking about here, Rick, it's our banking system. The lifeblood of our economy.'

But, is it? Are our banks' solvencies truly at risk? And, if so, will they become solvent by another Fed rate cut?

Personally, I am with Wesbury and Santelli on this one. I doubt that our banks are actually insolvent. I hate writing this, but if you consider where most have gotten into trouble, it's been in the newer securities areas where they were forbidden to play until...ah...yes.....Sandy Weill, late of Citigroup.....broke through Glass-Steagal and pushed commercial banks into underwriting and trading equities.

As my old boss, Chase Chief Planning Officer, Gerry Weiss, used to say,

'We don't need to break down Glass-Steagal. We lose enough money through bad management as it is now. All that will happen with the removal of that regulation is that we'll lose even more in new ways.'

Sure enough, BofA and Citi have posted most of their recent losses in securities-related efforts.

Which means that the original banking activities which we associate with institutions that access DDA accounts- deposit-taking, trust, custody, funds transfers and processing- are still intact.

What's changed over the years is the commoditization of so many of the lending businesses to which commercial banks used to turn for profits- consumer, business, credit cards and mortgage loans. It's routinely these areas which cause problems for banks, as they stretch their own risk appetites in pursuit of further growth. Compared to ten or twenty years ago, banks don't have nearly the choke hold on credit markets that they once did.

The bedrock financial systems of our country, however, remain intact and, if necessary, separable from institutions which lend to excess.

Thus, Liesman overreacts when he believes that some bad sub-prime loans, which account for something like 15% of the 15% of the mortgage loans outstanding, will sink our entire financial system.

It's not the bad loans, but, as Santelli noted, fear by counterparties of overpriced collateral.

The sooner we know that suspect loans have been written down, the sooner the commercial banks will be capable of returning to what loan business they still handle.

On Recent Equity Markets 'Volatility' & MFQ

Much is heard recently on the 'volatility' of US equity markets.

What is meant by this? My business partner and I discussed this topic yesterday over lunch.

Technically, volatility usually is inferred to mean something associated with a type of standard deviation measure, or some derivative thereof, such as variance (the square of a standard deviation).

On that basis, a graph of S&P monthly returns from 1990 to the present looks like this (click on the chart to see it in a larger version).

Optically, you can see that the S&P monthly returns became more dispersed in the middle of the period covered by the graph, but has calmed down noticeably in the past 3-4 years.

This next graph portrays the standard deviation of the S&P monthly returns over trailing 12, 24, 48 and 96 month period.

As you would expect, the standard deviations of the longer periods move much more gradually.

Even so, all four measures have been in notable and significant decline since early 2003. Only this month's current -6.6% S&P monthly return has disturbed this pattern in recent years. Even so, it isn't necessarily a bigger shock than those of mid-2004, which were only a brief exception to the longer-term, continuing decline of the standard deviation of S&P monthly returns.

If the S&P monthly returns, measured over various timeframes, aren't showing increasing 'volatility,' on what measure would the S&P, as the best broad US equity market measure, depict rising 'volatility?'

As my partner argued that my reference to this graph missed the point, we debated what would be relevant? That question led my partner and me to construct the following measure yesterday.

Begin with the daily adjusted closing price series of the S&P500, available, for free, from Yahoo's finance website. Calculate the first differences, i.e., a series of daily raw change in adjusted closing S&P500 price. From this series, identify each raw daily change as either positive, or negative in sign.

Then, construct a series which looks at each day's adjusted closing price difference sign, relative to the preceding day's closing price difference sign. The value for a day in this series will be "1" if the signs changed between daily adjusted close differences, and "0" they were the same.

In effect, each time the S&P close changes direction from the prior day, that day registers a "1." If the market records two consecutive up, or down days, the values for those second days would be "0" in this last series.

We call this last series, and its monthly total, the Market Fluctuation Quotient, or MFQ.

The nearby graph displays the S&P500's MFQ, on a monthly basis, from January of 2000 until yesterday.

The highest value we've seen for the MFQ was 17, in August of 2005. The lowest value was a 6, in September of 2001. However, that was affected by the market's close for a period during the week following the WTC attacks. Other than that datapoint, the series hit a low of 8 three times in the 95 months measured.
To more clearly understand the distribution of MFQ values during the 95 months of this decade, here is the same data arrayed in a histogram, by frequency of occurrence.
Two of the six MFQ values over 14, since January of 2000, have occurred since July of this year. If either today or tomorrow sees a closing S&P value lower than the preceding day, then November, 2007, will be the third over-14 MFQ value out of seven since the beginning of the measured period.
Since July of this year, no MFQ value has been below 11. The last similar period of elevated MFQs was from February to June of 2005, just prior to that year's hurricane season-affected equity markets.
If you are a frequent trader, than the MFQ is relevant. It clearly captures the recent, heightened day-to-day volatility, when that term means changes in closing market value direction.
We, however, are longer-term investors. Even in our equity options portfolios. As such, the MFQ doesn't really affect our investment decisions very much.
Still, it's interesting to note how divergent the two different perspectives on market 'volatility' can be- a series of standard deviations of month-to-month S&P returns, and a series measuring S&P daily close sign changes.
Clearly, volatility is in the eye of the beholder, and his/her frame of reference.

Wednesday, November 28, 2007

Citigroup's New Investor: $7.5B From Abu Dhabi

I suppose the big news yesterday was generally considered to be Abu Dhabi's sovereign fund investment in Citigroup. For $7.5B, the country's investment fund bought just shy of 5% of America's largest commercial bank.

Are we all quaking in our boots yet over foreign government takeover of our financial system?

As if.

My good friend and sometimes business partner, B, opines that perhaps the investment is calculated to insulate the Arabs by making our American interests coincident with theirs. By owning a significant stake in Citi, according to B, we can't punish Abu Dhabi without harming our own largest commercial bank.

Maybe. Maybe not.

How about this for a rationale?

The US dollar is currently under pressure. Its value has slipped enough in the past year to cause oil producers to consider diversifying their assets out of dollars. US Treasuries' yield has become anemic as their price is bid up during the current credit quality turbulence.

Citigroup hasn't outperformed the S&P500 over five years. In fact, its current price level has pretty much returned to zero over the period. Its dividend thus becomes its return. From CNBC this morning, I believe this to be around 7%.

Thus, by buying into a large US commercial bank, Abu Dhabi has done something fairly clever.

First, they will likely receive a return greater than that of the US dollar. Because Citi is the largest US commercial bank, the Arabs know that it's unlikely to fail without a rescue by the Fed and/or Treasury.

Second, as an equity, it has an embedded call that Treasuries don't. So the Abu Dhabians will get a dividend, plus possible equity appreciation, with some protection on the downside for free.

Third, as B noted, they invest in something important to the American financial system. So, like a virus in a body, any truly toxic action against the virus might hurt the body, too. The US government is unlikely to punish Citi for having a foreign minority equity investor. Even if, with the Saudi Prince, the two Arab interests own up to nearly 10% of the bank.

Parenthetically, you can pretty much dismiss idiotic Senator Chuck Schumer's grandstanding on this issue. Sure, his ego is soaring into the stratosphere at having been courted prior to the announcement. But most of his faux-warnings about the Arabs wanting board seats of confidential information via Citigroup's various financial network dealings are bogus. No outside board members would receive that sort of sensitive information- foreign, or not. With US public company board membership being the joke that it has become, nobody would realistically worry about this alleged risk.

All in all, it's a smart move. The Arabs probably realize that they bring nothing to the table by requesting a board seat. It would only upset Americans more than any benefit the investors would receive.

This way, they get better exposure to the US equity markets and economy, but with some protection. And it's an implicitly friendly, positive signal to US markets. If anything, the Abu Dhabians have sacrificed total return in exchange for safety, given their own domicile, and the furor they know they might arouse with investments seen to be spread among too many top-performing US large-cap companies.

CNBC's New Print Host

In this post yesterday, I neglected to mention the obvious companion development at CNBC in the past month or so.

Dennis Kneale, managing editor at Forbes magazine, has become a very frequent guest/host on CNBC. He's on for commentary most mornings, and occasionally present for an hour or so around noon.

Further, it seems that he guest hosts the morning SquawkBox once every two weeks or so.

Personally, I enjoy Dennis' comments and like him a lot. He is similar to Joe Kernen- sensible, analytical, typically optimistic. Perhaps the producers at CNBC chose him to offset the usually-liberal, negative sentiments of Carlos whats'his-name and Mark Haines.

In any case, as I reflected the other day on Kneale's much more frequent appearances, I realized that Alan Murray has pretty much disappeared from CNBC's screens. Were it only the absence of the senior Journal personalities, that would be one thing.

But with Dennis Kneale clearly signed on for significant air time on CNBC, you have to wonder if that doesn't provide evidence of major behind the scenes changes already between CNBC and the Journal.

Tuesday, November 27, 2007

CNBC: Where Did The Wall Street Journal Staff Go?

Is it my imagination, or have Alan Murray and most of the rest of the senior Wall Street Journal staff who used to appear on CNBC left their channel?

Time was, there were two Journal editors who used to have a midday stock selection discussion.

Kim Strassel and Dorothy Rabinowitz (I think) no longer seem to appear on CNBC.

And a look at the masthead of today's WSJ shows Alan Murray has moved from being a managing editor of the paper edition, to a senior manager of 'online.'

My guess is that, post-Murdoch purchase, the Journal is fulfilling whatever legal obligations it has with CNBC at the most minimal level, using relatively junior staffers.

For example, Dennis Berman and John Hillsenrath, both relatively light weight writers in the Money & Investing section, appear on the rival channel to Fox Business Network.

But the more broadly-focused, experienced Journal reporters and editors are now absent.

One has to presume that they have been re-assigned to preparing a coordinated online-and-cable-network application of the Wall Street Journal brand to Fox's existing distribution channels.

And a rather sad, to me, personally, footnote. I noticed my one-time squash partner and old friend, Paul Ingrassia, missing from the Journal's masthead. By Googling him, I discovered a piece elsewhere on the web announcing that he left the Journal in July, after having been passed over for the post of Managing Editor.

The Economics of Union Strikes: Broadway vs. Writers

Unions are, evidently, not all alike. Take the current two obvious union strikes, for example.

Terry Teachout wrote an editorial in the weekend edition of the Wall Street Journal concerning the Broadway crafts union strike.

Teachout wrote,

" I would gladly have paid a hundred bucks to see any one of these shows -- but would I have paid $1,800, not including dinner, to go to all of them with a date?

That last number came to mind as I read Mr. Brook's discussion of the high cost of playgoing in 1968. Even then, the curious, intelligent, nonconforming middle-class New Yorkers celebrated in "The Empty Stage" could still afford -- just -- to visit Broadway often enough to feel that they were keeping up with American theater. Now they're more likely to go once or twice a year, if that. Broadway is no longer a meaningful part of their cultural lives.

But Local One of the International Alliance of Theatrical Stage Employees, which is currently picketing 27 Broadway theaters, has made one statement that seems to me incontestable: "Cuts in our jobs and wages will never result in a cut in ticket prices." Yes, it costs a whole lot more to do business on Broadway now than it did in 1968 -- but producers have discovered that there are more than enough people willing to pay a whole lot more to see big, dumb musicals like "Young Frankenstein" and "Legally Blonde," which is why such shows now dominate Broadway. No matter who prevails in the strike, that's not going to change.

What has changed since 1968 is that America's regional theater companies took a huge leap forward in seriousness and significance -- without pricing themselves out of the reach of ordinary playgoers. The top ticket price at most of the major big-city regional houses is roughly $60, which is what you would have paid last month to see Primary Stages' wonderful Off-Broadway production of Horton Foote's "Dividing the Estate." That's not cheap, but it's doable, and the further you venture off the beaten path, the less you'll pay to see shows for which no artistic apologies need be made. Triad Stage of Greensboro, N.C., charged a top price of $42 for the brilliant production of "Tobacco Road" I saw there in June. As for the unforgettably fine revival of Brian Friel's "Aristocrats" mounted by Chicago's Strawdog Theatre Company that I reviewed six weeks ago, it cost $20 a ticket -- $3.50 in 1968 dollars.

Don't get me wrong: I like musicals, the same way I like ice-cream sundaes. But man cannot live by dessert alone, and now that most of Broadway is shuttered, it has become clearer than ever before that there are better and cheaper places to get a steak."

So Teachout provides a nuanced view of this strike. The union members realize that cutting their wages or jobs won't affect the revenues of the producers and investors in Broadway shows. Profit, yes. Ticket prices, no.

So, in effect, they are using their only lever to force producers to pay them their due. Perhaps, though one doesn't know from this column, the union members realize they may well be the last generation to actually have these jobs in any significant number.

I liken these guys to the UAW members in Detroit. They fight for wages- in the UAW case, often obscenely high wages- from firms whose leaders aren't exactly giving them cause for hope that theirs will be a long-term profession.

They clearly are penny-wise. Might they be being pound-foolish, as well? From Teachout's insightful analysis of regional theatre, one surmises that they are. At least it'll be a unionized group of craftsmen on the Broadway equivalent of the Titanic as the last show closes for the last time near Times Square.

The writers strike, by contrast, is all about an informed union prudently surveying the broad technological landscape of the future.

Unlike the theatre union, which is pretty much more muscle and less brainpower, the writers are one of those vaguely white collar unions. They seem to share some characteristics with longshoremen, about whom I wrote some time ago, here and here.

I'll bet the best writers wish there wasn't even a union at all. Let's face it, writing is a 'craft,' in the sense of carpentry. But the very best carpenters and writers create their own demand.

You look at a beautiful piece of molding, or a clever piece of woodwork in a home, and you want to know who the carpenter was, so you could potentially hire him in the future.

The best television programs feature above-average writing. From above-average writers, of course.

Still, they have a union. So even the best writers have to put the pencils down. And, perhaps, in this case, wisely so.

One or two great writers might not get protection, going forward, for technologically advanced uses of their product. Together, they may, as a group, do just that.

Unlike the Broadway theatre-related union, which seems to be more or less uncaring that they work in a sector that is rapidly pricing itself out of existence, the writers are incredibly sensitive to the potential future ramifications of their contracts.

A few wealthy people missing Broadway shows won't draw all that much attention, outside New York City. Losing all new video programming material on various network and cable channels, movies, etc., will.

It goes to show that not all unions are alike. The craftsmen on Broadway seems fairly narrow-minded. The writers, on the other hand, look a lot more like the longshoreman's union- savvy and, ultimately, wielding substantial power.

Monday, November 26, 2007

More On SIVs: Citigroup's Purchase Its SIVs' Commercial Paper

Earlier this month, I wrote this post regarding SIV ownership. In that piece, I wrote,

"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."

However, in today's Wall Street Journal, Citi is reported to have purchased $25B of its SIVs' commercial paper over the summer, in addition to $18B that it already held. This comes to a total of $43B of short-term SIV debt that Citigroup now holds to finance a reported $84B of CDOs in the SIVs.

To be honest, I hadn't thought about this particular scenario. It seems to me that by purchasing the debt of its own arms-length SIV, Citigroup is demonstrating, de facto, if not de jure, that it considers itself the ultimate owner of the SIV.

For example, if Citi had let the commercial paper go unsold, it probably would have triggered the default of the SIV, wiping out the equity-like 'senior note holders,' and dumping the CDO assets of the SIV onto the market.

But Citigroup's purchase of SIV debt begs the question,

"At what price did Citigroup buy the paper, and on what valuation assumptions?"

If Citi bought the commercial paper with the assumption that the assets were fully, and correctly, valued on the SIVs' books, then it perhaps overpaid, given the true risk of the vehicle, and its assets.

If Citi had been less involved, and more hard-nosed, might it not have paid less for, and demanded higher returns on the commercial paper? Of course, that would have necessitated a write-down or sale of some of the SIVs' CDOs, in order to preserve equality of assets and liabilities for the structured vehicles.

Granted, Citi has cleverly sidestepped legal actions which could be brought by its own shareholders for taking the SIVs onto its balance sheet, after having claimed them to be separate for so long.

However, as the Journal article details, there is now a debate over whether Citi's purchase of commercial paper from its own SIVs constitutes a "reconsideration event."

The term refers to conditions under which accounting determinations may be reversed, or changed, to reflect subsequent actions that change ownership of assets.

Citigroup claims its original SIV covenants, which obliged it to fund the vehicles by buying commercial paper which was unsalable in financial markets, obviates any reconsideration event.

However, other observers maintain that, as Citigroup's ownership of debt of the SIVs climbs, it effectively does own the vehicles, and, indirectly, the assets.

But, let's step outside the arcane world of interpreting accounting rules, and consider a common sense perspective.

If the SIV had been unable to roll over its commercial paper in the market at large, it could have attempted to sell some of its CDO assets to pay off the existing holders.

What if Citi had simply negotiated to buy said CDOs in a direct transaction? Whatever valuation it placed on the CDOs would be, of course crucial. If the SIV offered the CDOs and attracted no bids, or very low bids, and Citi stepped in with a higher bid, that would obviously constitute a bailout by the bank of the SIV.

It also would have been one way that Citi could effectively begin to bring the CDOs onto its own balance sheet, without technically repossessing the entire SIV.

But look at what we are describing. Whether Citi buys the SIVs' commercial paper, to prevent the SIVs from liquidating their CDO assets and becoming insolvent, or buys the SIVs' CDOs, in order to let the SIVs pay off their creditors and shrink their balance sheets, Citigroup is clearly giving their own SIVs special treatment.

Would they be doing this for, say, the SIV of another bank? Unlikely.

So just by Citigroup's own actions, especially if mandated by the SIVs' agreements that Citi buy any otherwise-unsold commercial paper, the bank pretty clearly behaves as if it owns the SIVs, and/or their assets and liabilities.

If you were to consider buying Citigroup stock, in light of this information, you'd be foolish not to assume Citi effectively owns the SIVs which it manages.

Despite the legal and accounting legerdemain, Citigroup's actions tell you all you need to know about who really owns its SIVs.

Contrary to what I believed in my prior posts, I would say, at least for Citigroup's SIVs, because of the new (to me) information regarding its requirement to supply commercial paper funding to its SIVs, that the bank owns those SIVs.

"Target-Proofing" Corporate Performance- How Probable Is It?

Friday's Wall Street Journal carried an editorial entitled, "Target-Proof Your Company," by Robert Pozen. Pozen is chairman of MFS Investment Management, and evidently adapted this piece from one he wrote for the Harvard Business Review.

Ironically, explaining that last part goes a long way toward explaining the rather ho-hum nature of his recommendations for how public companies may avoid becoming targets of private equity firms.

As I recall from many years reading HBR, it frequently would feature 'so-what' sorts of corporate pablum that espoused laudable, if largely unattainable goals.

For instance, Pozen's five questions for target-proofing a company are:

Is there too much cash on the balance sheet?

Is the capital structure optimal?

Does the operating plan significantly increase shareholder value?

Is executive compensation tied closely enough to shareholder value?

Do directors devote enough time and have enough incentive to increase shareholder value?

The first two questions are truly inane, at this point in modern corporate development. Any firm significant enough to merit private equity attention can afford a decent CFO who can make sure these tactical matters are appropriately managed.

The third question is, frankly, probably the toughest, hardest to achieve of any single question for modern corporate CEOs.

My proprietary research shows that, at best, only 10-20% of the S&P500 CEOs can figure out what to do in terms of fundamental, operating peformance, that leads to consistently superior shareholder returns.

Jeff Immelt's never done it. Chuck Prince never did, either. Nor most of the CEOs of large-cap companies. The best way to increase the odds of such shareholder return performance is, according to my findings, deceptively simple, and requiring of exceptional management talent and discipline.

Thus, Pozen's question, while useful, is, for all practical purposes, unanswerable by most CEOs and their boards. They simply have no clue.

If they did? They'd be doing it!

Questions four and five have elicited a myriad of posts from me over the past two years. Read my posts under labels such as 'corporate governance,' 'private equity,' 'executive compensation,' or 'Immelt.' Suffice to say, I've written about these topics prior to Pozen.

Don't pay CEOs for failure. Give them about $250-300K per year in cash, and the rest subject to a 3-5 year return performance that beats the S&P500. Lag that incentive compensation to force the CEO to focus on sustained outperformance of the S&P.

As for boards, I wrote this piece which pre-dated and anticipated Pozen's recommendations. I wrote,

"Here's another insight. If, as I wrote last summer as a solution to America's corporate governance problems, board members were required to "run" for the post, and invest significant assets of their own in the company, thus clearly aligning their financial interests with those of shareholders, it might improve corporate board oversight and involvement in the operation of companies.

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."

Pozen's ideas,

"Directors of private equity companies hold substantial equity in them, and share in the performance fees of the private equity funds -- typically, 20%-30% of the returns realized by these funds.

Such small boards may be particularly effective in smaller public companies, which have trouble recruiting outside directors,"

are precisely for what I have been arguing in this blog for years. They are not new.

Nor are they likely to happen. It's one thing to observe better practices. It's another to expect a set of wealthy, and growing wealthier, mediocre CEOs who sit on each other's boards to really care about their shareholders.

That's why, per this post, I forsook consulting with my research findings many, many years ago. Rather than try to change the culture of large-cap American businesses, it's easier just to invest in the ones that do what Pozen suggests, and leave the rest to muddle along on their own.

Sunday, November 25, 2007

A Holiday Shopping Story

Lest you think the US economy is headed for recession, consider this holiday story.

A friend of mine, and her daughter, drove 120 miles, on a 2 1/2 hour round trip, to not shop at an outlet mall in NY state.

Spending over $20 for gasoline, they arrived at the mall just after sunrise, and sat in traffic for half an hour. The approach to the toll booths for exiting the highway were jammed. As was the service road to the nearby mall. And the mall parking lot itself.

Realizing that shopping would be a nightmare among so many others, they turned around and retraced their route back to shop at a mall only minutes from their home.

Neither the price of gasoline, nor time, dissuaded them from their pursuit of huge discounts.

No, only the roads choked with thousands of other like-minded shoppers could do that.

Doesn't sound like a recession economy or holiday season to me.

Happy Thanksgiving weekend!