Saturday, December 15, 2007

Citigroup, Pandit & The $49B SIV Assets

Yesterday's big financial sector news was that Citigroup, newly headed by CEO Vikram Pandit, to reverse course and take $47B of SIV assets onto its balance sheet.

Shortly after Thanksgiving, last month, I wrote this post about these SIV assets. In contrast to my earlier belief that a bank couldn't legally, without exposure to shareholder lawsuits, assume the liabilities and, thus, the assets of its SIVs, I determined, on the basis of the then-new information, that Citigroup effectively owned its SIVs.

Yesterday's move confirms my contention. Due to the bank's agreement, in the SIV formation, to be the buyer of last recourse if the SIVs' notes were unsalable in the market, Citigroup has, indeed, become the owner of much of the debt obligations of its SIVs and, thus, its assets, as well.

This led to more downgrades of Citigroup, both in its debt, and as an equity investment. As the nearby Yahoo-sourced one-year chart of Citigroup's and the S&P500 Index's stock prices reveals, the large bank has really been punished by the equity markets beginning in mid-year.

Several things come to mind as I have read the recent Friday and weekend editions of the Wall Street Journals, both containing prominent pieces related to Citigroup and Pandit.

First, given how badly Citigroup's stock price has collapsed since June, one should expect that sometime in the next two years, Pandit will receive credit for when the inevitable snap-back from this huge drop occurs. It could have been anybody, really. At some point, when bad news stops hitting the bank, some institutional investors will probably buy in at the bottom, and send the stock soaring from its depressed values.

So, no matter who would lead Citi right now, it's almost certain that sometime in the next 18-24 months, some Wall Street Journal article will crow about how great the CEO is at having 'turned Citi around,' despite the fact that it will have only been a reactionary pop in the stock price due to the cessation of bad news.

The matter of the $49B in SIV assets coming onto the Citigroup balance sheet probably will be seen as confirming the precedent set by HSBC recently. For all practical purposes, I suspect the charade of these being arms-lengths creations is over for good. Which may result in some added downgrades for affected commercial and investment banks.

Friday's article concerning Pandit's options at Citigroup went into considerable detail about various breakup options, and their drawbacks. Primarily, the alleged constraints involve regulatory opinions, capital adequacy, and taxes on gains of sales of units.

I'm of two minds about these sort of analyses.

From my own experiences at Chase Manhattan Bank, I know that these can become serious impediments to the sort of strategic maneuvering in which a bank CEO may engage. Allocating losses in retained earnings such that some units would have to take those hits upon dissolution of parts of Citigroup is no theoretical issue. Neither are taxes on gains of units having some original purchase value.

On the latter point, by the way, a spinoff to shareholders would, I believe, be tax-free. Then, the putative CEO of the spun-off unit could simply agree to merge with another entity.

However, to the larger point, I would say that this really puts Citigroup shareholders, both present and prospective, in a major bind. It effectively forces them to choose between a slimmed-down, manageable bank with regulatory challenges on the road there, or the dismal prospect of being constrained to continue operating a discordant collection of businesses in a mediocre manner which, in total, stand almost no chance of ever consistently offering shareholders better returns than those of the S&P500 Index.

To tell shareholders that muddling through with the current stew of businesses is the least bad of various unpleasant options is to invite a gradual bleeding of market value from Citigroup, until it simply becomes too irresistible for someone to acquire, then split up.

Pandit had better hope he's not constrained from any business disposals at Citi, or he's in for a very sobering and unhappy tenure at the helm. I will forecast that the bank, in its current incarnation, won't reach the point, as Goldman has, of becoming a consistently superior total return performer, relative to the market. Without the freedom to simplify Citigroup's cumbersome and ineffective business mix, Pandit's virtually guaranteed to preside over more bitter years for shareholders.

Thursday, December 13, 2007

Great Marketing Is A Beautiful Thing

I love great marketing. Anywhere. Anytime.

Yesterday, I received a targeted dose of great marketing, and it paid off for the vendor.

Thursday was forecast to be a day of inclement weather in the Northeast US. Sleet began to fall before the morning rush hour. Light snow and ice were coming down by 11AM.

At 1:12PM, I received an email from a local restaurant chain named Charlie Brown's. My business partner and I occasionally have lunch there, and we both have affinity cards. As a result of that relationship, I am on their email list.

The email was a simple, but eye-catching graphic of large snowflakes on a light blue field. It said something like,

Bring this email in and receive 20% off your food order- eat in or takeout."

I immediately printed the email out. Later that day, when I picked my daughter up from school, I mentioned the email, and, since she loves that place, she agreed to drive over and have dinner there.

We arrived in a nearly-empty parking lot at 5:20PM. Upon being instantly greeted and seated, we produced the printed email. The host said that everyone who had come for dinner so far that night had a copy of that email!

Is that terrific, responsive marketing, or what? As I explained to my daughter, this email literally cost them nothing.

Think about it. Email is free. They targeted known customers who already agreed to have a special relationship with the restaurant. It's a smallish, local steakhouse chain with about 50 locations in the tri-state area, two of which are nearly equi-distant, a 10 minute drive in good weather, from where we live. Last night, with such bad weather, holiday parties, and seasonal shopping activities, the chain was looking at empty dining rooms and a fully-costed shift of wait staff, bartenders, cooks and busboys.

What to do?

Give loyal customers an immediate 20% off. Tailored to the local weather of that day!

Of course, we not only went there for dinner, but spent more than usual, because it was subsidized by their generous offer. Our waiter noted the immediate serving time, since there were only three other tables occupied upon our arrival. And, sure enough, we had finished an unhurried dinner in just under and hour.

As my daughter was having dessert, several families arrived. By the time we left, the dining room was probably half-full and noisy.

I love this story, and I love a management which can be so insightful, imaginative, and sensitive to immediate, overall marketplace conditions. On a frigid, icy, snowy night during the height of the pre-Christmas shopping and holiday party season, they managed to nearly fill their dining room. Instead of sustain an expensive night of empty restaurants.

If you need a reminder of what great management looks like in action, this is one.

Then, on the other end of the spectrum, we have a local appliance retailer.

As I was writing this post, I went to heat up some milk for another half-cup of cappuccino. My microwave oven died midway through the process.

The first thing I did was to check Bestbuy. They have the replacement GE microwave for about $200-250, depending upon the model. But their nearest location is further than I would ideally like to drive this morning. Costco only has one model, and they are located on the same busy state highway near Bestbuy.

So, I Googled a local appliance retailer at which I have bought entertainment electronics in the past. They have a one-page website with no useful product information. But their phone number was listed, so I called to leave a message requesting a price quote on what I wanted.

On a busy Friday, I figure it will be worth up to $25 to avoid traffic and time spent getting a 'better' price at Bestbuy.

Only this local retailer doesn't allow me to leave messages on their phone. And when I emailed them? The email came back undeliverable.

How lame is that? Both natural avenues of first contact for this guy's already-disadvantaged home appliance retail business are broken and useless.

I'll probably give the guy a call this morning, but I've already made plans to drive up to Bestbuy tonight with my SO to buy a microwave and look at flat panel TVs for her.

This local retailer is a family business. I can't imagine it seeing the next generation with marketing ineptitude like I experienced this morning. Can you?

The sublime...the ridiculous. And I've experienced both within 24 hours in the local business and marketing environment.

Have a great weekend!

Yelling Fire In A Crowded Theatre: The WSJ & CNBC Report On The Mortgage Situation

It seems that the major news media are piling in to convince the public that: the mortgage situation is a 'crisis' equivalent to the S&L problems of the 1980s, and; the US is virtually in a recession already, with the reality of said recession only a few months off.

Monday's Wall Street Journal featured a front page piece entitled "U.S. Mortgage Crisis Rivals Savings & Loan Meltdown."

The article begins with the passage,

" Over the past decade, Wall Street built a market for more than $2 trillion in securities sold globally and backed by loans to U.S. homeowners on two long-accepted beliefs and one newer one. The prevailing logic: The value of the American home would never fall nationwide, and people would almost always make their mortgage payments. The more recent twist: Packaging mortgage loans and turning them into securities would make the global economy more resilient if anything went wrong."

I don't know about you, but I never believed the first premise. Over time, over all regions, yes, if money supply and the economy continue to grow, real estate values should continue to rise.

But recessions occur. Money supply will, on occasion, tighten. No asset ever experiences a totally strictly monotonic rise or, for that matter, fall, in value.

In fact, the initial genius of the CMO, or collateralized mortgage obligation, as it was first used in the 1980s, was to solve the historic problem of regional weakness in the US housing markets. Rather than have entire regional banking franchises crater, as, say, Bank of New England and Shawmut did, in the New England area, during the 1980s real estate crisis, CMOs would allow regional diversification of Fannie- and Freddie-backed mortgages, with the added benefit of creating various tranches of the securities with respect to maturity, yield and risk.

The root of the current dilemma appears to be poor underwriting of risk by mortgage originators, often, it appears, abetted by fraudulent applications, encouraged by freelance mortgage brokers. However, the latter are no excuse for companies like Countrywide and their ilk for throwing caution to the wind and offering subprime mortgages without qualifying the borrowers against the higher, non-teaser rates, where a two-tier variable rate product was offered.

The securitization of these questionable loans is not, per se, the cause of the problem. But, yes, once the loans were made, their inclusion in securities with other asset classes caused an opaqueness that hasn't helped the financial system.

Still, nobody put a gun to any investor's head and forced her/him to buy a CDO containing subprime mortgage assets. Adult investors freely chose to buy them.

When many of these adults chose to buy, say, technology stocks in the late 1990s, and subsequently learned that they were overly optimistic about many of the so-called "dot com" companies in which they bought equity positions, nobody rushed to bail them out then.

It wasn't, even really a crisis, per se. The 9/11 terrorist attacks on the World Trade Center also affected markets during the aftermath of the technology stock bubble. Greenspan's Fed eased rates in order to facilitate economic conditions to restore employment, not merely to reflate equity asset values.

"An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century.

So far, the potential losses look manageable compared with the savings-and-loan crisis of the 1980s and the tech-stock crash of 2000-02. But the housing debacle could yet take years to work out, thanks to the sheer complexity of it. Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending -- a credit crunch that is already damping global growth and could tip the U.S. economy into recession."

There it is. The linkage with recession. And the solemn pronouncement that investors will be "jittery," and banks will "hold back on all kinds of lending."

But this isn't true. A colleague of my business partner's just secured a mortgage on a condo in Southern California! At something less than 6%, at that!

Doesn't sound like a 'hold back' on loans to me.

Next, the Journal piece attempts to size the current mortgage-originated situation. Using a chart labeled "How Big Is It," a comparison is made to the 1982 LDC debt crisis, the 1986 S&L crisis, the 1992-2003 Japanese bank crisis, and the 2000 tech bubble. According to the chart, the current mortgage problems are in the $150-400B range.

The relevant article text reads,

"House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% -- what it would take to restore their historic relationship to inflation, rents and incomes -- $6 trillion worth of housing wealth would be wiped out. Measured against the size of the U.S. economy, that is less than what was lost in the stock market between 2000 and 2002. Initial guesses at total losses on subprime and similar mortgages range from $150 billion to $400 billion.

The latter figure would equal about 3% of U.S. annual economic output. That is similar to the losses suffered by S&Ls and commercial banks between 1986 and 1995. But it is less than half the scale of Japanese bank losses in the wake of that country's burst stock and real-estate bubbles.

The current crisis, though, differs in crucial ways from the recent tech-stock bust and the S&L crisis.
For one, it centers on assets -- houses -- that, unlike stocks, most people have bought with borrowed money. On average, mortgage debt amounts to nearly half the value of houses. In recent years easy credit has allowed many to borrow up to the full value of their homes, making them more leveraged than any hedge fund."

While the text admits that the value of the current dilemma is far less than that of the Japanese bank crisis, the chart apparently chooses the highest allegedly forecast level of bad loans to claim that this current situation is the worst, at 3% of GDP.

I have yet to see a figure as high as $400B of losses estimated by anyone. The most I have seen is $250B.

Further, the article is not completely correct in comparing home loans to individuals with hedge fund asset values.

Homes are 'consumed,' and not, per se, primarily viewed as mark-to-market trading assets. Hedge funds, in contrast, are completely viewed as tradeable assets whose values must be marked-to-market.

Additionally, the subprime portion of bad mortgage loans is evidently about 2% of all mortgages, or some 15% of subprimes, which are, themselves, only 15% of outstanding home loans. There are other defaulting mortgages that are not subprimes. These are the ones, it seems, that feature the two-tier, step-up rate structures. Thus, the oft-mentioned rate resets aren't actually for subprimes. Those mortgages, I have read and heard, tend to be issued at a higher rate. The teaser-step-ups were not typically offered to subprime customers.

The Journal piece also states,

"At the end of 2006, the value of all homes in the U.S., excluding rentals, peaked at 153% of gross domestic product (or about $21 trillion) -- the highest level in at least six decades. By Sept. 30, that had edged down to 150% of GDP as home prices began to drop. With huge inventories of unsold homes soon to swell with foreclosed properties, that is likely to continue.
Falling home prices make consumers poorer and less ready to spend, and they make it harder to borrow against home values -- even if consumers are current on their payments."

But housing is a local market. To state a nationwide figure for home values relative to GDP is to imply a consistently rising national market. Nothing could be further from the truth. Everyone who knows much about the real estate woes currently affecting America would also know that there are several 'hot spots,' such as parts of Florida, Southern California, and Las Vegas, which have seen outsized property value increases. In fact, it's been claimed that all of California became overvalued, as Californians began trading houses with each other at ever-increasing prices.

Can you blame them, if national banks such as Wells Fargo, BofA, and Citi signed off on the rising values as collateral for their mortgage loans?

Then the Wall Street Journal piece turns to investors,

"Ken Guy, finance director of King County, Wash., says the county's investment pool bought short-term IOUs called commercial paper backed by several SIVs because they appeared to be low risk. "We relied heavily on the ratings agencies," he says. About 10% of his $4.8 billion fund was invested in such paper. When the mortgage-backed assets held by the SIVs suddenly started going bad, some of his investments were downgraded all the way to "default."
"How could this have happened so quickly?" Mr. Guy wondered with colleagues. "How could these be downgraded from top to bottom in a day or two?" Such questions have been raised repeatedly.

"We've seen an unprecedented decline in market liquidity, really beyond what we thought possible," says Noel Kirnon, executive vice president in charge of structured finance at Moody's Investors Service, one of the two large ratings firms.

"Ratings on SIVs are significantly impacted by the market trends...even when the underlying portfolio maintains its credit quality," says a spokesman with Standard & Poor's, the other large ratings firm.

The complexity of mortgage-backed securities is making banks more vulnerable to losses than expected. It turns out banks didn't manage to shed so much of the risk of lending by packaging mortgage loans into securities and selling them to investors. Instead, they kept a large portion of the risk in various forms, including pieces of the CDOs they helped bring to market."

Again, weren't all of these investors, and banks, professionals? Don't they get paid to make these assessments correctly? We're not talking about illiterate, marginally-employed consumers being hoodwinked into buying low-end homes with subprime loans.

Then the article discusses possible implications of bank loan losses,

"Because everyone from auto dealers to Main Street banks now depends on securities markets as a source of credit -- as opposed to banks -- such moves could make it more difficult for consumers and companies to get money.

Banks are also wary of lending to one another. They are trying to keep as much cash as possible as a cushion against potential losses, and they are worried that their counterparts could go belly up. As a result, they have been charging each other much higher interest rates. Those rates, in turn, affect monthly payments on millions of credit cards and mortgages in Europe and the U.S.

Asset prices stop falling when markets conclude that all the bad news has been factored in. At that point, so-called vulture investors pounce. But most are holding back because they think banks and SIVs could yet be forced to sell more of their holdings of subprime-backed securities into a market with few buyers."

This is all probably true. I have written about the counterparty risk several times in the past few months. It is this risk that is really 'seizing up' credit markets- not a lack of money. And banks have the ability to move questionably-valued loans and securities into their investment accounts, should they choose to. This obviates their continuing need to value these assets at market prices. Doing so would also send a signal to the market that these institutions will not be holding 'fire sales' on these assets, which, again, would tend to put a floor under valuations, and ease counterparty risk concerns.

Finally, the piece admits that perhaps this isn't all going to pitch the US into a recession- barely,

"In spite of the gloom, the economy may avoid recession. Housing comprises a much smaller share of the economy than business investment, which dragged the U.S. into recession in 2001. Also, the rest of the world is stronger than in 2001, boosting U.S. exports. For the entire U.S. economy to contract would probably require a broad decline in consumer spending, which hasn't happened since 1991.

And, while financial problems are serious, they aren't -- at least yet -- on a par with those of the 1980s, when many major banks would have been insolvent had they valued their Third World loans accurately. There is, indeed, a possibility that the opacity of today's mortgage securities means markets may be factoring in far larger losses than will actually occur. Though the Fed is still worried about inflation, it has plenty of room to cushion the economy with additional interest-rate cuts.

But after years of living off the debt-financed increases in the value of their homes, U.S. consumers are in uncharted territory. "A lot of people, including me, have been saying that the country has been spending more than it's been producing, and that will have to come to an end," says Mr. Volcker. "The question is: Does it come to an end with a bang or whimper?" "

It's worth noting, as I wrote here, that the Journal article is in conflict with one of its own more illustrious editorial contributors, David Malpas. Malpas wrote in an earlier WSJ editorial,

"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."

So, it's simply not true that all housing price increases got recycled into the economy as spending as if homes were and are "ATMs."

With regard to Volcker's concerns, even he can be wrong on occasion. As I commented here, Nobel Laureate Edward Prescott wrote in the Wall Street Journal in December of last year, in an editorial entitled "Five Macroeconomic Myths,"

"5. Government debt is a burden on our grandchildren.

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."

I then commented,

"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.

Rather than hand-wring about debt and retirement, Mr. Prescott implicitly assumes a preference for creating wealth, then assess whether the right debt levels are in place to most efficiently do that in the given context.

What I liked most about his piece is how, at a stroke, he removes most of the bases for those who assert we have a government debt problem, a savings problem, and a looming retirement-affordability problem."

So, although well-intentioned, Volcker's concerns are misplaced. The US economy constitutes the world's most vital, productive engine of growth, into which we should want to throw as many resources as we can, in order to build value for our aging population's future financial needs.

Finally, as if in silent complicity with the Journal, CNBC anchors have been pestering their guests and hosts for weeks to agree that the US now teeters on the brink of a recession.

It seems the less well-informed and educated about economics they are, e.g., Mark Haines, Steve Liesman and Maria Bartiromo, the more bug-eyed and insistent they are in their badgering everyone with whom they speak as to when we can expect the looming US recession to begin.

Despite all this hand-wringing and alarmist wolf-crying, the US economy is still growing with modest levels of inflation. Payrolls continue to grow, as do wages. Recent advances in information technology have moderated the sort of inventory-excess recession that used to plague our economy with dismaying regularity.

Investors make mistakes. Someone is always on the losing end of an asset exchange which, eventually, results in one of the asset rising further in value than the other. Sometimes, one falls. But unlike Dutch tulips, the assets at the root of the current US economic asset weakness are real, tangible, and have intrinsic value.

What we appear to have is a question of the timing of asset values, rather than declining employment, wages, or spending. That doesn't necessarily lead to recession, and, depending upon the concentration of asset value loss, maybe not even a crisis.

Charlie Gasparino on CNBC

Boy, do I wish Fox Business News was on Comcast cable. However, there are a few benefits to remaining a viewer of CNBC.

For instance, yesterday, the network featured an on-air shouting match between two of their guest commentators which was so vociferous that the anchor ended the segment early by cutting Charlie Gasparino's microphone.

I saw this live, finding it very funny, and would have let it go at that. Aside from emailing Alan Murray to relate Gasparino's behavior, since Murray had, back when he was still a frequent guest on CNBC, been the frequent victim of Gasparino's unbridled outbursts.

However, by late afternoon, I had at least half a dozen visits to this blog from searches for topics like,

"bill griffith goes off on charlie gasparino."

So, better late than never.

The topic was Vikram Pandit's recent choice as Citigroup's new CEO, about which I have written here and here. The guests were Dennis Kneale, Managing Editor of Forbes, Herb Greenberg of Marketwatch, a Dow Jones subsidiary, and Gasparino. This took place on the midday program hosted by Bill Griffith.

As they commented, initially in turn, on Pandit and Citigroup, Kneale and Greenberg were largely negative on Citi and Pandit, but not overly so. Gasparino ripped into the firm's cost structure and its architect, Sandy Weill.

For the record, I think Gasparino's points were on target.

When Greenberg opined that Citi wasn't that top-heavy with employees, Gasparino shot back that Citigroup had,

'three people most places where one would do,'

or words to that effect. Greenberg called Charlie on this rather senseless bit of hyperbole, and Gasparino shot back.

At this point, Kneale tried to chime in, while Greenberg was still attempting to rebut Gasparino. The television screen looked like a fight on the Brady Bunch, with three heads all squawking, but no intelligible words discernible amongst the three shouting heads.

After about fifteen seconds of this, the camera went back to a visibly angered Bill Griffith, and silence. Then Griffith said something like,

'We love him, but sometimes, you have to cut off Charlie Gasparino's mike.'

Griffith then very energetically twisted and crumpled the piece of paper in his hand, continuing to frown and visually express heated anger.

All in all, a pretty humorous episode as CNBC goes all out to defend against the incursions of Fox's new business channel.

Roger Ailes, if you're out there and ever read this.....

please get FBN on Comcast......quick!

Wednesday, December 12, 2007

Pandit's Interview: Footage From The Cutting Room Floor

This morning's Wall Street Journal's Money & Investing section featured coverage of Citigroup's elevation of Vikram Pandit to be its latest sacrificial lamb, a/k/a new CEO.
Last night, CNBC aired clips from an interview with Pandit. As I teasingly wrote here recently, to say that Pandit seems an unlikely candidate for the job is, itself, a gross understatement.

As luck would have it, I found this alleged transcript of elided portions of that interview in my email inbox this morning. Though totally uncredited and unconfirmed, if true, it makes for thought-provoking reading, never the less.....

Erin Burnett: So, Mr. Pandit, were you surprised that the Citi board chose you as the new CEO?

Pandit: You bet! Who could believe that I could go from struggling hedge fund manager/owner to CEO of one of the nation's three largest banks in only six months?

EB: With so many problems at Citi, why did you agree to take the job? You wouldn't seem to have the necessary background for it.

Pandit: Well, first, of course, there's the money. And Citi's culture and history of overpaying CEOs for miserable performance. I mean, being kicked out of Morgan Stanley was the best break I ever got!

EB: Interesting perspective on that 'career move.'

Pandit: Yes. Like many financial sector executives who lose out in power struggles, I naturally formed a hedge fund. Not that I had any experience mind you, but, really, does that even matter any more?

EB: Good point.

Pandit: And, thank God, even though I ran my hedge fund for less than a year, Bob Rubin was kind enough to convince the rest of Citi's board that they should not just hire me, but overpay for my underperforming, completely untested hedge fund, in order to get me into their alternative investments group.

You know, commercial banking is so different than investment banking. The senior managers tend to be much less, shall we say, 'quick?' At Morgan Stanley, we would never buy a hedge fund that hadn't demonstrated at least a 5 year track record of unblemished success. Heck, we wouldn't even allow them to charge us management fees for the first couple of years we allowed them to manage any money we allocated to them.

At Citi, they not only didn't care about my lack of a track record, they couldn't wait to buy the whole thing!

I thought I'd died and gone to heaven! Screw Zoe Cruz and Mack the Knife.....I just made a few hundred million!!!!!!!

EB: Yes, that was a pretty amazing turn of events for you.

Pandit: And by asking me to head up alternative investments, I was able to shed any direct responsibility for Old Lane as soon as I had my picture laminated onto that Citi ID badge. Whew!

Talk about a tough business! In hedge funds, you have to perform. Back at Morgan Stanley, I always had lieutenants, or the market, or competition to blame if any of the areas under me messed up. But with a hedge fund, you're only as good as your last returns. And Old Lane's have really disappointed pretty much everybody.

Did I catch a break, or what?

EB: I guess you did at that.

Pandit: "I'm just lucky to have this opportunity...." (and this is a direct quote from his interview)

EB: So, now that you are Citigroup's CEO, what are your plans? Mergers? Spinoffs? Cost-cutting? Growth?

Pandit: Well, give me some time. About 5 years. That's what Chuck Prince got, and I think I deserve at least as much time as he had to underperform.

You know, that's one of the things that attracted me to Citi in the first place. Besides (over)paying John Havens and me $600MM for our virtually untried hedge fund, they immediately gave me a bigger job! And even more money! You gotta love this place!

Back at Morgan Stanley, you tended to have to perform first. Commercial banking is much, much different.

And the board. God, I love this board! Chuck got, what, four years to not perform? To say I'm excited to have the opportunity to this board is an understatement.

But, to your question, Erin, what will I do? Well, I guess I'll try to turn the place around, although I have absolutely no experience in doing so. I'm sure there are plenty of better-qualified turnaround execs, some of them at places like Blackstone, who could really have Citi either up and running on all eight cylinders, or broken up for more consistently superior shareholder value.

When you think about it, while I obviously have a deep risk management background, I can hardly go around troubleshooting each and every Citigroup business personally. And, besides, my risk management experience tends to be with heavily traded asset classes, not the minutiae of consumer finance underwriting and portfolio lending. Frankly, I'm nowhere in that world. Plus, Citi has a wealth of 'financial plumbing' businesses, like trust, custody, and money transfer businesses that I've never even seen before.

God knows how I'll sort through this mess! Probably, like most unprepared and underqualified new CEOs, I'll call in McKinsey or Bain to do my thinking for me!

EB: I see. Well, that certainly seems like a safe thing to do.

Pandit: You betcha! This board is largely responsible for sitting on their hands while Sandy Weill glued this Godawful mess of businesses together in the first place, and, then while Prince mismanaged the result after Sandy had to take early retirement. So, telling them that I have a marquee consulting firm working the problem will no doubt go over well. If they sat still for Weill's and Prince's failings, what do I have to worry about? I've probably got a good 12 months until I have to present any sort of action plan. Then probably another 12 months to begin implementation.

Add in the SIVs crisis, and I can maybe buy another 6 months. That's already more than half of Prince's reign, and I won't have actually had to perform yet.

Like I said, I feel very fortunate to have lucked into this position. It may well be the last easy CEO billet in the financial services sector. And I got it!

Of course, I am joking about finding this 'interview' segment in my email inbox. It's clearly meant to be a humorous analysis of the Citigroup board's latest wacky decision, via a fictious portion of the CNBC interview with Pandit.

In truth, I feel sorry for the employees of Citi. I've been there. During my days at Chase, when Butcher and Labrecque "led" the bank, and I use the term very loosely, most employees felt embarrassed that we had such poor, unqualified executives at the helm.

I'm quite sure Citigroup workers feel the same.

In fact, a few weeks ago, I was discussing the Prince departure, and handicapping of Pandit as the next CEO, with a friend in the locker room of my fitness club. As it happened, a nearby member was a manager in the alternative investments group. He bemoaned the morale issues he now faced, as he tried to explain to his own staff why the inexperienced Pandit had been paid hundreds of millions to become their new boss. And why Prince exited with a nice payout, while he was being forced to cut his expenses and staff.

It's going to be a really tough few years for Citigroup. I can't say whether Pandit will succeed in pulling Citigroup out of its morass, and setting it on a road to consistently superior total return performance for its shareholders.

Judging from recent history, though, I'd say it's extremely unlikely. Consider this.

Citgroup's board put up with Weill's antics, and his fashioning an unworkable, unmanageable financial conglomerate, whose fundamental premise of cross-selling between business units never materialized. Then that same board sat still while Chuck Prince proceeded to mismanage the bank, after first resolving the outstanding regulatory violations Weill had left hanging. With a combined seven more years of inaction while Citigroup's performance stagnated, as the nearby, Yahoo-sourced price chart indicates.
Do you really think that a board, whose executive committee has been so ineptly headed by Bob Rubin, the second-highest compensated Citi executive, which sat still for this performance, has the ability to choose the best executive to lead Citigroup out of this long nightmare?
Neither do I. It's simply inconceivable and unbelievable that this crew could do the right thing, when they've done nothing for so long.
I remain only partially joking when I refer to this recent post as a more effective solution to Citigroup's woes. That post actually appeared on the Topix, and has been read dozens of times, according to my Sitemeter visitor data.
What Citigroup needs, in my opinion, is a turnaround guy. Someone who's focus is to do whatever is necessary to unlock whatever shareholder value remains, in about six to twelve months. Pandit's actual blather about aligning Citigroup's business performances with the alleged tremendous market opportunities miss the point.
Most of Citi's businesses are commodities. There are too many stuck together in one entity to ever possibly instill entrepreneurial drive and flair in the management of almost any of them. All they currently do is cross-subsidize their joint mediocrity.
At this point, probably the simplest, best approach a new, temporary CEO could take is to simply separate the various large business groups and spin them back to shareholders, a la the ATT dismantling of some years ago. In one or two cases, such as the remnants of Smith Barney, or the consumer or institutional commercial bank units, they might be profitably sold to a competitor first.
In the final analysis, my own prognosis is that I won't be seeing Citigroup among my equity strategy's selections anytime soon. And this morning, Morgan Stanley, as if to take a well-aimed slap at its departed colleague, Vikram Pandit, recommends Citigroup as the best short for 2008, declaring,
"But looking to 2008, we see 3 reasons to be short: earnings are deteriorating, they expect new management to deliver a dividend cut, not a breakup, and they expect further hybrid issuance, diluting current shareholders."
Perhaps my final comment should be directed to the hapless Citigroup board. Do all of you have sufficient director's liability coverage?

Tuesday, December 11, 2007

Why We Have The Federal Reserve Board

With only a few hours before the Fed's rate action and statement become public this afternoon, I thought I'd write a few related, topical thoughts.

First, to lead with some humor, I heard one of the most incredulous, ridiculous explanations for a rate cut from CNBC's on air un-economic reporter, Steve Liesman.

Rick Santelli correctly noted that we currently have a counterparty risk problem in financial markets, not a basic economic production problem, and that cutting rates would do little to keep a homeowner with negative equity paying his mortgage.

Liesman agreed, then further explained that what Santelli did not understand is that the marginal home buyer would buy those underwater homes with lower rates. That this effect would be enormous.

Santelli was gracious and didn't break up into a roaring laugh on camera. Liesman remained with his usual idiot's grin on his face before the camera moved elsewhere.

But, onto more substantive aspects of the current debate about Fed action.

We have a Federal Reserve Board precisely to keep monetary policy out of the hands of biased, self-serving politicians and businessmen. Both groups are known, historically, to manipulate monetary conditions, i.e., rates and money supply, to further their own short-term agendas.

At present, there seem to be three competing conditions for which the Fed must balance the effects of its actions.

The broad US economy is currently continuing its productive growth. Across the country, outside of a few former housing hot-spots and the financial center of New York City, the US remains in possession of a healthy economy. Businesses are growing, employment is growing, loans are being made.

This economy, if over-stimulated with too-easy money, will eventually overheat, and lead to inflation. Many forget the pain of the inflationary years of the 1970s and early 1980s. For all the accolades which Alan Greenspan has been given, he never had to exercise the 'tough love' of monetary restraint that Paul Volcker practiced.

We look to the Fed to remember these lessons, and do the right thing for the long term health and growth of the broad economy. Right now, that does not seem to involve further easing of interest rates.

Some will argue that we are poised for recession, because of the effects of the contraction of housing prices, the damage to the homebuilding industry, and the financial losses of investors on subprime mortgage-related instruments.

However, as I have pondered what is so essential about the current economic situation that would require Fed easing, I find myself noting that the Fed is most effective in its influence on flows, not stocks.

That is, on using money and its price to help soften or shorten periods of unemployment and decreasing demand throughout the economy. These are flow variables- incomes, spending, and business investment.

What we have now is the loss of capital in some very specific asset classes. Not income or job losses, per se, on a broad scale.

Thus, the second competing interest for the Fed's actions is the financial sector. Many are calling for another immediate 50 basis point rate cut today. They claim that this will help stabilize asset values in troubled sectors like CDOs and other mortgage-related instruments.

But, here, the problem is inter-bank counterparty risk perception. As Brian Wesbury wrote recently, on which I commented here, flooding markets with more money won't solve this problem.

Many pundits, some of whom have been appearing on CNBC this week, debate whether we've seen 'the last' of the mortgage-related asset writedowns at large banks.

We surely have not. Why? Because, if nobody can make a market in these assets, and they do not trade in orderly, continuous markets, then you can be sure that banks are hesitant to take an aggressive write off of the value of these assets, until forced to do so.

In the meantime, analysts are busily measuring average writedown percentages, and opining on who probably still has more to lose before they hit bottom on valuations.

Again, this proves my, and Wesbury's point. We are not experiencing a shortage of money. We are experiencing a shortage of honesty and candor about the true value of collateral at many financial service firms- commercial banks, mutual funds, hedge funds and investment banks.

A Fed rate cut will, at best, simply pump up some asset values, by dint of lower rates with which to calculate discounted present values. But this is book entry stuff.

Real values will be found by selling some of the assets.

I remain sceptical that the financial services sector is so stricken that Bernanke's Fed must sacrifice healthy, moderate-inflation growth of the broad economy in order to rescue it.

In effect, people like Liesman, Larry Kudlow, et. al., want Bernanke & Co. to bail out private sector equity owners of financial firms, at the expense of inflationary pain on the broader US citizenry over the next few years.

And what about the value of the dollar? The same on-airhead anchors at CNBC who, today, cluck and shake their collective heads about the state of large US banks and the mortgage situation were decrying the fall of the value of the dollar only last month!

Which do they want?

Because a 50 bp Fed rate cut today will tank the dollar's value even further.

What happened to cries to defend the dollar? Simply put, you can't have it both ways in this context.

So it's very crucial for the Fed to sanguinely assess the source of the greatest risk to our economy's continued low-inflation, productive growth. Will that be best served by bailing out bad financial market decisions on Wall Street and at large money center banks, while inducing more inflation through easier money and a cheaper dollar?

Honestly, I doubt it.

CNBC had former Fed Governor Lawrence Meyer on the air this morning. After billing him as the closest source available to the current Fed, Liesman and Kernen both tried to backpedal when Meyer didn't tell them what they wanted to hear.
He directly rebuked Liesman for contending that 'the communications mechanism of the Fed with the markets is broken,' retorting that, if anything, the mechanism has become too efficient and fast.
Kernen wanted to hear Meyer say the Fed would cut the interest rate by 50 bps today, but Meyer was confident it will be only 25bp. He cautioned that the real message would be the wording of the accompanying statement, which would give clues to the overall stance of the Fed in coming months with respect to inflation vs. sustained economic health.
When Meyer stuck to his informed, experienced views, Liesman tried to cast doubt on Meyer's comments.

Finally, we have various observers, including the usually clueless Liesman of CNBC, professing confusion over the Fed's actions and words of the past five months.

To this, I would simply remind all that Bernanke stated, upon assuming the mantle of Fed Chairman, that he would be data-driven. And data change. So the Fed has been weighing developments and fresh data as they move between deliberations and actions, month by month.

That the pace and directions of their various pronouncements would echo those of the data they see and interpret is hardly surprising.

At least to those of us who actually listen to the Fed, and use common sense.

Monday, December 10, 2007

The Writer's Strike: Severing The Gordian Knot

This morning's Wall Street Journal featured an article concerning the current strike by the screenwriter's union.

As three of the Journal's reporters explained,

"As the entertainment industry enters the digital age, the writers and the studios are battling over a key question: how writers should be compensated when studios distribute their work in digital forms, such as streaming and downloads. Digital media are expected to provide an increasing share of Hollywood's revenue in coming years.

Last week's talks, however, bogged down over side issues that included the union's attempts to organize reality-TV and animation writers and its effort to remove a clause from its current contract preventing it from joining strikes by other Hollywood unions.

Barring the emergence of a new mediator who can ride to the rescue, Hollywood is starting to come to terms with the idea that the walkout could drag on well into 2008. The TV networks are feeling the most heat; without writers, they have been forced to shut down many of their productions in the past month. Now, they have just a handful of their most successful shows left in the can.

Lev L. Spiro, who directs episodes and pilots of TV series such as Showtime's "Weeds" and ABC's "Ugly Betty," sent a letter to the leadership of the directors' union last week arguing that starting talks would be a public-relations disaster for the directors and would prolong the writers' strike. The letter circulated among writers and directors.

"We are all, to state the obvious, sister guilds of artists and craftsmen, engaged in collective bargaining with corporate behemoths whose primary raison d'etre is to make profit," Mr. Spiro wrote. "I suggest to you that it would be shortsighted to act exclusively in our own self-interest at this time." "

Reading this last passage brought me up short. Mr. Spiro depicts 'corporate behemoths' as the enemy with which writers, directors, et. al., must fight for shares of profits from the new distribution channels spawned by digitalization of media.

Yet, now, more than ever, the reason for these unions may be withering away.

A few weeks ago, I watched my first episode of a popular television series, NBC's "30 Rock," on my laptop. Having missed the scheduled network run of the episode, I viewed it from the NBC site, for free. There were some commercials, as on network television, but I honestly could not tell you who the sponsor was.

But, why did I need to go to NBC's website?

In this day, with production and distribution costs so low, why aren't good writers simply parsing out equity in their script projects to directors and craftspeople, renting equipment, and distributing directly through their own websites? Using Paypal and advertising to collect revenues?

I wrote a simpler piece on this topic last March. Prior to that, I believe I wrote another, with more detail, in the same vein as this post.

Rather than see themselves as 'artists and craftsmen' arrayed against 'The Corporate Media Man,' why don't screenwriters see themselves as private creators of value who can hire whom they please to bring their creations to digital fruition?

The simple tool of a contract among the various artisans, craftsmen, et. al., provide each screenwriter with the power and freedom to demand terms commensurate with his/her prospects, in the eyes of his/her peers and colleagues.

Surely a cameraman or director will judge, Larry David's projects as having a higher expected value, and lower risk, than, someone new, without an established reputation.

If anything, this recent strike might actually, finally, separate the 'real' screenwriters, the ones whose work sees production, from the hundreds of union members who never actually see their work produced.

Screenwriting is probably now at the cusp of being the high-value-added driver of video content it could not be when large studios controlled the expensive, few elements of production and distribution.

Rather than wrangle endlessly over one-time terms for future profit sharing with producers and distributors of their work, why don't the better screenwriters simply begin assembling funding and teams of colleagues to produce their own work?

Right now?

Technology has a way of radically altering prior work relationships. Railroad brakemen disappeared with the arrival of George Westinghouse's air brakes. Physical gas and electric meter-readers are nearly extinct. As are many gasoline pump-jockeys.

Should this most radical of innovations in video content, the development of equipment, editing software, and distribution for digital video content, not alter the balance of power in the entertainment industry?

Rather than settle for haggling over terms with some large corporations, why don't the screenwriters stage their own Exodus from the Egypt of the entertainment 'behemoths,' and simply strike out on their own as businessmen and businesswomen, owning and controlling the production and distribution of their own scripts?

Perhaps this is one strike that won't end, but also won't end the provision of high-quality video entertainment. It may just end the virtual monopoly of such entertainment by the three networks and the movie studios.

Sunday, December 09, 2007

FedWatch For 11 December: Brian Wesbury's Views

As my partner and I discussed the potential effects of Tuesday's Fed rate decision on our impending options portfolio purchase, we turned to a discussion of Brian Wesbury's excellent editorial in Friday's Wall Street Journal, entitled, "Let's Not Panic and Ruin the World."

Demonstrating, once again, why he ranks at the top of my personally favored and trusted economists, Wesbury notes evidence of the US economy's continuing strength, and the lack of need for another Fed rate cut.

Among those signs are: real GDP growth, consumer price rises of 3.5% in the past year, positive recent consumer spending data, and the beginning of the credit market's self-healing, with purchases of or into distressed situations, such as Citigroup and E*Trade, by Abu Dhabi, Citadel, and CIFG's parent.

The primary ailment of the US financial markets at present is counterparty risk. That is, parties are worried about the soundness, or solvency, of counterparties which may hold assets, the value of which is overstated. These would include any assets involving subprime mortgages, e.g., CDOs.

It is not apparent that banks and other institutions are short of lendable funds. If that were true, rates would be higher. Rather, despite lower rates, certain problem areas are not receiving new loans. Such as the riskiest sorts of mortgages.

And, with Federal activity in the sector, and calls by various Presidential candidates for even more punitive actions, the long term market for investors who would buy mortgage-backed CDOs has to be evaporating.

As Wesbury points out, trying to "save the world" now will only put it at greater risk. What is really a problem for only a small part of on economic sector, subprime mortgage lending, is causing actions, including Fed over-easing, that may well damage the overall economy in the longer term.

Nobody wants to see the US fall victim to the type of liquidity trap which ailed Japan for almost a decade.

Hopefully, the Fed will hold the line on rates Tuesday, and surprise the market. By withholding the latest dose of economic narcotic from the markets, equity prices may temporarily decline. And fixed income rates will likely rise, decreasing prices of those assets, too, for a while. But to ease with another rate cut is to risk the beginning of yet another asset price bubble of the sort that the US markets saw peak in 1999 and 2007.

US employment, as we know from last week's jobs numbers, continues to grow. Personal earnings continue to grow, as does personal spending. The fundamental drivers of the economy, jobs and incomes, are solid and growing.

The US does not have an economy poised for recession. Rather, it has an overabundance of mediocre economists mistaking a single-sector credit problem for economy-wide weakness.

Fortunately, Mr. Wesbury continues to point us in the direction of sound data, correct interpretation, and preferred actions.

Or, as we hope this week, Fed inactions.