Friday, May 30, 2008

Bear Stearns' Management's Naivete

Earlier this week, I read the second part of the Wall Street Journal's retrospective series concerning the demise of Bear Stearns. The piece ended with the following passage,

"At about 6:45 a.m., Bear Stearns officials received an email from Stephen Cutler, J.P. Morgan's general counsel. It was the draft of a news release announcing that the bank had agreed to provide Bear Stearns with financing "as necessary" for up to 28 days.

The money underwriting the rescue was coming from the Fed, which was also bearing the risk of the loan. It was the first time since the Great Depression that the Fed had made a loan like this to an entity other than a bank. It would provide the bailout through J.P. Morgan, because as a commercial bank the firm already had access to the Fed's discount window and was under the central bank's supervision.

Inside the sixth-floor conference room where Messrs. Molinaro, Upton and others had huddled, executives cheered and exchanged high-fives. They thought they had four weeks to sort out their problems."

When I read that last paragraph, I just shook my head. Those guys must be idiots.

The bulk of the article described the steady drain of customer assets and counterparty business fleeing Bear Stearns that week. Anyone with as much experience in financial services as Cayne and Schwartz should have remembered how quickly Continental Illinois Bank went from healthy to shuttered.

Once customers and counterparties smell weakness in a leveraged financial institution, it's over. Nobody will risk their cash with a counterparty or custodian who might, on any day, suddenly become insolvent. It's more than just 'staying away until the dust settles,' as one institutional customer told their Bear contact.

With sufficient numbers of other trading houses in the sector, who needs to do business with a cripple what might collapse in the next day's market decline?

What were those guys thinking? Did they really believe that the 11th-hour loan, brokered by the Fed and run through Chase, would actually save them? They didn't have a month to 'sort out their problems.'

They never had more than that weekend, because as soon as Monday morning's market open, every remaining customer would flee the obviously-weakened firm, and counterparties would step back, too.

You don't have to be a rocket scientist to understand that the Thursday night loan simply got Bear through one last day before a weekend deal to arrange the transfer of positions to whomever became the new owner of what remained of Bear Stearns.

I haven't read part three of the series yet, but the end of part two just left me incredulous that the guys at the top of Bear Stearns could have been so naive and clueless. Truly, they did not deserve to continue their corporate existence.

GE, Immelt, O'Reilly & Olbermann...And Corporate Governance Again

It seems that every time Bill O'Reilly mentions GE, Jeff Immelt and Iran on his Fox News program, my blog visits skyrocket. When people Google any two, or all three, of the words 'Iran GE/Immelt O'Reilly,' one of the top results is one of my blog posts regarding my appearance on O'Reilly's program last month discussing the business aspects of GE's dismal performance under CEO Immelt.

This morning, however, I received a visit from a reader who found my blog from this referring post. I don't really follow the O'Reilly-Olbermann feud, although I have friends who keep me abreast of it from time to time.

What I find interesting about the post and its author is its apparently objective viewpoint that, based on the facts, O'Reilly is probably right on this one. And, thus, with his link to my blog, which is unabashedly critical of Immelt's inept management of GE, he also sustains my own views on the matter.

I have yet to find anyone who can counter the points I have made in my many GE- and Immelt-related posts (conveniently located by searching under those labels on the right-hand side of this page). Whatever Olbermann's faults may be, there's no denying his boss-of-bosses, Immelt, has pretty much flatlined GE after its many years of at least market-paced performance under his predecessor, Jack Welch.

Cable Gamer ends his GE-related post,

I should stop there, but I do have just one more thing on my mind: GE shareholders should be mindful that none of this controversy is doing them any good. This blogger, The Reasoned Skeptic, makes the point that GE has been hurt financially by all this ruckus. And when I see that GE stock is at 32, I think that surely somebody is going to come and rescue shareholders from this worst of both of both worlds--an amoral relationship with an American enemy, as well as poor economic performance.

In keeping with my recent rant about what shareholder democracy really means- and there will be an upcoming post exploring this in more depth- let me reprint a key passage. I wrote,

"But the investment angle of the story, as represented by Mr. O'Reilly's institutional manager/guest last night, now focuses on the wrong point.

The wonderful thing about our American economic system and environment is that you don't have to own GE! Or any other underperforming asset!

There are thousands of investing options available to both institutional and retail investors alike.

Rather than wait, like those poor souls anticipating Godot's arrival, for the seemingly-always-coming 'corporate governance' solution, investors are better off to just sell what they don't like and buy something else."

Someone come to GE's shareholders' rescue? How about they just do the sensible thing and sell the damn stock???!!!!

I spoke with my partner about this a few nights ago. Why, he asked, do people hold onto equities of companies that are such long-term poor performers.

He believes it is due to a basic element of human nature- a tendency to be in denial about the bad outcome of prior (investment) decisions. Rather than admit a mistake and sell the equity, keep it and hope someone will 'fix' it.

I don't think I can express it any better than I did in that post, so I'll just reprint the conclusion-

"There are so many opportunities for investment in the American economy that there's simply no reason to hold onto a problematic equity and either hope, yet again, that this year will bring change for the better, or, worse, lobby for 'management change' or 'board action.'

It probably makes more sense to trust the senior management and board of the firm in which you invest to do a great job with the assets under their control than to invest in a company which you think could, or wish would, do better than it has with the company's assets, and then try to change the management and/or board's behavior."

Technology's Disruptive Effects

Technology- multiplier of manpower, driving force of innovation, cutter of prices, improver of living standards

Technology- destroyer of jobs, wrecker of industries, change run amok, reducer of investment values

Technology is an awesome and typically unpredictable force in our society.

Yesterday, my partner was remarking on a factoid he read last week concerning financial services employment among large US companies. At least, I think that was the universe.

Anyway, the fact was that, before the recent purges of financial services employees, following last year's credit debacle and subsequent writedowns, financial services employment had just about reached the same level it had prior to the sector's last major cuts, following the attacks on the World Trade Center on 9/11.

He and I were frankly puzzled that the labor force in the sector had swollen by so much again. He asked whether the industry should not have become more productive, and, thus, had fewer employees at its recent peak?

That seems correct to me. We discussed productivity, and he asked how I would define that measure. I cited the method I've always used, which is value-added divided by the number of employees. Value-added, the meaning of which my partner inquired, is, classically defined, the net of revenues and purchased goods and services.

Our conversation brought me back to a similar one in the library of the then-headquarters of my former consulting employer, Oliver, Wyman & Co., in 1995. I was discussing issues of size of markets, growth, revenues and gross margins among financial services businesses with my then-colleagues John Stroughair and David Boone. We gradually came around to discussing the role of IT in the sector, beginning in the early 1960s.

This led me to conjecture that it was possible that the industry's gross margin dollars had remained relatively constant as the application of information and electronic technologies to financial services had expanded the number of customers while reducing prices. For example, credit cards, money market and mutual funds became more ubiquitous, and fees for these services fell, thus opening them up to a much larger and broader mix of customers.

Even if the gross margin dollars grew, they probably grew at a slower rate than that of revenues or customers.

My point is, the application of technology has a decidedly mixed effect, even upon industries which undertake it for its supposed benefits.

In financial services, the thinning of gross and, ultimately, net margins probably led to less cushion against risk, as ever larger customer bases were served against shrinking profitability levels.

Technology tends to lower or remove barriers to entry, which, of course, leads to lower profit margins.

Returning to my discussion this week with my business partner, I mentioned an industry with which he is familiar, and in which he has had some fairly influential contacts- recorded entertainment.

Does anyone doubt that electronic and digital technology has gradually, at first, then rapidly decimated the businesses of producing and marketing audio and video entertainment?

Prices and margins fell through the floor with each new technology- cassettes, CDs, DVDs, VCRs, MP3 & 4 players.

This is part and parcel of what Joseph Schumpeter observed and codified almost a century ago. Businesses which enjoy substantial growth, especially from technological sources, open themselves to a bargain with the devil. Technology allows for the dramatic growth in new products and services, but with the accompanying shrinking of margins and ease of competitive entry. Thus, once on a path emphasizing technology-based change and growth, businesses which pause tend to get overrun by market forces- either consumer- or competition-based.

Existing products and services, like those in entertainment and banking, become cheaper, and, thus, appear more costly to offer, in terms of gross margin. Thus, firms which fail to move forward by shifting their business mix to new, higher-margin products and services, suffer from lower profitability, even if they were initially pioneers in the technologically-based changes.

Technology is, indeed, a two-edged sword. Having initiated its use to spark growth, firms run the risk of longer-term obsolescence if they fail to appropriately continue to ride the back of this tiger. Once begun, a business' affair with technological advances can't safely be ended, or even brought to a point of just 'maintenance.' To do so is to invite an early death.

Thursday, May 29, 2008

Details...Details...What's In The Boilerplate Of Those Securities?

Yesterday's Wall Street Journal's Money & Investing section featured an article discussing the putting back of bad mortgages by institutional investors to sellers of the instruments.

The article cites Countrywide Financial as having reset its liability for such repurchased bad mortgages from $365Mm last year to $935MM now.

According to the Journal article,

"Additional pressure is coming from bond insurers such as Ambac Financial Group Inc. and MBIA Inc., which guaranteed investment-grade securities backed by pools of home-equity loans and lines of credit. In January...MBIA began working with forensic experts to scrutinize pools it insured that contained home-equity loans and credit lines to borrowers with good credit. "There are a significant number of loans that should not have been in these pools to begin with," says Mitch Sonkin, MBIA's head of insured portfolio management."

Further on, the article relates that WMC Mortgage, a unit of GE, made improper representations and warranties of subprime loans it pooled which PMI insured. Essentially, PMI is suing GE's unit for fraudulently describing the loans, for which PMI charged a fee to insure, because, in reality, the loans were much riskier than had been represented to PMI. PMI also wants WMC to repurchase the loans or pay damages to PMI, as the delinquency rate on the loans rose 30% within eight months.

What I find comforting, on some level, is that the legal agreements underpinning various mortgage loan and securitization instruments allow for buyers and insurers to recover for fraud and breach of contract, putting back the misrepresented instruments to the sellers.

Somewhere, in a handful of Wall Street investment banks, i.e., the few still solvent and publicly-owned, I can imagine rooms full of young financial wunderkinds being taught a lesson about the real meaning of those thick piles of documentation that accompany traded, securitized loans.

Buying a security that is what it says it is, and losing money, is one thing. Buying a fraudulently-described mortgage-backed security is quite a different matter. It's good to see that astute buyers are forcing the sellers to take back their fraudulently conveyed paper.

I wonder how much more in losses than currently expected this will bring to the larger mortgage-backed securitizers of the last few years.

Wednesday, May 28, 2008

Annheuser-Busch's No-Brainer Choice

This week's news in the beer industry has taken on quite the dramatic quality. European brewing giant InBev is planning a bid to buy the dominant US brewer, Annheuser-Busch.

For entertainment purposes, business media outlets, including the Wall Street Journal, are playing up the family angst angles, but it's really a no-brainer for shareholders. Vote for the acquisition, sell your AB shares, whatever.

I should probably provide a quasi-disclaimer. Although I own no AB stock, and never have, I do have some acquaintanceship with the company and family. My undergraduate alma mater is Saint Louis University in Saint Louis, Missouri. That university's student center is named the Busch Center. At the time I was completing my BS in marketing, one of the Busch children was also a student. The city reveres the first family of American brewing. The St. Louis Cardinal baseball team plays in.... Busch Stadium. At least it did. I believe the newly-built field is also named for the team's owners.

Suffice to say, I am well-acquainted with the family's identification with the company whose shares they sold to the public some time in the last century.

As CNBC co-anchor Michelle Caruso-Cabrera stated so clearly earlier this week, as I paraphrase,

'The family wanted capital and went to the public to sell shares. If they wanted full control over the company, they shouldn't have done that.'

She's right.

Further, look at the nearby five-year price chart of AB (ticker symbol BUD) and the S&P500 Index. The brewer has done its shareholders no favors. Clearly, having Busch as your last name doesn't seem to do much for achieving consistently superior returns for shareholders. Over five years, AB hasn't even made it back to a flatline performance, while the S&P has chalked up a +40% return.

The family situation of the Busch's also reads like that of the Ford family. Bloodlines thinned of talent over the generations. Divorces, underperforming sons, distant father-son relationships.

We read that the current CEO, August IV, was basically estranged from his father, by way of divorce. He, the son, went on to become a typical wealthy bad boy in his younger days.

The most chilling passage of the Journal article is its last, which reads, quotes the current CEO as saying, of his relationship with his father, August III,

"Succeeding atop Anheuser is paramount to the relationship, he says. "I honestly do believe if I failed in my professional life, it would be much harder to ever gain his respect," he says."

Meaning, I guess, that the AB shareholders are hostage to whatever it takes August IV to do to gain his father's respect.

Damn the shareholders- focus on dad!

The Journal piece does a fine job cataloguing the company's fending off Miller Brewing in the 1970s and '80s, then eschewing international expansion via mergers or acquisitions. Now, AB is the lone family brewer among large global players, and its performance is hurting.

This Yahoo-sourced price chart of the brewer and the S&P500 from the early 1980s tells an interesting story.

For nearly two decades, the brewer tracked the index, briefly declining to equal the latter's performance by 2001. At that point, the brewer's performance flattened slightly, but, relative to the bubble-bursted index's decline, posted a few years of outperformance. But by 2003, the index was rising again, while the brewer's performance dipped, then flattened.

Hardly laudatory performance by the Busch family on behalf of their public investors, is it?

It's pretty clearly time for a change. For any of the privileged Busch's to see the brewing company as a personal playground for settling family and personal issues is just wrong and unethical.

Looks like it's time for one less headquarters in Saint Louis, and a new division for InBev.

Tuesday, May 27, 2008

Ford's Bad News Could Be Long-Term Good News

Perhaps the biggest industrial news last week was Ford announced disappointing earnings news.

Ironically, though, this 'crisis' may be the ultimate turnaround opportunity for Detroit- or what's left of it.

The facts are these. On Thursday, Alan Mulally announced that, due to high gasoline prices, truck sales are off in a major way. Mulally used the term 'tipping point' to emphasize that gas prices have, for now, shifted consumer buying away from trucks for the foreseeable future.

The company is cutting truck and SUV production by as much as 40% in the second half of 2008, according to a Wall Street Journal lead article in Friday's edition of the business paper.

The consequence of this gasoline-price-driven change is that Mulally said it's now "extremely unlikely" that Ford will, as he had earlier predicted, return to profitability in 2009.

This is huge news, because Mulally is seen as a very capable manager. Unlike the incompetent crew across town at GM, Mulally has proven his managerial expertise at Boeing, and already made a positive difference at Ford. The unexpected, though small, profit this quarter, and the shedding of Jaguar, have demonstrated this.

The nearby Yahoo-sourced price chart for Ford and the S&P500 for the past year bears this out.

But a longer-term look at the same data, using a five-year chart, tells a different story. Seen from this perspective, it's evident what a tough job Mulally has if he ever hopes for Ford to deliver at least the S&P's returns to his shareholders. Right now, on a five-year basis, Ford is about 60 percentage points behind the index.

But with gasoline-driven cars finally seeing their demise due to global oil economics, it's quite possible that Ford, Toyota, Nissan, will have a golden opportunity to replace all the cars in America's vehicle fleet with hybrids of various sorts. Or even mono-fuel vehicles that don't use gasoline.

GM might not make it out of the desert of gasoline-powered cars into the promised land of hybrids. But Ford stands a decent chance.

With Kerkorian aboard as an investor, it's not hard to imagine him brokering an alliance, or even merger, between Nissan and Ford, much like he tried to arrange for GM a few years ago, before that company's CEO, Rick Wagoner, fought to prevent it.

To me, the auto industry may now be in a position akin to the recent years of television set manufacturers. Like the giant digital television replacement cycle currently underway, automakers may be able to view high gasoline prices as their salvation, not their demise.

Like it or not, I think most intelligent Americans now expect to seriously consider owning a non-gasoline-only car by the end of the next 5-7 years. I know I do.

While environmental concerns might be trumped-up, there's no missing the obvious implications of much higher oil and gasoline prices on American drivers and the cars they use.

I wrote about them in this post last December.

Just when the conventional design and production of automobiles was causing havoc for Detroit, the appearance of widespread demand for non-gasoline vehicles could change everything.

Battery makers and developers of efficient, usable hybrid drives will reap windfalls. And they should. As will clever designers of uniquely desirable vehicles incorporating various new non-gasoline power systems.

Maybe it'll be electric vehicles, or hybrids. But whatever it is, it could well mean a new lease on life for Mulally's Ford in the years ahead.