Friday, July 25, 2008

Why Do We Need Publicly-Listed Commercial & Investment Banks? Part One

With all the capital-raising activity of various publicly-listed, privately-owned commercial and investment banks- Chase, Citi, BofA, Wachovia, Lehman, Morgan Stanley, Merrill- it occurred to me this week to ask:

"Why do we need these banks?"

How much investor equity has been written down- destroyed- in the past twelve months by the managements of the financial service firms I listed above, plus Bear Stearns? It surely tops $200 billion. And to those firms, you can add UBS, a foreign bank with substantial US operations.

Fannie and Freddie are now in danger of having to be resuscitated because they imprudently risked their investors' capital, too.

But with all this capital vanishing down the drain in less than a year, has our economy seized up? It has not.

I can still use my credit card. If I chose to buy a home in my locale, with 20% down, I could.

I don't read about any going concern complaining that they cannot finance operations.

So, let's ask the question again, in a modified form,

"If the largest US commercial money center and investment banks- except Goldman Sachs- vanished tomorrow into a single entity, would it matter to the US economy and its consumers?"

I believe it would not.

In this first of a two-part post, I'll explain why I believe that contention. In part two, appearing within a few days, I'll describe what I believe a perfectly functional, better-managed, private capital solution would look like.

Banks essentially do six things:

-take deposits

-lend to consumers for housing

-provide installment lending- a/k/a credit cards- to consumers

-finance business operations and underwrite their capital issues

-manage assets

-operate and participate in the financial 'plumbing system' of the US.

So let's review the potential outcomes of removing publicly-listed, privately-owned, meaning not government owned, commercial and investment banks from each of these activities.

Deposits below something like $100,000 are FDIC-insured. So if tomorrow, every commercial bank were replaced by a US Treasury or FDIC branch on the same corner, dispensing your cash and taking new deposits, you wouldn't really know the difference.

Consumer lending has been more successfully done by non-banks for decades. MBNA, Capital One, First Card, to name three, were or are non-bank credit card startups. MBNA was spun out of the Maryland Bank, but it ran and grew as a standalone firm.

You don't need to be a bank to be a successful credit card firm. These companies ravaged commercial bank credit card customer bases for a decade, than let themselves be bought back, at premiums, by the same banks off of whom they made their fortunes.

Mortgage lending has actually never been a big commercial bank business. That's why S&Ls were around. Before Countrywide, there were other national mortgage lending companies, the most recent from the 1980s being Lomas & Nettleton. Again, banks would buy these standalone mortgage lenders at premiums. No need for a publicly-listed bank here, either.

What about lending to and underwriting of businesses? Private equity can do that. And does. Or dozens of smaller investment banks which are still private partnerships.

In fact, due to the loss of their AAA credit rating by most commercial banks two decades ago, they have used their balance sheets as staging areas to securitize commercial loans and capital offerings.

What about asset management? That's not even a commercial or investment bank business to begin with. It's probably one of the two (the other being retail brokerage) largest cottage industries in the financial services sector. Think: Fidelity, Vanguard, T Rowe Price. Commercial banks buy these units. Or compete half-heartedly with second-rate employees who aren't paid as much as their more skilled colleagues at hedge funds, private equity shops and the better fund management complexes.

What's left? Financial plumbing.

The one thing that a Federally-chartered US commercial bank can do that nobody else can do is access various secure financial transaction networks. Fedwire, Chips, etc. Somebody has to provide secure, identity-assured means for clearing and settling any transaction in the US that requires cash to be exchanged. From your debit card to settling large-scale asset sales of businesses, DDA accounts and electronic transfers have to be made. Foreign exchange transactions have to be settled.

But a 'bank' that does these things, like BONY-Mellon or State Street Bank, doesn't have to even be a big player in anything else. And their risk is nearly microscopic, next to the tens of billions of losses being taken by their lending brethren.

You could easily have just two or three financial plumbing-oriented competitors in the financial clearing-systems sector, and most Americans- consumers or business- would never know the difference.

So if, on Monday morning, only one or two 'banks' existed where once Citi, Chase, BofA, Wachovia, Wells Fargo, Lehman, Merrill Lynch and Morgan Stanley had once been, doing the same businesses with the same inept class of employees and senior management, would anyone really notice, from a functional perspective?

Credit would be available. Deposits would be available. Capital offerings would be underwritten. Assets would be managed.

We don't have a financial/bank crisis in the US. We have an oversupply of mediocre management running too many mediocre, publicly-listed financial service firms.

Now is the time to weed them out and let them die/consolidate.

As I will discuss in part two of this post, the Blackstones, TPGs, KKRs, Blackrocks, SACs, etc. of the financial sector are where the most competent, astute managers are. They have done a better job of risk management. Because, like financial partnerships of old, they own their risk.

Our modern, heavily-overseen and -regulated, publicly-listed financial services sector is a testament to the fact that all the regulatory oversight in the world can't take the place of good risk and business management in financial services.

In fact, it can be argued, and I do argue and contend, that regulatory oversight has taken the place of good management. The result is a crowd of less-talented people mismanaging publicly-listed, privately-owned financial services companies.

Don't prop them up. Don't rescue them- including Fannie and Freddie. Let them consolidate/fail, and make room for the more astute practitioners in the privately-owned, unlisted world of finance.

Thursday, July 24, 2008

Jeff Immelt's Deal In PalookaVille

Much has been made this week of GE's arrangement with Abu Dhabi's ruling Al Nahyan family.

Ostensibly, GE's financial unit will, according to '' in the Wall Street Journal,

"invest surplus cash generated by its enormous oil resources. Over three years, each side will invest $4 billion. That total of $8 billion will be leveraged up to five times with debt, and the pot of as much as $40 billion will be invested in the Middle East and beyond."

Honestly, I don't see all that much that is special here. So GE found someone to co-invest with in the Mideast. May I remind people that GE hasn't managed to move the total return needle under Immelt in six years?

What is suddenly going to change now? Sand, surf and sun?

But the really telling aspects of the deal come later in the article,

"It is like private equity, with GE-friendly twists. The company gets orders for products ranging from gas turbines to clean-energy technology for Abu Dhabi's "carbon-neutral, zero-waste" Masdar City. GE will even establish a local version of its management-training program. Unlike an investor in a buyout fund, GE has an open-ended investment horizon.

Abu Dhabi gets something for its dirhams, too. GE's products and services may be useful, but they should come with a bonus for a developing economy: the transfer of technology and know-how. Compared to some of the emirate's previous ventures -- a Ferrari theme park and an affiliate museum of the French Louvre, for instance -- bringing GE in looks like a step up."

In effect, here's what GE/Immelt are really doing.
As the nearby Yahoo-sourced price chart for GE and the S&P500 Index displays for the past five years, the industrial conglomerate has failed to give investors a total return even remotely similar to that of the market. It has barely remained flat over the five years. Over the entire course of Immelt's nearly six-year reign, the result is essentially the same, at best.
What this means is that many intrinsic "technology, know-how," brand and other intangible values on GE's balance sheet have become worthless in terms of market value.
Immelt's inept leadership have nullified decades of prior value creation.
As such, Jeff is basically hauling out the family silver, setting dinner for the Al Nahyans with it, and letting them take it with them after the meal.
Immelt is training Abu Dhabians in management and transferring GE's vast technological prowess, undervalued by global investors, to the desert Muslims.
As such, he's both giving away valuable American know-how to get some cheap financing, as well as exporting knowledge-worker jobs to the Gulf.
Where's the Congressional outrage over this deal?
Having struck out- miserably- on the global stage while managing GE, Jeff headed to Palookaville to get a deal with some investors whose last shrewd deal was "a Ferrari theme park and an affiliate museum of the French Louvre."
What's next, Jeff? An investment deal with South Africa? Trade jet engine technology for rights to invest diamond revenues?
Equally sadly, CNBC, GE's wholly owned toady-business-news network, and other business media, fail to notice and report on the real implication of this deal. That GE can't get respect or earn appropriate total returns for its shareholders in major equity markets.
So the company has turned to hooking up with novice investors in far-flung corners of the globe, giving away valuable technology and future white-collar jobs to attract capital.
Is this the portrait of a well-run American large-cap company?

The Minimum Wage Rises Today

Did you buy gasoline today in a state that mandates attendant service?

Was that fillup more valuable? Today, according to Congress, it was.

Because, according to an AP wire story,

"About 2 million Americans get a raise Thursday as the federal minimum wage rises 70 cents. The bad news: Higher gas and food prices are swallowing it up, and some small businesses will pass the cost of the wage hike to consumers.

The increase, from $5.85 to $6.55 per hour, is the second of three annual increases required by a 2007 law. Next year's boost will bring the federal minimum to $7.25 an hour."

So whether you think so, or not, many vendors whom you patronize are being forced to pay some of their employees more just....because.

Is more value being created? Probably not. Will those minimum-wage employees work more than 10% harder and more creatively?


This is one classically-defined manner in which we invite inflation into our economy. Paying more for no more value creation.

If, like me, you covered this topic in economics in college or grad school, you know that today's minimum wage hike probably will result in the under- or unemployment of a few tens of thousands of low-end laborers whose new minimum pay won't be justified.

Moreover, if the AP story is correct, this only affects 2 million workers. Out of how many? 153.1 million estimated in 2007, according to this CIA factbook entry. Less than 2% of workers.

Yet another instance of government wrong-headedly propagating antiquated notions of 'fairness' from an era in which labor, capital and other markets were much more primitive and functioned less effectively.

God save us from ill-conceived and continued legislation like this, e.g., mortgage foreclosure moratoria, energy production prohibition, and more government-guaranteed housing financing.

None of which would seem to be adding value in our economy. Because, if they did, producers would already be doing them.

Wednesday, July 23, 2008

Regarding The Length of The Period of Turmoil in US Fixed Income Markets

I recently had lunch with a friend to discuss investing and the current economic conditions.

In her opinion, the equity markets are poised for more declines.

I don't disagree with her. Right now, my partner and I are positioned in puts, and our equity allocation signal is to the short side.

Regarding the economy and credit markets, I believe that the longer and deeper various regulatory and legislative authorities muck around in the current turmoil, the longer it will take to arrive at market clearing prices and, thus, recovery in various markets and the economy.

Two areas in particular come to mind: structured financial instruments and home values.

In discussing these with my friend at lunch, I reiterated that structured financial instruments such as CDOs may have no current, tradable market value, while still being performing assets.

Thanks to the genius of the latest batch of young Wall Street wunderkinds, we have a conundrum in which an instrument which possesses intrinsic value by virtue of the normal operation of the underlying assets and payment streams is forced to be valued, for accounting purposes, as having virtually no value.

If we decided to focus the question of valuation on performance, rather than market value, then some of the recent value destruction at various investment and commercial banks would have been unnecessary.

Paradoxically, I think that structured financial instruments are causing much unnecessary damage due to some wrong-headed valuation decisions, when their long-run values are actually fairly robust. At this rate, some hedge funds and private equity shops will surely reap most of the longer-term value from these instruments, if only to buy them at fire-sale prices and simply collect the interest. Not having to meet public valuation standards, these firms logically will bottom sweep the market and realize most of the profits.

Does it not seem somehow mistaken that our regulatory and accounting structure make it impossible for publicly-held banks to do the same?

Then we turn to housing values.

Here, Congressional ass-covering and regulatory power-grabbing are conspiring to prevent the useful and natural fall in housing prices until they reach market-clearing levels.

So long as bribe-taking Senators like Dodd and Conrad push for Federal forbearance of mortgage defaults and the implicit support of home prices, nobody in their right mind will be buying distress housing.

When you know someone is artificially propping up prices, why bother paying good money for over-priced real estate?

The longer this continues, in its many forms, including FDIC freezing of foreclosures at IndyMac Bank, expanding Freddie's and Fannie's lending authority, and the attempts by Congress to forgive defaulting homeowners, the longer credit will avoid returning to finance housing.

And the longer buyers will wait to purchase excess/distress housing stock.

Of course, the Resolution Trust Corporation solution of the 1980s worked in the opposite direction, and very effectively at that.

Naturally, then, the current Congress is heading in the other direction.

If Congress has its way, who knows how long housing values could take to reach market-clearing levels, thus opening the way for new financing to enter the sector?

Thus, I'm rather jaundiced about any particular economist's call for the date or quarter at which these markets will be healed.

Valuation rules for structured finance could keep the publicly-held banks undercapitalized for quite some time, while political meddling in housing finance could delay the return of those markets to normalcy for years.

Tuesday, July 22, 2008

Shorting Bank Stocks

This past week's introduction of new rules for shorting a selection of financial service stocks was evidently calculated to shore up confidence in institutions which are deemed by governmental and regulatory officials to constitute the necessary core of the US financial services system.

Several observations occurred to me as I read about the new regulations which took effect yesterday.

First, why were such loose applications of the already-extant rules regarding the borrowing of shares to short not simply enforced?

In a parallel to the recent introduction of criminal statutes focused on intent, e.g., 'hate' crimes, these new regulations seem superfluous. There were already perfectly adequate rules in effect, if only they were correctly and uniformly enforced.

Second, much as Truman invited the invasion of Korea when he drew the US security perimeter of the 1940s as excluding that country, the focus on a few financial institutions implies that the others don't matter to US financial system stability.

Doesn't this more or less declare open season on shorting those institutions not on the list?

Finally, does anyone really believe that a governmental propping up of presumed weak, or vulnerable financial institutions, will truly eliminate danger?

In finance, due to counterparty risk, perception of strength or weakness is far more important than actual strength or weakness.

Ringing the favored institutions with a special set of regulations designed to make it harder to easily short those equities in an illegal manner may safeguard their equity values, but, surely, investors also realize that it also will tend to prevent true price discovery in a significantly downward fashion.

It's an interesting question, though. Did illegal shorting contribute to Bear Stearns' downfall? Will prohibiting such illegal over-borrowing of shares to short merely bring correct price discovery back? Or will it actually inhibit price discovery?

It seems like another reason, in my opinion, to steer clear of most financial sector equities for a while longer. There just seem to be too many 'special' situations and allowances being made for them at present.

What the real value of a mediocre US financial utility is in the long run is anybody's guess now. So many questions exist regarding Fed window access, equity market regulations, and mark-to-market rules, that it just seems too risky to hold them when plenty of other opportunities exist in equities and derivatives in which to invest and outperform the S&P500 Index.

Monday, July 21, 2008

The Yahoo Circus Continues

Today's breaking news regarding Yahoo is that investor Carl Icahn has settled for three board seats, including one for himself, rather than offer a complete hostile slate at next month's election.

I wrote this post last Tuesday, which included some thoughts about Icahn's activities at Yahoo. At the time, I, like most everyone else, expected a bare-knuckle brawl between Icahn and Yang-Bostock.

To be honest, I think it's a bad thing for Yahoo shareholders that Icahn felt it necessary to compromise- or capitulate- to Yahoo's management and board.
The nearby 5-day price chart for Yahoo and the S&P500 Index illustrates that, from a peak last week of about a +7% gain, Yahoo is now down to a flat performance. The S&P, for comparison, is still up a few percentage points.
From a longer perspective, this six-month chart of the same information shows Yahoo pretty much in steady decline since the initial Microsoft offer drove it up to a +40% return.
Since that time, in early February, the company's stock has declined to a return of only about +10%, a loss of 3/4 of the value pumped into it by Microsoft's original interest.
You can see the bump due to Icahn's jumping into the fray in the past month, but even that effect has now attenuated by about half its peak strength.
All of which suggests that investors aren't particularly happy about Yahoo's prospects now, either. Icahn may have had a long shot at replacing the firm's board and firing Bostock and Yang when he was running his own competing slate of directors.
Now, he has only 3 votes on an enlarged, 11-member board. And according to CNBC this morning, major institutional holder Bill Miller of Legg Mason supports the current Yahoo board.
Can Icahn make a difference anymore? Will his 3 votes actually convince 3 more on the firm's board? You can bet he won't be getting Bostock's or Yang's votes for anything material.
I wouldn't dispute Carl Icahn's instincts. But at this juncture, is he playing for a gain in his Yahoo position, or just a smaller loss?
Either way, as I have stated as far back as my initial post regarding the Microsoft bid for Yahoo, this deal won't be any good for Microsoft's shareholders. And Yang and Bostock already botched the best financial deal their shareholders were likely to see for a long, long time.
Carl Icahn is trying to salvage some value for kindred shareholders of Yahoo, but I'm not sure the situation is really going to work to his advantage in this case.
The next month should be very revealing, including the outcome of the annual meeting.