Friday, August 15, 2008

Auction Rate Securities, Goldman Sachs & "Sophisticated" Investors

Last week, I wrote this post about the ARS settlement reached by Merrill Lynch, Citigroup and UBS.

In that piece, I wrote,

"Buyers of financial service products, especially 'structured' products, should know the intrinsic value and risks of such products on their own. They should not simply trust an institutional salesperson to tell the the truth- the whole truth.

Buyers of ARSs were defrauded- this is clear. They were lied to regarding how liquid the instruments would be, and that the added yield over money market instruments was somehow riskless.

But, really, in the end, should they not have known enough to ask questions? Like,

"But, how can they have a higher yield with no added risk? Surely, there must be something about them that is riskier? What is it?"

When you read about retail customers losing millions of dollars in these ARS investments, don't you wonder how they could be sufficiently intelligent to amass that much money, only to be so easily hoodwinked by some financial schlockmeister spinning tales to separate them from their hard-earned money?"

Thus, yesterday's Wall Street Journal article concerning Goldman Sachs' refusal to repurchase ARS securities sold to their clients is an exception to the recent trend among banks which sold this toxic dreck.

According to the Journal article,

"Wealthy clients, institutions and corporations have been largely left out of those pacts."

And, knowing Goldman's clientele to be much more high-end than the other banks, I can understand their reticence to reimburse sophisticated investors- especially institutional ones.

The Journal article exemplifies a former INtel and Dell senior executive, one Carl Everett, as having become disillusioned with Goldman's failure to rescue his position in ARSs. The piece doesn't mention his net worth, nor the face value of his ARSs. One somehow suspects that they would qualify Mr. Everett as a 'sophisticated' investor.

Which brings me to a hilarious companion piece in the same WSJ edition.

It seems that James B. Stewart, a regular investment columnist who writes "Common Sense," lost his. He spent yesterday's column bitching about his lack of satisfaction as a 'victim' of the ARS mess.

Stewart alleges,

"It's not like we were clamoring to buy these securities. Like other victims I've heard from, I got a call urging me to take advantage of an offer that was being extended to valuable clients."

For more on this, see my prior, linked post, for my story of the early days of CMOs and their buyers.

But, back to Mr. Stewart. For someone so lofty as to write a column in the WSJ on investing, wouldn't you think he would know better than to offer an excuse like the above for purchasing ARS notes? Really- something for nothing, James?

Free extra returns, just for 'valuable clients?'

I have to laugh, because I've never bought any structured finance instrument in my life. The market-making assurances on these instruments are simply not to be believed.

Anyone with any experience in securities markets would know this.

Should James B. Stewart even be writing a weekly investing column for the WSJ, if he was taken in by such a simple ruse as the ARS game, and went for the old 'something for nothing' con?

Thursday, August 14, 2008

Terry McGraw's Problems At S&P

The Wall Street Journal ran a very revealing article two weekends past on how McGraw-Hill and, in particular, its CEO, Terry McGraw, are dealing with the fallout of S&P's disastrous fumbling of rating CDOs.

The article begins with this passage,

"Last October, a hedge fund manager asked McGraw-Hill Cos. Chairman and CEO Harold McGraw III whether bond ratings downgraded by the company's Standard & Poor's Ratings Services unit amid recent market turmoil should have ever been issued in the first place.

'What we do is provide access to the capital market,' Mr. McGraw responded. 'If the market wants those kinds of products and the institutional investors want those products, then we move with the market and we're going to rate whatever.' "

The Journal piece goes on to state, about McGraw,

"But he helped set the tone at the bond-rating firm, which stressed profit growth and keeping costs relatively low."

Doesn't that just explain it all?

In a companion piece in the same edition of the WSJ, on the same page, one reads,

"At S&P, revenue from rating the mortgage-laden bond portfolios grew more than 800% from 2002 to 2006, but related staffing doubled. At Moody's, the comparison between revenue and staff growth was similar, but its growth rate in CDOs was somewhat lower than at S&P."

The party line from McGraw-Hill about this sensitive issue was, as reported in the article,

"S&P 'has consistently invested in resources and increased its professional staff across its business lines.'"

I think this alone is evidence for anyone with experience in large corporate cultures to understand what happened.

Terry McGraw and his senior staff were determined to collect as much of this 55% per annum revenue growth on the corporate bottom line as possible. Nobody was going to be seeing anywhere near even +25% growth in expense or staffing levels per year.

In the aftermath, of course, it seems short-sighted for McGraw-Hill to have been so stingy. Its reputation, and perhaps even its prized, unique access to the bond rating business, is now severely damaged. But just on the basis of the financials, it's easy to see that the firm made a fatal miscalculation that the quality and content of its ratings work were, in effect, of no actual value. It was the application of 'some' rating to an issue that added the value.

And for that, who needed to maintain internal quality and operational standards?

Another quote from the second article confirms this. An internal email has one S&P staffer writing, regarding an issue,

"we should not be rating it."

The email received a reply contending,

"we rate every could be structured by cows and we would rate it."

It's evident that the pressure to crank out revenues, earnings and, parenthetically, ratings, was intense at the S&P unit of McGraw-Hill. The Journal piece focusing on the CEO concluded by noting that S&P became the high-growth unit to offset sluggish performance in the less glamorous parts of the publishing giant.

The article contends that Terry McGraw wanted his family firm to becoming a growth equity, and decided that pushing for abnormally-high growth at the ratings unit would deliver on that objective.

As with most high-growth businesses, they don't remain so indefinitely, nor without commensurate costs over time.

One way, or the other.

Wednesday, August 13, 2008

Immelts Shuffles Deck Chairs On The S.S. GE

Yesterday's Wall Street Journal contained a priceless piece of comedy in the form of an article on GE's CEO, Jeff Immelt, shuffling deck chairs- er, organizations- at the company he currently mismanages.
According to the article, GE announced, two weeks ago, that it was reorganizing itself into four groups, instead of the six it had before.
Prominent in the reorganization is Immelt's about-face on GE Capital. Taken apart when he became CEO in late 2001, ostensibly for issues of transparency, the unit is being reconstituted. The business of finance accounted for 41% of the firm's second quarter revenue and about half of its earnings, according to the Journal piece.
Being absorbed into other units by the reorganization is health-care, while the industrial-products group, a relatively small contributor to sales and earnings, will be spun off or sold.
The most hilarious line in the article is a quote from Russell Wilkerson, a GE spokesman. He told the Journal that the old structure gave Immelt,
" 'a direct line of sight' into the various finance businesses and unfiltered contact with their leaders."
Nearby is a five-year, Yahoo-sourced chart of GE's and the S&P500 Index's price performance. Note how GE has actually lost market value during the past five years.
So much for Jeff's 'direct line of sight' into anything at the company he has mis-led for nearly seven years.
Of course, reorganization, like patriotism, is the last vestige of a corporate scoundrel. Internal comparisons are blurred for years, and excuses to investors and observers become based on 'the new way of operating.'
Let me put it more directly. If a simple reorganization is the only thing that Immelt needed to do for the past seven years to avoid his wanton destruction of value for GE shareholders, why did he wait so long?
If it isn't, what should make investors believe anything will change now? GE is so large that it simply defies belief to think that Immelt can personally add value to any business in the diversified conglomerate.
His record, instead, is one of clear and absolute shareholder value destruction. At least with the planned separation of the industrial units, the inept CEO of GE is finally on the right track- breaking up the conglomerate into its natural, standalone units.

Tuesday, August 12, 2008

An Interesting View Into Microsoft's Recent Activities

As I continue to catch up on last month's Wall Street Journals, I came across a rather innocuous piece announcing the departure of Microsoft's head of operating systems and online efforts, Kevin Johnson, to become the new CEO at Juniper Networks.

Among the things mentioned in the Journal piece were a subsequent internal memo from Microsoft CEO Steve Ballmer stating he wants to

"out-innovate Google" and "changing the way we work with hardware vendor" to fight Apple.

These would be humorous, if they were not so sadly out of the realm of possibility for the aging, inept software giant.

When is the last time anyone saw Microsoft innovate?

And compete with Apple in hardware? Is Ballmer serious? How? With a follow-on to the abysmal Zune?

Now, in the wake of Johnson's departure, Ballmer is reversing course on his decision of only three years ago to split the desktop operating systems group from the online group.

Given Microsoft's dismal performance record for its shareholders over the past few years, as depicted in the nearby, Yahoo-sourced chart, you have to seriously wonder if anything Ballmer touches will work.

Monday, August 11, 2008

Update on UBS's ARS Settlement

I wrote in error last week, in this post, that,

"Breaking stories this afternoon on the internet have UBS agreeing to repurchase some $8.3B of the ARS instruments they bamboozled their clients into stuffing into their portfolios."

In fact, according to this weekend's Wall Street Journal headline, UBS agreed to pay $19 billion to clean up its share of the ARS mess.

Thus, Merrill, Citigroup and UBS have agreed to make good on a total face value of $36B, not just $25B, in fraudulently-marketed, misrepresented ARS notes.

This makes UBS the 'winner' in this sad story, outstripping even securities giant Merrill Lynch in its ability to churn out and place these toxic investment securities to its customers. In fact, UBS accounts for just over half of the total.

Who's going to subscribe to a new equity issue of the Swiss bank now, in order to help plug this latest gaping hole in its balance sheet?

More About GM's Failures

Last Thursday's Wall Street Journal featured a significant editorial concerning GM by longtime auto sector expert and former WSJ and Dow Jones executive, and former squash partner of mine, Paul Ingrassia, entitled, "Can America's Auto Makers Survive?"

I am pleased to see that most of my criticisms and conclusions about GM's recent performance are echoed in Paul's piece. Specifically his remarks about the 'dumbing down' of financial failure under Wagoner, about which I wrote here recently.

As Paul put it,

"The late Sen. Daniel Patrick Moynihan used the term "defining deviancy down" to describe the acceptance of behavior that was once deemed intolerable. Now Detroit's car companies are defining disaster down.

In 1991, General Motors posted a then-amazing, full-year loss of $4.45 billion, and 10 months later CEO Robert Stempel was out. Last week, GM reported a $15.5 billion loss for just one quarter, and GM's board this week reaffirmed its support for CEO Rick Wagoner. GM's loss easily eclipsed the quarterly loss of $8.7 billion announced by Ford just a week earlier."

Paul goes on to conclude, as have I, that GM, Ford and Chrysler should have seen the gasoline-price-related crisis in their sales and profits coming, Ford has the best chance of survival, and the demise of any of the three, while sad and disappointing, would no longer be a body blow to the American economy.

On this last, and crucial point, he wrote,

"Detroit's fight for survival doesn't threaten economic doomsday for America, but it's incredibly sad nonetheless. The three companies, and General Motors especially, once symbolized the bedrock strength of American capitalism. If they can restructure and recover, as must be fervently hoped, they will symbolize the potential for renewal."

Perhaps Paul is correct to believe that a return from the edge of the financial and business abyss by any one of the three, especially GM, would symbolize 'the potential for renewal.'

But, might it not also symbolize an overly-nostalgic preoccupation with past American business success, in lieu of moving forward into product/markets where we can create more value-added?

Products such as computers, autos and commodity chemicals were once dominated by American companies, but are no longer. And, tellingly, they are no longer sources of large-scale, proprietarily-based value-added creation or consistently-superior total returns for shareholders in those companies.

The significant decline in the fortunes of all three large American auto makers without a recession or consequent severe economic dislocation in the US economy provides evidence of just how little the performance of these former industrial titans now matters for the average American.

If labor productivity is sufficiently high, some auto makers will build vehicles in American plants. They may not be US companies, and the factories/assembly plants may not be located in Michigan or, in fact, in the northern part of the US. But, as I wrote in an earlier post concerning GM, wouldn't it be better for those workers to be part of a growing, healthy auto maker, than an ailing one?

Paul Ingrassia is right. Detroit's demise, while sad, is no longer an issue or risk of economy-wrecking magnitude. And the boards of all three companies- GM, Ford, and Chrysler, when it was public- are responsible for presiding over some of the worst US management in recent decades.

Sunday, August 10, 2008

Why Financial Services Losses Are Different This Time

This morning, over coffee, I had the occasion to discuss the current situation of publicly-held US commercial banks with two friends after playing squash. All of us have had, or currently have, positions with major US banks. And we all agreed that the long term outlook for the current crop of America's five large commercial banks- BofA, Chase, Citi, Wachovia and Wells Fargo, plus the investment bank Merrill Lynch, Lehman and Morgan Stanley- is dim.

I wrote about some elements of this recently, here and here.

For commercial banks, the reason they may finally be fatally wounded is that, this time, it's not loan portfolios against which reserves can be taken, and losses can be 'worked out,' that have wounded them.

Nor can historical values be claimed and the assets stuffed into 'investment' accounts to be written off over longer periods of time.

No, this time both investment and commercial banks jumped into marketable securities and got burned. Now hostage to 'mark to market' rules on illiquid securities, they are paying the price for hanging on to this toxic financial waste which they manufactured.

So the commercial banks can't just massage the loan loss reserves, chargeoffs and investment accounts. This time, they have to abide by market values.

And if someone like Merrill suddenly takes a huge haircut to purge its balance sheet, so must every other institution holding similar paper.

For example, take the ARS settlement of this past week. This has just put another expensive, multi-billion dollar whole in John Thain's Merrill Lynch balance sheet. Didn't he just raise another $8B recently to cover the losses of the sale, with reserve, of a bunch of bad mortgage paper to that Texas private equity outfit, LoneStar?

Which is why no CEO can claim to know that they have hit bottom on the valuation of these structured instruments. Nor have any control whatsoever, short of just basically giving the assets to some private equity shop for a few cents on the dollar.

So, who will be stupid enough to buy any more equity in the three parties to the ARS settlement- Citigroup, Merrill and UBS?

After demonstrating appallingly-bad risk management judgement for the past several years, why should anyone continue to keep these rotten, inept managements afloat? They've lost most of their capital in the past year. Schumepeter would probably observe that they should simply be allowed to perish, as more adept, better-managed competitors fill their niches in our financial services system.