Friday, September 12, 2008

Boone Pickens Writes A Book

Yesterday, the Wall Street Journal published a review of T. Boone Pickens' recently-published book, "The First Billion Is the Hardest," by Robert Bradley, Chairman of the Institute for Energy Research in Houston, Texas.

Perhaps this passage is most telling in what we will learn of Pickens from this book review,

""Boy geologist" Boone quit a promising job at Phillips Petroleum in the mid-1950s and built, over the following decades, Mesa Petroleum, a top North American independent oil and gas producer. Mesa found lots of oil and gas, provided jobs for hundreds of workers, and earned wealth for thousands of investors. During the same years, Mr. Pickens's attempts to take over Cities Service, Gulf Oil, Phillips and Unocal made the whole oil industry shape up: His bids required the managers of each company to look hard at its practices and improve its shareholder returns.

Such accomplishments are the core of Mr. Pickens's 1987 autobiography, "Boone," which was updated 13 years later and retitled "The Luckiest Guy in the World." In those books, Mr. Pickens's political philosophy rang loud and clear. "I believe," he stated, "the greatest opportunity lies in a free marketplace." He warned: "There are powerful forces afoot trying to restrict that freedom in the interests of the vested and already wealthy. I am talking about a relatively small collection of corporate executives who would use the engine of American commerce for their own narrow ends."

And he was as good as his word, rebuffing oil-tariff proposals when crude prices plunged in 1986. In "Boone," he bragged that a U.S. senator once remarked: "Boone Pickens is the only businessman I know that if Congress would leave him alone he would never come to Washington." Alas, "The First Billion Is the Hardest" brings us a new T. Boone Pickens -- one a bit more roughed up by experience and a lot more inclined to travel to Washington."

Mr Bradley relates, in his next paragraphs, parts of Pickens' story which, at the time, I'm pretty sure I knew, but had long since forgotten,

"In the late 1980s and early 1990s, Mr. Pickens faced financial death: Mesa had made major acquisitions on the assumption that natural-gas prices would not drop; but drop they did, and Mesa's debt proved so burdensome that the company was poised on the brink of bankruptcy. New owners eventually fired Mr. Pickens, a defeat that still rankles him. Then he founded BP Capital, devoted to investing in energy futures. It got off to a rocky start, though in the past eight years it has earned roughly $8 billion in commodity speculation. Now Mr. Pickens has new dreams -- and he is lobbying Washington to make them come alive."

This, along with a later opinion that, along with already having substantial investments in natural gas distribution stations and wind turbine projects, a third major reason for Pickens' current energy 'plan' is,

".....less obvious. Mr. Pickens refers to Big Oil as "the monster." Why such an animus toward an industry that has been at the forefront of the American dream? As it turns out, both Mr. Pickens and his father (a failed independent) spent unhappy years at Phillips Petroleum. During the takeover battles with Big Oil, Boone was professionally and personally smeared and was ultimately denied his dream job: running an integrated major. He also links Mesa's fall to overdrilling by the cash-flush majors."

You don't hear that from Becky Quick on CNBC. Or from Pickens himself, obviously. But I think it's not a small thing in this recent crusade by Pickens to 'save' America from the horrors of free, Ricardian trade. By that, I mean paying $700B/year for oil imports, which we, it is assumed, use for more valuable purposes, ultimately creating one-quarter of the world's GDP in the process.

Finally, Mr. Bradley finds some problems, as I did in these posts- here, here and here- with Pickens' choice of wind and natural gas as immediate substitutes in America's energy mix,

"His arguments for a government-led remake of the nation's energy use are sketchy at best, dangerous at worst. Despite his grand claims, generating wind power is uneconomic, and transmitting it is even more so (windy places are far from electricity markets). Wind is unreliable, requiring constant backup from natural-gas-fired plants in particular. Wind takes summer days off. In Boone-speak, wind is all hat and no cattle.

As for natural gas: Mr. Pickens scarcely mentions the manifold problems with natural-gas vehicles, from the price premium for a new car (around $6,000) to the cost of fuel conversion (averaging around $12,000 per car). Converted vehicles must sacrifice trunk space to accommodate a heavy natural-gas cylinder. The task of retrofitting service stations, let alone cars, puts the cost of the Pickens Plan north of a trillion dollars. And what happens if oil prices fall and natural-gas prices spike?"

It seems I was not alone in wondering about the details of these proposals. Holman Jenkins castigated Pickens for skipping the details, and Mr. Bradley now provides some reinforcement as to why that may be.

I've written a few other posts involving Pickens and his energy 'plan,' which sentiments are also echoed in Mr. Bradley's piece. Specifically, that Boone Pickens is enjoying celebrity and attention over all of this, while casually dismissing his critics as being anti-progressive.

To my knowledge, nobody such as, say, Brian Wesbury, has weighed in on Pickens' claims of the danger of importing a lot of a commodity of which you have less, like oil, than you need for your economy's requirements. Nor have I heard any economists crediting Pickens with being a capable and reliable macroeconomist.

Yet, at base, those are the supposed foundations of Pickens' argument for his wind- and natural gas-driven energy 'plan.'

Mr. Bradley's review provides me with both good news and bad news. Good, in that I am apparently on target questioning Pickens' credentials, motives and analysis. Bad, in that, well, I'm on target questioning Pickens' credentials....motives....and analysis.

Few other people seem to be calling for more details on how you construct a nationwide natural gas distribution system for automobiles, nor for research on consumer acceptance of the new types of cars they'll be buying as a result of Pickens' self-enriching energy agenda.

As a friend agreed with me last night, whether we were to make a nationwide switch to electric-powered, or hybrid, or natural gas-fueled cars, either will require some pretty steep investments and detailed logistical questions to be answered. For example, how does a street-parked car in Manhattan get its batteries recharged? How does an average American family cope with having one car without a trunk, and only a short driving range before refueling?

And you can bet, whichever alternative power source were to be standardized in our country, you are going to be paying for the construction and operation of its distribution system. Who else will?

Which also brings me back to my point in this recent post- when is Pickens going to tell us all how his energy 'plan' will cause a rise in inflation for US consumers?

Mr. Bradley's review is timely and informative. I may even read the book, although, to be honest, I don't really want to further line Pickens' pockets with my money.

Thursday, September 11, 2008

Armando Codina On CNBC

What do Home Depot, GM, American Airlines and Merrill Lynch all have in common?

Armando Codina, the Florida real estate tycoon, sits on each of their boards.
Is this a good thing? Well, nearby is a Yahoo-sourced, five-year price chart for each firm and the S&P500 Index.
What do you think? Armando's firms all trail the S&P over the past five year period.
What's really scary is to listen to his expound his views, as I did this morning on CNBC. Here are some of the chestnuts I heard:
-Lehman should be saved, in some capacity, and continue to exist, because it is such an 'important' financial institution.
-GM's CEO, Rick Wagoner, has the full support and confidence of the board.
-GM should be given assistance from the US government, in the form of aid in raising capital, which may include loans, in order to invest in 'green' technologies and buy time to return to financial health.
-GM and the rest of the American auto makers are more important now than when then-GM President Charlie Wilson uttered his famous remark, "What’s good for the country is good for General Motors, and vice versa." Thus, we must save GM.
This isn't an exhaustive list of Mr. Codina's shocking remarks, but they are the ones I most vividly recall.
What we see, from his comments, is a board member of four large, ailing American companies who believes companies should never die. If they are in danger of dying, even from their own misguided actions, they should be given a stay of execution by the Federal government. No large company, it seems, should be allowed to fail.
Evidently, Mr. Codina never heard of Joseph Schumpeter and ideas on the dynamic nature of capitalism. Companies rise and fall, are born, and die.
From his roots as a real estate developer, it's believable that Mr. Codina just doesn't really understand the realities of the larger system of American business. In real estate, land generally remains in existence. People need places to live. Businesses need places from which to offer goods and services for sale.
But businesses such as Home Depot, Merrill Lynch and the other firms on the boards of which Mr. Codina sits, can and do fail. Their business models may fail to adapt to new competitive or market realities. Or they simply may no longer offer attractive merchandise for sale to consumers.
Just because they fail does not mean that you can't buy a car, fly to another location, trade equities or bonds, or buy a tool for home use. If it's a profitable need to fill, someone else will still be around to offer competing goods or services.
It's instructive to hear the actual views of a live, sitting board member of ailing firms like these four. Now we can better understand why they have no shame. They overpay underperforming executives, wait too long to fire them, and see no wrong in, having badly overseen the management of the firms on the boards of which they sit, approaching taxpayers, via the Federal government, for help in remaining solvent.
Makes you sick, doesn't it?

Lehman's "Franchise" & Good Bank/Bad Bank Structure

The Wall Street Journal carried several articles concerning Lehman yesterday. The two elements of the firm's activities yesterday on which I would like to focus are Fuld's remarks, and the evolving 'good bank/bad bank' structure proposed for the firm.

According to the Journal,

"A subdued-sounding Mr. Fuld acknowledged that "losses created by these concentrated legacy assets have clouded the underlying value of our franchise," distracting clients, trading partners and employees. "While they continue to stand with us, we nevertheless cannot put the strength of our franchise and their continued trust at risk." "

Who is Fuld kidding?

"Legacy assets?"
"Underlying value of our franchise?"

Where does Fuld think his 'legacy assets' came from? Did he go to the men's room for the last five years, came out and suddenly saw them on the firm's balance sheet?

What, specifically, amidst this residue of Lehman's appalling risk management, does Fuld think is the firm's 'franchise?'

Franchise typically refers to some intangible value. In this case, an outgrowth of respect for management skill and/or talent. Where is Lehman's? How do you argue for any skill in a firm which, by virtue of Fuld's ego, expanded way beyond it's original capabilities in bonds, to embrace the fast-growing mortgage securitization business, as well as buy an asset management unit, too.

Guess what the firm's 'restructuring' entails? Selling a big part of the asset management business and hiving off the disastrous mortgage-related assets into a 'bad Lehman.' Leaving the original non-mortgage, fixed-income business as the 'good Lehman.'

Apparently, it is Dick Fuld's fervent wish and hope that, having cast his major blunder adrift as a separate entity, investors and counterparties will revalue his firm's 'franchise' and let him go back to business as usual.

But it's going to be the same Dick Fuld, minus some of his former employees, operating the 'good Lehman,' who built the 'bad Lehman.'

So, why should anyone believe it will be different now? Lehman, as a firm, has gone through these cycles for decades. The split between Lew Glucksman's traders and Pete (now Blackstone) Peterson's investment bankers drove the old Lehman into the arms of American Express' James Robinson.

Lehman has a history of making mistakes after the fat years, then careening to disaster in the lean years thereafter. This time is really no different.

In fact, I suppose you could even argue that Fuld's pride at being continuously employed by Lehman for so many years assures you that this flawed corporate gene is embedded in him by now.

Lehman can try to split its rotten mortgage assets into a 'bad Lehman,' stick it to shareholders as a special, separate piece of equity, and pretend that the 'good Lehman' is now all better. They can try to retain part of the asset management unit.

But step back and look at the whole picture. Dick Fuld ran Lehman out of control. He got out of his depth, splurged on mortgage assets at precisely the wrong time, and tossed good risk management out of the window.

Now, he claims the core 'franchise' of the firm he has nearly ruined really needs to be saved, due to that core value. The core value Fuld maintains he really has this time.

This is the kind of stupid, myth-based, sentimental thinking that gets business people in trouble. Last night, I sat with my business partner and listed the investment banks operating when I left graduate school, but no longer with us as identifiable firms- Kidder Peabody, First Boston, Salomon Brothers, Drexel Burnham Lambert, and Bear Stearns. Morgan Stanley and Lehman are now seen swirling around the drain, Lehman the closer of the two. Let's not get all misty-eyed over the loss of another one or two publicly-listed investment banks, shall we?

Lehman should simply be dismembered, assets sold, and allowed to sink quietly into oblivion, along with its inept senior management, never to prey on shareholders again.

Wednesday, September 10, 2008

Lehman- *Sigh*- Again: Are We At The End Yet?

Dick Fuld has almost destroyed all the value Lehman has created in the last 24 years. From a split-adjusted high in the 80s, Fuld's mismanagement and blindness to market realities have resulted in a catastrophic decline in the firm's equity price in the past year.

Looking at the last three months, the firm's equity price has dropped nearly 50%. Yesterday alone it sunk 45% from the prior day's close.

Of course, with so much equity value destruction, it begs the question of when Lehman will finally take the huge capital hit everyone believes it is avoiding. This will result, so the market evidently believes, in inadequate capital levels, prompting a dilemma for regulators regarding the fate of Lehman.

Personally, I am hard put to see how Lehman's failure as a corporation could possibly unravel the global financial system. It's a relatively small, concentrated investment bank. And one so badly run that it really needs to exit the scene.

As I've written in prior posts, most recently this one,

"As I last wrote about Lehman here, last week, Lehman is basically a collection of badly-purchased assets, bad management, and one still-reasonably valuable, separate asset management firm.What's the big mystery about where this is headed?

Neuberger will be spun off, back to management, or sold for cash to another firm. One way or another, further asset value reductions will be realized, shareholder value will be further reduced, thanks to the long term effects of Fuld's ineptitude, and the firm will either shrink or die. Its valuable assets and positions will be taken over by other firms, equity value will take further hits, and the firm will finally leave the competitive field.

You can expect a lot more ink and air time over the precise manner and style of these steps. But you know, as I do, that they are coming- and soon."

Is it this week? Will today's earnings- or lack of them- announcement trigger the denouement of this financial drama?

God, I hope so. It's getting tiresome.

Kill the company, already, will someone? Put it, and those of us witnessing this depressing spectacle, out of our collective miseries.

On Auction Rate Securities & Brokerages

I have written five pieces on the subject of auction rate securities, the latest one found here, less than a month ago. In it, I related the humorous and shocking revelation by James Stewart, a financial advice columnist for the Wall Street Journal, that he, too, was a victim of these instruments. In my post, I wrote,

"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."

Now, in an article from the weekend edition of the WSJ, we learn just how misguided and gullible Stewart really was for believing the 'valued customer' hokum.

Here are some of the choicer passages from the Journal's recent piece,

"For years, financial advisers promoted auction-rate securities to clients, friends and even family. Now, in the latest twist of the roiled credit markets, some brokers are siding with customers who allege that the securities weren't as billed. They were widely pitched as higher-yielding alternatives to easily bought-and-sold, super-safe money-market mutual funds -- but investors like Mr. Pellizzetti have been trapped in them since February, unable to cash out at full value after the market for auction-rate securities collapsed.

The auction-market crisis appears to be slowly working itself out. In recent weeks, most of Wall Street's biggest brokerage firms, including UBS, have agreed to buy back more than $40 billion of auction-rate securities from their clients, including individuals, charities and small businesses. Some have reached pacts with state and federal authorities to resolve probes into their sales, while other investigations continue. The pacts may help investors like Mr. Pellizzetti get their money back.

In the wake of all this, a behind-the-scenes debate is unfolding about the role played by brokers. Even as the auction market burgeoned to $330 billion in recent years, many brokers knew little about its inner workings, according to regulatory documents, lawsuits and interviews with brokers and their clients. Does that make financial advisers victims, too, if they reasonably relied on their firms' descriptions of the products, however thin they were? Or are securities brokers obligated to learn as much as they can about any investment they pitch, ensuring they themselves fully understand what they are selling?

Tamar Frankel, a professor at Boston University School of Law, says brokers' legal liability is a bit of a gray area, but her opinion is that a broker is obligated to learn about what he sells. "If he sells poison, he's got to know."

In interviews conducted by Massachusetts regulators and included in the state's complaint against UBS, a UBS financial adviser, Leonard Burd, acknowledged receiving no training on the securities other than marketing materials posted on UBS's intranet, and said he didn't read those materials or know of any risks before UBS pulled out of the market in February.

"All I knew" was that the auctions "worked in my career for 10 years seamlessly, and I had no understanding as to the backdrops of it at all," said Mr. Burd in the interview. Reached by phone, he said attorneys didn't want him to speak to the media.

"According to Mr. Pellizzetti's son, internal UBS sales meetings described any chance of auction failure as 'remote & temporary' explaining that at worst any illiquidity would be resolved" in the very next auction for that security, the claim alleges. After his son left UBS, Mr. Pellizzetti continued to purchase the securities through another UBS broker, the claim says.

One factor in financial advisers' willingness to promote the securities may have been the richer commissions they brought. At UBS, for instance, financial advisers received a portion of the 0.25% reward received by their firms for managing the securities, while no commission was available for putting the same investors in UBS's standard money-market fund, according to the Massachusetts complaint.

UBS denies that its advisers had an incentive to put clients into auction-rate securities.
Some brokers apparently did dig deeply enough to figure out that the securities were problematic. The Massachusetts complaint against UBS cites Jan. 10 emails from Sarah M. Sullivan, a financial adviser in Boston, to a senior manager explaining her reluctance to pitch the securities to clients who wanted alternatives to low-yielding money-market funds.

She had just listened to a conference call by UBS auction-market specialists aimed at boosting sales of the securities, according to the complaint. "We continue to be frustrated by the lack of information that they are providing to us," she wrote. She said she would be particularly concerned about putting any client into the securities just ahead of the April 15 tax-filing deadline. "If there is a failed auction, the client may not be able to access the funds. The bottom line is that rather than moving more cash into [the securities] we will probably be liquidating them for many clients."

She concluded: "Given the strange and difficult environment, it is imperative that we are fully aware of the risk we are taking. We do not want to imperil any relationships over something as 'simple' as their cash investments."

A follow-up email from the senior manager instructed a colleague to "get one of your people on the phone with Sarah ASAP so we can provide the appropriate color." The complaint doesn't detail Ms. Sullivan's subsequent actions. A spokesman for Mr. Galvin, the Massachusetts' regulator, said the state wouldn't comment beyond what is in the filings. UBS declined to elaborate or make Ms. Sullivan available for an interview."

My reason for presenting these extended passages is to refute some truths implied by the WSJ's financial columnist, James B. Stewart.

To wit, I contend that, in reality, you should believe that your broker is NOT:

a) well-informed and educated about what s/he is peddling to you.
b) truly interested in your economic welfare first, before their own.
c) unmotivated by commissions on what they sell you.

When you hear the phrase 'valued client' from a broker, run, do not walk, the other way. Hang up the phone, close and delete the email.

From the Journal's extensive article on the UBS case involving auction rate securities, we see that many brokers simply have no idea of the nature and behavior of many financial instruments which they sell to clients, once those instruments go beyond basic equities, debt and simple money market accounts.

Investor beware.

Tuesday, September 09, 2008

Kerry Killinger Gets His Comeuppance At WAMU

Yesterday's and today's Wall Street Journal were full of articles regarding the weekend sacking of Washington Mutual's (WAMU) CEO since 1990, Kerry Killinger.

Back in May, I wrote this post discussing the then-existing situation in which Killinger and other smaller 'national' bank CEOs had escaped the axe while destroying tremendous amounts of shareholder value, while Chuck Prince, Stan O'Neal and Marcel Ospel had already been fired at Citigroup, Merrill Lynch and UBS.

In that post, I argued that, Killinger's and other CEOs' continued tenure to the contrary, the real evidence of effective reactions to their incompetent management of their banks was the negative total returns they had earned for their shareholders.

For example, I have included in this post the Yahoo-sourced 1-, 2- and 18-year charts of share prices for WAMU, Citi, Chase, BofA, Wachovia, and the S&P500 Index.
Among all of these crippled banks, WAMU fell furtherst in the past twelve months, losing its shareholders some 70% of their value. But all had negative price changes for the period.
The two-year picture is similar, only in this one, Chase, too, is below the S&P. All the banks again sport negative price changes for the period. WAMU is again the worst of the lot.
My contention is that Killinger's shareholders voted with their feet over the past year. That's why the stock price fell further than those of other banks, on a percentage basis.
Now Alan Fishman has been hired, with a $7.5MM upfront signing bonus, i.e., combat theatre pay, to rescue WAMU.
For once, I agree with Dick Bove, the bank analyst quoted in today's Journal as opining that a new CEO at WAMU won't have any effect on its balance sheet full of rotten mortgage loans.
Thus, as bad a beating as some prior shareholders took to exit WAMU stock, they are probably going to look good compared to the value remaining shareholders have after the sale of the bank Fishman will likely have to engineer.
I know he says he'll get WAMU back into solid financial shape. But, let's be honest. Who will invest in it now? Doesn't it make more sense that, when the Feds find Fishman's five-year plan doubtful, they will help arrange the sale of WAMU, or it's better assets- physical offices, better financial assets, etc., to another financial institution?
Too bad shareholders can't get the board to financially penalize Killinger on his way out. After looking at the nearby price chart for 1990-present, it's clear that Killinger left WAMU's shareholders about where they were when he took over as CEO, except for dividends.
But that's hardly a performance that merits Killinger's haul of, according to the Journal,
"1.2 million shares of common stock....worth about $5.2 million. He also has $14.9 million in deferred compensation and $3.5 million in pension benefits, according to the filing."
So, even after zeroing out the common equity value, Killinger receives about $19MM for wrecking WAMU over the course of 18 years.
Who says crime doesn't pay? Well, maybe just appallingly bad management of a bank?

Boeing's Tough Choice

The machinists' union's strike against Boeing Aircraft has been big news for the last few days.

Among other aspects of the story is that of how much Boeing's situation and fate may be like, or unlike, those of GM and Ford, before them.

Stretching back over several decades, the auto makers caved in to exorbitant union demands, ultimately crippling their manufacturing competitiveness, to add to the Detroit car makers' troubles with designing vehicles which Americans wanted to buy.

If observers of Boeing are correct, then the management of the firm faces a crucial, agonizing choice this month. Do they restart production of their planes, including the already much-delayed 787 Dreamliner, at higher costs, or hold the line on costs and take a prolonged strike, in hopes of preserving their longer-term ability to remain competitive with European and Asian aircraft producers?

I'm not personally expert in the area of aircraft manufacture and assembly management, but it does seem that Boeing's leaders screwed up pretty badly on their outsourcing choices and management for the Dreamliner.

As a Wall Street Journal article noted, it's ironic and rich for Boeing's managers to turn the to workers from whom they took the work, to ask them to hurriedly hand-assemble the first Dreamliners, thus saving management's chestnuts.

The series of charts in this post depict Boeing's, GM's, Ford's and the S&P500Index's price performance over, respectfully, 2, 5 and 45 years.

In the first chart, even Boeing hasn't beaten the S&P in the past two years. It looks uncomfortably like Ford and GM.

Over the five-year timeframe, Boeing looks different. It's trajectory has remained similar to that of the S&P, while it has also remained above the index's curve, as the auto makers fell precipitously.

Since the early 1960s, not surprisingly, the collapse of the auto makers has not been mirrored by Boeing. The aircraft producer has had a fairly solid, upward trajectory, even above that of the index. But it is marked by some fairly severe downward drops. No doubt, it's due to the lumpy nature of the plane-development and order cycle in the sector, as well as periodic problems in Boeing's business.

It seems that every 7-10 years see a need for the firm to incorporate recent technology and change design and/or construction practices, which seem to lead to investor concerns and a fall in Boeing's total return.

In this decade, except for the past two years, the company has been on a tear. So this strike would seem to be a key turning point.

One key lesson of the auto makers was that unwise concessions on labor rules, pensions, etc., allowed smooth near term production at an ultimate expense of perhaps fatally wrecking both Ford and GM.

Just on that basis alone, Boeing should probably hang on to its flexibility options, regardless of near term production and market share consequences. There will be other planes and market share battles. But labor union battles have very long term effects.

And the business of designing and producing aircraft is, indeed, becoming more like the automotive industry, not less. More foreign competitors are entering the business. Scale is necessary to afford new technologies, meaning those technologies are released to more competitors faster.

If anything, Boeing will probably face more competition as time passes, not less. From China, India, and even continued improvement from Brazil's aircraft producer.

Since American competitive advantage ultimately rests with intellectual property, innovation and change, it's probably the wrong way to go if Boeing agrees to less flexibility and more union control over its decision-making.

The firm has evidently botched the Dreamliner's outsourcing. Maybe it has learned valuable lessons that it will use to prevent a repeat of the Dreamline fiasco. Maybe not.

But for the sake of Boeing's shareholders, the management of the firm should probably bet that it has, and fight for the right to continue to make those calls.

Monday, September 08, 2008

Treasury's Takeover of Fannie & Freddie

As I wrote in this recent post, there really is a lot less than meet the eye to the necessary consequences of the weekend's takeover by Treasury of Government Sponsored Entities and mortgage finance conduits Fannie Mae and Freddie Mac.

The bare minimum action required in this market situation is for Paulson's Treasury to stand behind the value guarantees of any of the GSEs' issued mortgage-backed securitization instruments. That is, to assure the same level of valuation implied by the original government backing, regardless of whether Fannie or Freddie exist.

I checked with my mortgage banking veteran friend B this morning, by phone, to see if I had missed anything. His most recent views on this mess were presented in this post, written almost two months ago, which featured an email of his to me, pasted verbatim.

Despite much public hand-wringing, including a local radio station's excited headline at 6AM this morning that,

'the Treasury stepped in to rescue the two mortgage companies in order to prevent the collapse of financial markets and, quite possibly, followed by the US economy,'

the only real crisis, as Paulson articulated in his public comments, was that of investors, including foreign governments and institutions, losing confidence in the US government guarantee of Fannie and Freddie securitized instruments.

The continued operation of both firms as conduits for securitizing mortgage loans really isn't a critical issue right now.

Again, despite breathless questions on CNBC this morning of a Republican House member who is voting against the takeover as to what he would say,

'to a constituent of yours who is just out of reach of a mortgage now, thanks to this takeover failing and the mortgage markets seizing up,'

I don't see that as a problem. Neither does B. He warns me that it is a political issue how to clear out the GSEs from the conduit business, in order to usher back in private sector players.

But it's not an economic one. And, again, contrary to CNBC's 'task force' which worried on air about whether or not the mortgage securitization business should exist, let me make something clear. Just because a poorly-run pair of GSEs messed up in no way means it is an unattractive, nor unnecessary market activity.

But it clearly is not one to be performed by Fannie, Freddie, or anything structured like them.

High quality, 20% mortgages are still being made in the US. These were the backbone of the sector for decades. Problems arose when sector executives decided to stoke growth by reducing the percentage of downpayments they would accept for mortgage loans. When the downpayments became too lean- probably somewhere between 5-10% - the model failed. Housing prices dipped by more than the downpayments, wiping out the owner's equity in the home, and triggering defaults.

But this isn't a function of Fannie or Freddie, per se. It's the fault of private-sector, publicly- and privately-owned banks.

The existence of Fannie and Freddie really have little to do with this. Sure, they took the resulting mortgages and securitized them. But bankers made the loans to begin with.

If the mortgage securitization business has been poisoned by the bankers themselves, due to bad risk and growth management in the past decade, then they have nobody else to blame for the moribund market. B thinks it may indeed, as I surmise, be at least five years before private conduits can flourish in the wake of Fannie and Freddie.

Until then, US mortgage finance may temporarily return to the old days of local and regional financing.

But, until all the weak and badly-managed players are gone from the sector, investors won't touch mortgage-backed securities anyway.

All the more reason for Paulson to kill off the GSEs entirely, as I argued in that first linked post from last month. Guarantee the securitized instruments, pay off the GSE bond-holders, pro-rata if necessary, then leave shareholders with the remainder, if there is any.

In time, if it's profitable, mortgage securitization will be provided by good-quality banks by selling off their portfolios of mortgage loans again, like they used to before Fannie and Freddie began increasing the sizes of the mortgages they accepted, and gobbled up so much of the securitization market.

John Mack's Old & Tired Ideas For 'Refocusing" Morgan Stanley

The weekend edition of the Wall Street Journal carried an article describing John Mack's efforts to 'refocus' Morgan Stanley.

The lead sentence in the piece tells you the trouble Mack is courting,

"For two weeks in July, Morgan Stanley Chief Executive John Mack moved into an office near the research analysts who work at the Wall Street firm's headquarters in New York's Times Square. He had two goals: boost morale in a unit hit hard by layoffs and figure out how to squeeze more value out of stock research."

John, do you recall a guy named Elliot Spitzer? Do you remember what he charged many Wall Street firms with doing? Including your own, Morgan Stanley, regarding Mary Meeker?

As I recall, Spitzer reached a major, sector-changing settlement with your firm, and others, for ....squeezing more value out of stock research!

Mostly by improperly attaching it to trading and investment banking, so access to star analysts, and their involvement in boosting firms underwritten by their own firms, shifted their work from independent, objective research, to mere marketing on behalf of clients and trading desks.

A friend of mine, formerly a senior communications systems management at Lehman, now at a major tech firm, confirmed this for me last summer. He regaled me with stories of 'research analysts' getting in on the pitch to prospective underwriting clients on how they would support the new client via opinions to institutional clients and their own trading desks.

This is the sort of thing that the storied settlement was supposed to change.

Now, John Mack is reportedly,

"Since having dinner with research division leaders and informal chats with analysts as part of his two-week immersion, Mr. Mack has been talking with lieutenants about what should be changed in research. One challenge: quantifying the value generated by good ideas used by both the firm and its clients. The topic has come up several times at recent weekly management-committee meetings."

First, isn't that the holy grail of Wall Street? And has been since time immemorial? Please tell me, John, that you don't really think this is new ground you are plowing.

"Quantifying the value...." of research is the age old quest of brokerages trying to figure out what those expensive eggheads actually do to make money for the firm.

And, since the modern brokerage has three major businesses- institutional sales/trading, proprietary trading and underwriting- the analyst must be adding value to one or more of these, if s/he adding value at all.

The first and third businesses are exactly where Spitzer's hunt focused- improper use of analysts to win underwriting and then lever those products into institutional trading clients.

Using analysts to improve proprietary trading is, of course, an obvious path. But if this were simple and effective, wouldn't it already have been done? Then, again, the really good analysts, eventually, become money managers. So maybe that's not as simple as it seems. And it puts great pressure on analysts to produce consistently and well. Maybe that, too, doesn't work so well in practice as in theory.

It just strikes me, from the Journal article, that none of Mack's alleged new ideas is actually new at all. And if they are known to work, wouldn't the article note that, too?
As the nearby five year price chart for Morgan Stanley and the S&P500 Index indicates, it's been a terrible 18 months or so for Mack and his battered shareholders.

It seems to be another stumble of John Mack's on the long journey through the desert of bad performance on which he has led Morgan Stanley these past few years.