Friday, September 19, 2008

The Fates of WaMu & Morgan Stanley

As of this morning, news stories still report Wachovia considering the purchase of Morgan Stanley, while, somewhat comically, in relation to the reports of Citigroup considering merging with WaMu, the former's CFO, Gary Crittenden, was quoted as saying,

"People view us today as being a source of the solution, instead of part of the problem."

Only in a rapid consolidation like the current one would so badly managed a bank as Citigroup be considered as a 'source of the solution.'

Perhaps it's just a matter of relativity. As inept as Citi's management is, WaMu's was worse.

Would the financial system be worse off with WaMu's assets slapped together with Citigroup's? Probably not. In this environment, it's not clear what WaMu's other options are, besides orderly sale of its non-mortgage consumer business to some other large bank, while shareholders keep the damaged mortgage assets to offset whatever equity remained.

As to Morgan Stanley's China option, one wonders how that would work? A country whose army still employs prison labor in its commercial manufacturing businesses would now also one one of America's larger investment banks? Not to mention a country whose ownership rules for foreigners doing business in country are so restrictive as to be laughable? Where does the issue of trust enter here?

(At this point, I had written substantial additional material which was published earlier this morning, but has now, inexplicably disappeared. I shall attempt to reprise those additional thoughts.)

But, the larger point is this. Most of the publicly-held US investment banks failed to adequately understand the environment in which they were operating for the past twelve months.

Despite the ranting of CNBC financial hothead Jim Cramer to the contrary, most of these banks did, indeed, debauch their own franchise values. Cramer, only this morning, was nearly breaking his arm while attempting to pat himself on the back for calling for an RTC-style entity in July. In the next breath, he alleged that it was unfair that Bear Stearns, Lehman, Merrill Lynch and, probably, Morgan Stanley have or will vanish as independent entities.

He also contended that Morgan Stanley and Goldman, in his opinion, were in danger of going insolvent yesterday.

I disagree. Those two investment banks, as I wrote here, had options. And still do. But that doesn't mean each should remain as a publicly-held, independent entity.

If it takes today's, and the past two weeks' efforts by the Treasury, Fed, SEC, and other Federal regulatory agencies to rescue a raft of large US financial service entities, then it's fair to question how ably these companies were being run in the first place, isn't it?

They all- or almost all- clearly misunderstood the current financial environment, and failed to take adequate steps in sufficient time to avoid bankruptcy or sale to another firm. Their risk management efforts were terrible.

Why should anyone want those managements to continue to operate in our financial services system? Doesn't the existence of such inept management teams- risk and general- put our entire financial services system at risk?

Yes, it does.

You may argue, as Zachary Karabell did in yesterday's Wall Street Journal, that this is all due to the Enron-era Sarbanes-Oxley legislation which mandates 'mark to market' of thinly-traded, poorly-understood structured financial securities.

So be it. But the whiz kids at these Wall Street houses, and AIG, all knew the rules, or should have. What they apparently didn't know, in reality, was what could really happen to complex instruments, and the values of their firms, which held so much of this paper, when markets for such instruments simply vanished.

Ironically, we saw the same miscalculations when the same firms used 'portfolio insurance' approaches to risk management in the crash of 1987. It didn't work.

Wall Street is, in truth, littered with past crises and market crashes during which the predominant risk management solutions of the day failed to anticipate the next risky environment.

Part of the reason, of course, is the concept of the 'fallacy of composition.' I first learned of it in Paul Samuelson's classic text, "Economics," in my undergraduate economics courses.

What the typically-young, inexperienced risk management model-builders on Wall Street usually fail to anticipate is that, when a market is composed of firms operating similarly-run risk management functions, then they will all behave similarly in the face of the same price information. What happens next falls under the fallacy of composition. All desks try to sell at once, and prices plummet even further, triggering even larger sales of even more instruments.

Of course, it has worked on the upside, too, occasionally. But, on the downside is where crippling side effects like margin calls and capital inadequacy appear.

Think what you may, but John Gutfreund recently and sagely noted the inability of firms such as Lehman to come to terms with the new realities of highly-leveraged investment banking operations in a world of overcapacity and too-thin margins.

Thus, as the moderating economy of the US caused the first ripples of doubt among holders of structured financial paper backed by subprime and alt-a mortgages last summer, the die was effectively cast ending either the independence, or existence of most US investment banks.

Poor risk management and the denial of reality by boards and senior management delayed the inevitable recognition of declining value of many assets held by these firms. And by several large commercial banks.

What's happening now, frankly, ought to occur. Everybody knew what SarBox meant for marking balance sheets to market. And everybody knew that the last batch of securitized mortgages were of lower quality than those of five, or even three years ago.

WaMu's and Morgan Stanley's fates are comparatively strokes on a larger canvas of ineptitude of risk and general management by many large, publicly-held US investment and commercial banks in the past few years.

As a society, we own these behaviors. We can't let the them destroy our financial system. Thus, today's governmental actions which have either nationalized some aspects of, or curbed the operation of free markets in US finance, may be temporarily necessary.

In the longer term, some simpler, clearer means of firewalling leveraged activities needs to be developed, so that, with minimal oversight, natural human behaviors to seek to maximize opportunities for profit, and misunderstand concomitant risks, won't bring a repeat of this financial services sector debacle.

Modern Risk Management- Time To Return To Yesterday?

Many years ago, mortgage finance was a regional business. Back in those days, pre-1980, the US commercial banking industry consisted of several large 'money center' banks- Chase Manhattan, Bank of America, Citibank, First Chicago, Chemical, Manufacturers Hanover, and Contintental Illinois, to name most of them- and many smaller regional banks. The latter would do business with the former using a model known as 'correspondent banking.'

In a sort of semi-formal partnership, smaller local and regional banks had an explicit relationship with their big-city, money center correspondent bank which allowed them to buy pieces of whole bank loans. Similar to the securities industry's syndication of underwritten listed securities, banks syndicated pieces of loans to their correspondents.

For the most part, due to restrictions on deposit-taking across state lines, money center banks sold loan participations to regional and local banks, thus, in effect, gaining by these sales funding which they could not access as direct consumer deposits in other states.

This correspondent function also had the effect, albeit, in this pre-electronic era, at considerable expense in terms of people and operating expenses, of diversifying loans throughout the US economy, on a loan-by-loan basis.

Particularly prevalent in these correspondent relationships would be business loans. The system was not without risk. Several banks, such as SeaFirst, in Seattle, went bankrupt after buying too much correspondent-originated energy loan volume in the infamous Penn Square Bank debacle of the early 1980s.

To see how regional mortgage finance was at the time, witness how many regional banks failed in the residential mortgage finance crisis of the late 1980s, when the RTC was created to clear the bad loans from the active banking system. Shortly thereafter, Salomon Brothers, First Boston and Kidder, Peabody dove into the private-label securitization of S&L mortgage assets, liquefying the balance sheets of the latter, and expanding capital available to housing finance.

Fast-forward to today.

In the last decade, the regional mortgage finance model was scrapped, as Countrywide Finance, Pulte, Toll Brothers, Centex, and other builders, helped to create a nationally-scoped residential construction and finance industry. With Congressionally-approved increases in the sizes of jumbo-mortgages taken for securitization by Fannie Mae and Freddie Mac, mortgage securitization reached new highs.

Investment banks, including Merrill Lynch and Bear Stearns, actually bought mortgage origination firms to provide a lower-cost supply of the instruments, with which to manufacture, for sale, securities backed by mortgages. Citigroup did likewise. Other firms, such as Morgan Stanley and Lehman, vastly expanded their mortgage securities trading and sales operations.

In effect, rather than restrict mortgage delinquencies and defaults to the regions which were typically economically impaired, and the banks in those regions, the new, securitization model of mortgage finance spread mixtures of mortgages from anywhere in the US into structured finance instruments sold to investors on a global basis.

Thus, when US real estate markets such as California, Las Vegas, and Florida, overheated, stalled, and collapsed, overextended mortgagees in those markets began to default. Instead of a few regional financial institutions being easily identified as affected, insolvent, and removed from the industry, the effects of the defaults were hidden amongst thousands of structured mortgage-backed instruments held in portfolios worldwide.

It doesn't take a genius to see how this insidious spreading of risk, meant to lower systemic risk, actually increased it by causing massive, ubiquitous concerns over counterparty risk.

To use risk management language, default risk of a particular instrument was replaced with counterparty risk involving any other institution suspected of holding mortgage-backed paper that might contain questionable mortgages which were about to default.

Thus, what began as a new idea for spreading and, thus, reducing, systemic risk from mortgage financing, while providing more capital, ostensibly at lower rates, to this sector, has, in fact, created disproportionately more risk, as counterparty risk, to the entire global financial system.

This brings me to a point I made in conversations with my business partner recently.

Way back in the early 1990s, when I was attending CMO conferences sponsored by Salomon, First Boston,, I discussed the phenomenon with my boss, Chase Manhattan Bank SVP of Corporate Planning and Development, Gerry Weiss. How, I asked, could the total risk of a system which was attributed to mortgage finance, be reduced by adding more layers of securitization, with each layer taking a 'haircut' of a few basis points for expenses?

It simply makes no sense that total risk can be reduced. Any one player's risk may be reduced, but only by transferring, i.e., selling it to another party. The benefit to the system would be that each party could lay off excess risk, beyond its ability to afford or, ultimately, bear the consequences of the risk turning into actual loss. Thus, more parties could assume some risks, up to their capacity, in the form of mortgage-backed paper, to which they otherwise would not have had access, while other parties could reduce their risks to match their ability to sustain loss.

But, surely, the system did not reduce its risk.

Now, we see the outcome of this new approach. It doesn't work. Instead of containing losses, due to realized risks, among a few real estate-heavy lending institutions, these losses have spread among countless other institutions, be they underwriters, trading desks, or portfolio managers.

If, as we know from the last few decades of corporate finance teaching and research, an investor can more easily diversify his holdings for himself, than any corporation can for him, could the same be true for investors, with respect to fairly opaque structured financial instruments?

Would it not have been easier, when all is said and done, for institutional investors to pay a bit more to pick and choose the mortgages they wish to hold, rather than hope that someone who is paid for simply 'slicing and dicing' payment streams of mortgages like some financial butcher, without retaining risk in the structured financial paper he has manufactured, has accurately represented the risks therein?

Buying individual, seasoned mortgages directly from portfolios of banks or other financial institutions which underwrote the loans would have probably, in the end, cost less than what the current financial mess is costing us in terms of fear, uncertainty, and extensive counterparty risk.

I think it's time to acknowledge that securitization, as we have seen it for two decades, does not work. Unless the model is scrapped, or somehow modified to require significant shares of any securitization to be held by the structurer, who among us will again trust the party who sells us structured finance paper, being paid for the transaction, without holding it himself?

Maybe returning to the days of more regionally-based residential finance, geographical firewalling of mortgage finance problems consistent with economics of the region, and the buying of individual mortgages, or seasoned securitizations of them, makes more sense.

Thursday, September 18, 2008

What Regulation Will Never Stop: Greed & Stupidity

Amidst the recent changes of ownership of several large American financial institutions, there seems to be a lot of misunderstanding and misinformation rampant among the media, political office seekers, and average citizens.

First, there is no new crisis this week directly affecting average American citizens. The overall economy, while slowing, is not in recession. Don Luskin's excellent piece in the Washington Post debunks the myth that we are in a recession, much less something even close to the Great Depression.

What we are seeing is the fairly rapid restructuring, thanks to accounting rules involving mark-to-market of traded securities, of the financial services sector. But no bank accounts of American citizens are at risk. There is, and will be, no bank holiday.

Let me illustrate the non-crisis nature of these actions with a comparative example. Over the past few years, there has been a substantial consolidation in the industrial sector involving minerals extraction. BHP, Rio Tinto, Alcan, Alcoa, FreeportMcMoran and others have been engaged in the buying of competitors to secure supplies of commodities and lower production costs. Especially as global commodity prices soared.

Nobody considered this a crisis. It was simply an industrial structure change in response to changing market conditions.

What we are seeing now in US financial services is the same.

Take Fannie and Freddie. These were not retail banks. They were a misguided, depression-era, and later, boneheaded Democratic party idea for supporting 'affordable housing.' Because of their Congressional (lack of) oversight and bizarre public/private structure, they exploited regulatory gaps, bought favorable treatment from Congress, and evaded harsh regulatory treatment by appealing to their bought Senators and Congressmen (among the top campaign cash recipients were: Chris Dodd (D-CT), Barack Obama (D-IL), and Barney Frank (D-MA).

If there was any material damage from the excessive growth of the two GSEs by securitizing specious mortgages, it was probably by deluding the marginal, recent subprime and alt-a home buyers. By securitizing those mortgages, the GSEs wrongly fostered a sense of real demand for questionable mortgages which probably would never have been made by private conduits, were the GSEs not already doing so with subsidies from their government funding.

Taxpayers are holding the bag for Congressional graft and corruption, but, in general, the average citizen isn't affected in her/his daily life.

What about the exit of Bear Stearns, Lehman, Merrill Lynch, AIG and, probably, Morgan Stanley?

Again, no consumers' bank accounts have been robbed. In the securities arena, the analogue of FDIC bank deposit insurance, known as SIPC, also insurers a like value of brokerage account values.

The three investment banks don't deal with retail customers in much of their business activity. Lehman and Merrill had retail brokerage operations, but, again, no consumers have actually lost money in those accounts.

That's not to say that consumers with money in funds managed by other institutional managers didn't unwisely buy debt or equity of any of these firms, only to see those values crater. But that is a risk every investor takes by choosing to withdraw money from a bank and place it in any uninsured investment vehicle, such as a money market, equity or bond fund.

So, too, have many pension funds which invested with professional money managers lost value because of the stupidity of those managers. But, again, these are risks taken in pursuit of higher returns. Nobody put a gun to the heads of various pension and other fund directors to place money in riskier investment vehicles which, ultimately, have performed poorly.

AIG was perhaps the only company whose demise could have affected the daily lives of US consumers. If insurance policies were not honored, and mutual funds suddenly frozen, that would cause panic and havoc. So, not having the time to organize an orderly separation of those businesses from the riskier, rotten operations that tanked AIG, due to the company's management's own decision to roll the dice on their continued existence throughout this past summer, Paulson's Treasury felt it necessary to seize the firm, rather than lend to or save it.

Again, no citizens have been negatively affected in terms of their assets.

What has occurred is that a lot of financial service sector employees will be out of jobs. Like employees of poorly-run companies in America, eventually, business ebbs, employees are released, and the business dies.

When they are large, old, visible businesses, like Bear Stearns, Lehman, Merrill and AIG, and it happens rapidly, people notice. But it's just a telescoping of normal business cycle events.

So, to my way of thinking, what has occurred thus far in no way constitutes a 'crisis,' a 'broken economy,' or the 'worst economic crisis since the Great Depression.'

More apt comparisons, as my business partner and I recalled over lunch yesterday, are:

-Long Term Capital Management's demise in 1998
-The crash of 1987
-The collapse of the famed 'Go Go' era of mutual funds and the "Nifty Fifty" equities in the 1960s
-The end of fixed foreign exchange prices under Nixon, also known as the end of "Bretton Woods."

All of these were financial-sector sourced phenomena, some of which had ripple effects throughout the real economy. Particularly the last two.

If you really want a comparison with prior real economy crisis, how about these two?

-The closing of the gold window by Nixon after Johnson's inflationary attempts to fund the Vietnam War

-Stagflation under Nixon and Carter resulting, 6 years later, from Johnson's 10% income tax surtax and deficit creation to fund the war.

What we are witnessing now is just the result of too much investment banking capacity having expanded into too many risky businesses, such as securitizing marginally-worthy mortgages. Because securitization results in instruments which, unlike bank loans, must be marked to market, any institution holding them must immediately record capital losses when the trading markets for them disappear or collapse.

If this has been only limited to a few mortgage banks, then the damage might have been lessened. But, thanks to Bob Rubin's and Bill Clinton's tacit removal of the firewall between commercial and investment banking, and insurance, with their explicit approval of Sandy Weill's merger of Citibank with Travelers Insurance (which also owned an investment banking operation), commercial banks and insurance companies co-mingled their normal businesses with these securities underwriting businesses, and related swaps trading.

So, in truth, much of the damage wrought in these past few weeks and months is directly traceable to Federal government lapses. The removal of Glass-Steagall, and the feeding and growth of Fannie Mae and Freddie Mac were direct causes of all of this mess.

Despite what John McCain, Barack Obama, the business media and others will tell you, 'greed' is not the cause.

You can, and should, count on 'opportunism' in the financial services sector, which some call 'greed,' to always exist. We want it to exist.

You will never stop or remove opportunism from the American economy. You won't remove stupidity, either.

Make no mistake, the managements of Bear Stearns, Lehman, Morgan Stanley, AIG, Citigroup and Merrill Lynch all behaved stupidly. So did buyers of their debt and equity. All those who behaved stupidly are now being scorched.

This, too, is not a crisis. It's the market's way of disciplining those who forget that excess returns typically have excess risk.

But all of this is normal in the course of corrections in financial services. Risks are taken, risk is priced too high, then too low, and, eventually, some get burned by attempting to enjoy excess returns without excess risk, for too long.

But our commercial banks still operate. Citizens' deposits are safe. Appropriately-lent mortgages still perform. The financial component of most Americans' lives remain untouched by this past month's events, unlike the fallout of market turmoil which began the Great Depression.

It's a totally different financial services sector today. For the most part, those who were injured were sophisticated investors or vendors who knew, or should have known, the risks they took.

Regarding Goldman Sachs' & Morgan Stanley's Endgames

My business partner and I had our weekly working lunch meeting yesterday. As we reviewed the developments in the financial services sector, he mentioned how far Goldman's equity price had fallen in the past week or so. As he drove to lunch, it had dipped lower.

We opined that Morgan Stanley would probably shop itself to some bank. Thinking Wachovia too weak, Chase already struggling with the remnants of Bear Stearns, Citigroup in near-fatal condition itself, I suggested that maybe Wells Fargo would be a buyer. As I write this at 5:30PM on Wednesday afternoon, the online Wall Street Journal reports that Mack has been talking to several banks, Wachovia being the only one actually named.

But the real shocker, in the opinion of my partner and I, will be Goldman. We haven't seen anything in the media yet about our expectation of its endgame.

For reference, see the nearby, Yahoo-sourced price chart for Goldman and the S&P500 Index over the past six months. While the S&P has fallen only about 10%, Goldman's equity has rocketed down nearly 30%!

In terms of actual price, it's gone from around $180/share in early June to $114.5/share yesterday.

This does not, in our view, alter the fact that Goldman remains the class of the class of investment banks, public or private.

So, when everyone else is selling equities, what should the best equity house on Wall Street do?

Buy, of course.

We believe that, while John Mack's weakened Morgan Stanley runs for cover at a large, mediocre commercial bank, Lloyd Blankenfein and his management team will, in conjunction with selected private equity investors, tender to take Goldman Sachs private again.

It makes sense. Goldman's risk management has held up well while all their publicly-held competitors are finally driven from the field. Why should the best managers in investment banking cast their very desirable pearl before the....ah....well, you know....sell to a commercial bank and work for its probably-dimmer CEO?

As I wrote here in March of this year,

"Specifically, I would expect fewer separate publicly-held, regulated entities such as commercial banks, investment banks, and brokers. Instead, I think you will finally see the integration of these functions into fewer, larger and more diversified European-style universal banks, with larger shares of more financial services businesses.

Of course, with this 'bulking up' will probably come even more anemic, inconsistent total return performances. Again, just like that of European universal banks.

Seen from a more distant vantage point, does this not all make some sense? We had a concentration of financial capacity and risk taking among lightly-regulated firms specializing in peddling ever-more opaque, complex products to investors. When the value of these complex 'structured finance' instruments became difficult to discern, and the concentrated risk came home, capital shrank as losses among commercial and investment banks caught holding these instruments had to account for the newer, dramatically lower values.

Risk and capacity are likely to be further concentrated, but, in exchange, more tightly overseen and regulated.

A natural consequence to this will probably be even more smart financial services people migrating back to the privately-financed arena. Just like consumer goods merchandising has the 'wheel of retailing,' whereby new entrants compete at the low-cost end of the market, as existing players migrate upwards in terms of quality, service, selection and price, so, too, it seems, will financial services now have its own version of this 'wheel.'

Only in financial services, the 'wheel' is between publicly- and privately-held concentrations of capital and risk management. Again, viewed from afar over decades, the story of commercial and investment banking for the past forty years has been a gradual selling of transactions, asset and risk management businesses at their 'tops,' as formerly-private banks of both stripes went public, followed by managerial ineptitude, decline in risk management, and excesses in pursuit of growth via more risk.

Now that the public is absorbing the brunt of the losses, via equity ownership of these firms, the logical next step is for the better executives to join the early-adopters in forming new, or joining existing private equity and hedge fund shops.

And the wheels continue to turn...... "

Yes, indeed, the wheel turns.

But look at the nearby price chart for Goldman Sachs since its public offering in 1999. Yes, less than ten years ago!

It went public at around $75-80/share, peaked last year near $250, and is now at about $115. By the time the firm issues its tender, it may only have to pay $100/share.

How sweet is that? The probable, intrinsic value of the firm is way north of its current price. Much closer to $200 than $100.

So for borrowing public funding for a decade and more than doubling the firm's value, the remaining partners and their backers- folks like Blackstone, TPG, KKR, and some hedge funds- will get all that value at only a 20% premium, before inflation, to the original IPO price.

That's my- our- prediction. It just seems too obvious that when Goldman's price has been unrealistically depressed, due to near-term market conditions, far below its long-term intrinsic value, those who know it best- Goldman's managers- will do a leveraged buyout.

You read it here, if not first, early.

And that will be the finish of the 30+ year-long cycle of Wall Street going public, shearing its clients, then selling the wreckage either to other investment banks, commercial banks, or back to itself. Investment banking will have ceased to be an independent, publicly-held market function.

I'll even predict that, with time, the private investment banks will out-maneuver and -compete the commercial banks which bought the remnants of the poorly-run, remaining publicly-held investment banks. And we'll be back to a de facto version of Glass-Steagal, with a few commercial banks half-heartedly trying to compete with their sharper, better-paid privately-held competitors.

Wednesday, September 17, 2008

About AIG

I wrote the prior two posts appearing today before the close of the market yesterday. Thus, the AIG loan package from the Federal government was not yet finalized.

How could I not write a few words about the AIG debacle today?

At first, it seemed to me a reasonable solution that AIG should be induced to file Chapter 11, with the Treasury or Fed as trustee. In short order, three companies would be created, one being the collection of pure insurance firms which are registered in various US states and foreign countries, the second being those units which functioned as mutual fund managers, and the third being 'all other,' including proprietary risk-taking businesses of AIG.

In discussing this last night with a friend who works at Fitch, we agreed that such a solution would make sense and be reasonably pragmatic.

Thus, my initial reaction to the loan extended to Willumstad's AIG was that it is a needless and further corruption of the doctrine of moral hazard. One look at the nearby Yahoo-sourced chart of AIG's equity price for the past twelve months clearly illustrates that AIG's management had fair warning that investors were not going to be receptive to providing new capital at reasonable prices.
From January of this year, the company's share price decline began accelerating, hitting a sharper decline after May. But that was over three months ago.
Like Lehman, one may fairly argue that Martin Sullivan, Willumstad's predecessor, had plenty of time to see danger ahead and do something about it.
As I said to my business partner, and the friend with whom I spoke last night, Hank Greenberg was to AIG what Jack Welch was to GE. Both presided over corporate structures and performance in ways that effectively sprinkled pixie dust over analysts and investors. As soon as each was gone, both of the latter groups suddenly declared the companies 'complex,' 'difficult to understand,' and the value of both firms plunged.
One can question, in both cases, but especially AIG, why anyone let such a complex financial grabbag of businesses be so highly rated for so long.
In that sense, I disagree with the Federal loan arrangement, which seems to reward building impenetrable financial corporation structures, then waiting too long to shore up capital.
On the other hand, panic among consumers holding life and other insurance policies from AIG, as well as investors in its mutual funds, would create needless and unwarranted upheaval.
Perhaps the warrants that the US government holds, which have value, should AIG not effectively dismantle itself, creating sufficient value to pay off the $85B loan, is sufficient price to dissuade other financial service entities from taking prudent action before needing to fall on the mercy of the US taxpayer.
Perhaps not.
If the loan truly only buys breathing room for the dismantling of AIG into an insurance firm, an asset manager, and the rest of the mess which comprised it, and the values of the good parts repay the loan, with the US government as senior creditor, then it might make sense.
I just question whether the larger signal that CEOs can continue blithely ignoring capital inadequacy and clear weakness, knowing that the more complex, entangled and diversified the firm is, the more likely a regulator will ultimately take it over, is a net benefit.
I don't think it is.

Ken Lewis' Appetite- An Addendum

In my prior post, I discussed, at length, why I think Ken Lewis has made a disastrous mistake for his shareholders in his purchase of Merrill Lynch at $29/share.

He could have waited longer, or even for bankruptcy, in order to pick up the firm's "assets," such as they are, more cheaply. Perhaps buy the interest in BlackRock at a lower price. Maybe directly hire whole brokerage offices or just brokers, if Lewis and his management truly feels they are still valuable.

But, having watched CNBC yesterday, there is one narrow, one-time opportunity which Lewis may, unwittingly or with intent, be pursuing.

Because so much of the recent write downs of assets by investment and commercial banks are more correctly described as 'markdowns,' as a CNBC guest noted, BofA may be betting on the eventual remarking of Merrill assets upward.

As I have noted in prior posts this spring, such as here and here, totally aside from Ken Lewis' claim to have foreseen the collapse of investment banking seven years ago, two types of institutions can weather markdowns- private equity and commercial banks. Specifically, at the end of the second post, I noted,

"Now, however, we have performing structured finance instruments which have no markets because of their questionable asset value, not their income streams. And commercial banks are as culpable as any other financial institution in this mess.

BofA, Chase and Citigroup aren't your father's bank anymore. It's debatable, in the wake of Glass Steagall's demise, that any publicly-held brokers or investment banks should or can really exist independently of a commercial bank. In the new environment of securitized toxic structured finance instruments, a large commercial bank is uniquely able to survive, by dint of its Fed access and judicious use of its 'investment account' provisions."

While I stand behind my prior post's conclusion regarding the long term nature of consistency, or lack thereof, of Ken Lewis' BofA, I will agree that, because of a commercial bank's ability to use the investment account, Lewis may have cleverly executed a one-time low-ball purchase of some assets that will continue to perform and, eventually, be remarked up. This will result in a one-time gain, probably reflected, at some point, in the equity price of BofA.

Lewis may even use the old commercial bank trick of carefully 'realizing' higher values on these securities in a more or less consistent stream of markups.

But that won't be long term operating profit. It will be managed recognition over time of a one-time asset buy at bargain basement prices.

I still do not think that BofA is now poised to perform well as an equity in the future, aside from the unpredictable effects of periodic markups of securities it may have purchased with Merrill Lynch.

Ken Lewis' Oversized Appetite

Yesterday's Wall Street Journal had a brief article on the back page of the Money & Investing section entitled "Bank of America's Hefty Dowry for Merrill."

One passage well into the piece caught my eye,

"But Mr. Lewis is still giving roughly one-quarter of his bank to bet on Merrill's recovery.....And executives declined to quantify likely write-downs on Merrill's $60 billion of residential- and commercial-mortgage assets."

Lewis has offered a stunning 70% premium for an investment bank that was perilously close- probably only days- from following Lehman into Chapter 11. If anything, I'm surprised John Gutfreund only clucked at Lewis' "greed," and did not suggest the likelihood of shareholder lawsuits.

Just what has Ken Lewis bought? His grinning countenance during the press conference with John Thain announcing the purchase seemed to indicate a sort of dunce's lack of understanding of what he'd done, rather than the cool, confident demeanor of a shrewd buyer of distressed assets.

Let's review, once again, what Ken Lewis bought, and why.

First, his motives. With Merrill Lynch and Countrywide, Lewis has, as I mentioned to my friend B in a phone conversation yesterday, assembled at least the second financial utility in America. One may argue that Citigroup is the first.

But Lewis may well have built the first true financial 'utility' in the sense that he bought two huge, if nearly-dead giants in their respective fields- mortgage finance (Countrywide) and retail brokerage (Merrill). Sandy Weill assembled a financial conglomerate, but it has always been a much more widely-diversified and complex corporate entity than BofA will be.

That said, as Gutfreund also noted, Lewis wants to be the predominant financial institution to every middle- and lower-income American. Sounds wonderful, doesn't it? That's what Lewis, grinning ear to ear, kept repeating in the news conference.

But here's the problem. Ken Lewis just made BofA's equity into a bond. Aside from occasional days or weeks of occasional, unpredictable spurts up or down, BofA's total return performance will now attenuate to that of a safe, low-growth corporate bond.

As my original financial services research, conducted while I was director of research at then-independent consultancy Oliver, Wyman & Co., made clear, no money center, investment or other multi-line bank ever broke into the ranks of consistently superior total return performance for over a decade. As I like to say,

"When you're a big bank, commercial or investment, with multiple businesses, you're much more likely to hit every pothole in the road of financial services."

These "potholes" occur with distressing regularity every decade. It's human nature in financial services, about which I have written before, in posts labeled 'risk management.'

Real estate in the 1980s, sovereign debt writeoffs in the 1980s, energy lending in the early 1980s, credit card weakness, mortgage finance and securitization in this decade. It's always something.

Expect Ken Lewis' new omni-bank to slowly grind down to a GDP-like revenue and earnings growth rate. Top talent will, with the next economic upturn, leave to become bigger fish in new, smaller financial service ponds. The large corporate infrastructure will levy an overhead tax on each business, eventually pricing some out of profitable growth in their own markets.

Then you have the traditional commercial bank risk-averse overlay on growth-oriented businesses like residential mortgage and investment banking.

The prospects of BofA being anyone's go-to equity investment to routinely beat the S&P500 is close to zero.

Ken Lewis bought Countrywide and Merrill to fulfill his, and his regionally-rooted commercial bank's dream of becoming the largest, by asset-size and number of relationships, financial institution in America. Not to become the best-performing equity in America. Not to consistently reward his shareholders with superior returns.

He just wants to continue the old NCNB dream of outliving the money centers and being the biggest commercial bank in the country.

By paying so much for both near-dead entities, Lewis has diluted his own shareholders' value to acquire broken business models in two businesses which are about to undergo, or have undergone, radical change.

It would seem, as the Journal article notes,

"Given the precarious environment, Mr. Lewis has paid too generous a price."

Sure, Merrill passively owns half of BlackRock. Maybe Lewis just keeps that on his balance sheet. Maybe he tries to get Larry Fink to sell the other half. But that's a high-end business.

Most of what Lewis has acquired is a failed mortgage bank, just as mortgage finance is about to change radically, as result of the excesses in which Countrywide itself participated.

Same with Merrill Lynch. Its trading function is nothing special. Its underwriting of mortgage securities is what brought the house down. How much is that worth? Lewis could have bought the new Merrill risk management team, fresh from Goldman Sachs, for much less than the price of the whole firm.

And those retail brokers? Oh, yeah, 'wealth managers.' Right. It's a dying business, or an increasingly less profitable one.

Lewis is hoping they will give him a piece of his 'grab the assets' strategy. By having a business in each consumer asset class, Lewis, like most not-too-bright commercial bankers, believes that, eventually, he'll hoover up all the consumer assets in sight.

But time and again, stretching all the way back to Jim Robinson's American Express 'financial supermarket,' this model has failed. Consumers worth having are too smart to settle for mediocre, big-bank asset management and other services. Those desiring the supermarket model are rarely wealthy or sufficiently sophisticated to be profitable for the vendor.

The conclusion is that Ken Lewis, the latest in a long line of average commercial bank CEOs, is making classic mistakes in the face of investment banking travails. The outcome for BofA shareholders is unlikely to be any better than it was for Lewis' predecessors' shareholders. And that is, inconsistent, or consistently inferior or average total returns, despite the extra risk of holding just one equity to achieve them.

Tuesday, September 16, 2008

How- and How Not To Manage Risk

Yesterday, on CNBC, one of their on-air guests uttered some of the worst ideas yet on risk management and regulation thereof. If I'm not mistaken, the guest was former Clinton-era economic advisor, Laura Tyson.

Ms. Tyson's bright idea was to have more detailed audits of each financial service company's risk management procedures by regulators.

Unfortunately, she seems not to have any working knowledge of how risk is really managed in the trenches of a modern investment, or even commercial bank.

For examples, look no further than Kidder Peabody last decade, or Merrill Lynch several years ago. In both cases, risk managers who dissented from business managers' desires to heighten exposures were either intimidated, as in the case of Kidder, or simply fired, as in the case of Merrill Lynch.

I happen to have actually known the risk manager of the unit which was responsible for the losses which Kidder suffered, thanks to Joe Jett's government instruments trading, while part of GE. His explanation of what happened, between squash games one night, was that, upon discovering positions which exceeded risk limits, he was simply told to shut up, or leave. Being subordinate to the operating unit's management, he had little choice. He looked the other way.

At Merrill Lynch only a few years ago, veterans Jeff Kronthal's and Doug DeMartin's forced departures solved the problems of risk management for business managers in the fixed income unit which was busily increasing the firm's exposure to newly-minted mortgages and their securitized final products.

Laura Tyson's bromides are worthless. It's not the printed risk management policies that matter at a financial institution.

Rather, it's how the risk management organization is structured, and to whom it reports. I don't know the details of Goldman's current risk management organization. But I have read several different accounts which confirm that the company puts a premium on objective, independently-housed risk management challenges to each trading and investment business. Risk and business managers swap jobs, in order to imbue each business manager with a fresh and recent perspective on the importance and practice of the risk management function.

Of course, it helped enormously when investment banks were private partnerships. Never so much as when their own money was at risk have investment banks practiced effective risk management.

However, like their commercial banking brethren, once becoming listed public entities, even investment banks learned that taking on excessive risk paid them, as employees and managers, while leaving shareholders owning any imprudent and, ultimately fatal exposure.

In my opinion, there is simply no substitute for risk managers being equal with business managers, capable of vetoing business decisions, and reporting up through a separate command chain to a Chief Risk Manager who reports to the CEO or CFO. To execute prudent, objective risk management, the function has to be separated, organizationally, from the businesses to which they are assigned.

Anything less will eventually become corrupted, no matter what the former Clinton economic official might see in her visit to an investment bank to audit their risk management policies, procedures and operations.

Needless Panic Over Normal Capitalism

Yesterday evening, I saw a few minutes of an almost unbelievably misleading exchange between two anchors on CNBC.

Brian Williams, who is apparently NBC's nightly news anchor, was doing, or had done his broadcast from the CNBC studios. As he discussed this with a CNBC anchor, he began to wax, misty-eyed, at what a serious and faith-shaking event was the sale of Merrill Lynch to BofA.

Launching into his own personal story, Williams talked of his boyhood on the New Jersey shore, where 'the wealthy people' in the community would trust the broker in the 'storefront Merrill Lynch office.' That, of course, Brian's family wasn't one of them, but clearly, some people 'trusted that image of the bull.'

The 'thundering herd.'

Yes, Brian, those were the days. People probably drove DeSotos, watched Zenith or RCA televisions, if they could afford one, and drank regular, unbranded coffee, when they weren't brewing Maxwell House or Folgers at home.

News Flash to Brian Williams: it's 2008! GM is almost dead! Merrill Lynch wasn't your father's retail wire house anymore!

Honestly, to hear the media yesterday, not to mention political candidates, you'd swear Herbert Hoover was in office, and the Great Depression was starting.

At least two networks had on-air talking heads breathlessly promising an evening program to 'tell you where to invest to keep your money safe!'

Let's all calm down and take a deep breath. It's not the Depression. There will be no bank holiday.

Per my prior post regarding John Gutfreund's comments, Lehman had to file for bankruptcy because CEO Dick Fuld's ego caused him to wait long past the point at which he could have sold the investment bank at a decent price. By misleading analysts and investors earlier this year, especially by dangling attractive female and then-CFO Erin Callahan in front of analysts to voice Fuld's deliberately vague assertions of asset values, Fuld merely dug Lehman's hole deeper.

Gutfreund is right. Lehman's collapse did not have to happen this way. Fuld chose it. It's not a retail bank. Nobody's deposits were at risk. It's merely another badly-managed, weakly-capitalized, over-leveraged investment bank in a sector with over-capacity.

Merrill Lynch? It hasn't been the nation's cherished large, retail 'wire house' for decades. Ever since Walter Wriston's era, the brokerage firm has diversified into other investment banking businesses, though rarely with very much success. It has never been more than an also-ran underwriter. The retail, full-service brokerage business is dying, and has been for years. Due to its size and public ownership, Merrill never attracted the same quality of trading and risk management talent that other investment banks did.

The firm whose departure Brian Williams bemoans hasn't existed for at least twenty years.

What puzzles me is why everyone references the Great Depression, which saw integrated commercial/investment banks stuff their customers' investment portfolios with questionable securities underwritten by the banks themselves.

What this financial sector upheaval reminds me of much more is the end of the famed 'Go Go' '60s mutual fund era. Why is nobody mentioning this?

Bernie Cornfeld, of IOS infamy, and Bob Vesco ran afoul of securities regulations. Many smaller brokerages and analysts shops shuttered in the wake of the decline in prices of the "Nifty Fifty."

In fact, when I went to work at EF Hutton in 1981, I remarked to a friend, on a lunchtime walk around the streets of lower Manhattan, how you could see brickwork patterns on many buildings indicating another had once existed next to it, cheek by jowl. My older colleague, with years of industry experience, explained that those were the remaining evidence of the many buildings pulled down which had once housed myriad small brokerages. They went bust in the wake of the 1960s market crash.

My point is, Wall Street has lost firms before. Retail broker and investment bank ranks have been thinned before. Technology, poor risk management and market cycles have been the cause of many institutional deaths in this sector over nearly 100 years.

What is not happening now is a loss of retail commercial bank deposits of the general American public.

This is really much ado about what is, in fact, normal, Schumpeterian dynamics. Weak businesses fail, excess capacity leads to predatory pricing, excessive risk-taking, and, eventually, removal of the capacity.

That's what we are seeing this week with Lehman and Merrill Lynch. These are not so much systemic problems as failures of management. Something that routinely happens in our capitalistic system.

John Gutfreund On Recent Capital Markets Events

CNBC snared one-time Salomon Brothers CEO John Gutfreund for about five minutes of incredibly candid, sensible interview time.

If you recall Gutfreund from the days just before his ouster at Salomon, you would, as I did, remark that he has aged very well. Further, for a guy who was among the most powerful men in investment banking, at the apogee of his power, he is very understated, unassuming and plain-spoken.

Almost the opposite of his former economist, Henry Kaufman.

Gutfreund was asked how Lehman's demise came about, and he said something to the effect,

"By the over-optimistic actions of the firm's CEO and his senior managers."

Pressed further, he allowed as how the firm was unrealistic, in this era and environment, to believe it could remain independent while grappling with its writedown problems. Gutfreund never used Fuld's name, but pointed out that Lehman had had months in which to gracefully sell itself before coming to Chapter 11.

On BankAmerica's purchase of Merrill Lynch, Gutfreund was far more terse and opinionated. He caustically asked, was this not the bank that had, in years past, bought, then sold brokerage firm Charles Schwab?

Gutfreund then opined that,

'commercial bankers like brokerages for what appears to be their simple business model, and the brokerage commissions.'

However, he noted, this century was already far different than the last, and the brokerage business of today is not that of last decade. With that, he simply dismissed BofA's purchase as too expensive, "greedy," and something doubtless to be punished by shareholders as they sell the company's stock in disgust and disbelief.

Gutfreund's attitude regarding the BofA-Merrill transaction was little short of disdain. He clearly believes that Ken Lewis is making a major mistake that he, and his remaining shareholders, will regret.

As the nearby, Yahoo-sourced chart for BofA over the last five days indicates, Gutfreund was right on target.

It was refreshing to see a sensible, blunt Wall Street veteran avoid needless emotion and hysteria, while simply calling yesterday's events as he saw them. Nothing to be panicked about.

Rather, one company, Lehman, prolonging its own agony, while another, BofA, foolishly bought a troubled, also-ran investment bank.

Monday, September 15, 2008

Lehman's, Merrill Lynch's & BofA's Busy Weekend

What a busy weekend! As CNBC's anchors chortled last night, publicly-held US investment banks shrunk in number from five in January of this year to just two today- Goldman Sachs and an ailing Morgan Stanley.

Over the weekend, Lehman filed for bankruptcy, while John Thain unexpectedly sold Merrill Lynch to Ken Lewis' BofA.

What to make of all this turmoil and change?

First, I'm thankful that Lehman is finally pulling the plug and dissolving itself. It's way past time to do so.

Second, I bet John Thain wishes he'd stayed at the NYSE and never been tempted by the wreckage Stan O'Neal left behind. Too much damage, not enough time. Who'd have guessed that Thain would be out of a job before Vikram Pandit at Citigroup?

I understand why Merrill needed to be sold, albeit with pressure from the Fed. Thain was continually finding more writedowns each quarter, consuming more and more capital, while new investors were understandably reluctant to be his latest pigeons.

What I don't believe is that Ken Lewis is any more able to handle merging the Merrill wreckage with BofA than he has been with Countrywide. In case nobody's noticed, retail brokerage is a dying business. Merrill Lynch's investment banking, via mortgage underwriting, sunk the firm.

What's left that is truly worth having now? Didn't he just finish firing a bunch of his own investment bankers earlier this year?

So, let me get this straight. He was long investment banking, then shortened his exposure, but has now lengthened it again by purchasing the wreckage of one of the Street's worst-run risk-management operations?

Ken Lewis just bought a crippled player in a game whose Schumpeterian dynamics have decreed that excess capacity is now to be eliminated. I wouldn't be a buyer of BofA equity anytime soon. Not with Lewis at the helm, and this new jetsam aboard.

And isn't that how this all came about? If there wasn't excess underwriting and trading capacity, would Lehman, Bear Stearns, Merrill Lynch, Morgan Stanley and Goldman have leveraged themselves up above 25 times equity?

As I've noted in prior posts, all of these firms now exist at the pleasure of some commercial bank's broker loan division.

You won't catch me weeping over any of these corporate departures. Lehman, Bear Stearns and Merrill Lynch all exhibited horrifically bad risk management in a sea of financial excess and excess capacity. That's why capital was leveraged up so highly- to offset razor-thin margins. Guess what those margins, even on higher capital turnover, could not offset?


Now the investment bank version of musical chairs has two players left, and, ostensibly, one chair.

I doubt Goldman Sachs is worried. Their risk managers are the best in the publicly-held financial services sector.

Do you think John Mack is worried today?

Trading Counterparties, Systemic Risk & Investment Bank Collapses

The weekend edition of the Wall Street Journal contained an article bemoaning the lack of a centralized exchange for various derivative and swap transactions, in the wake of March's crisis involving Bear Stearns, and the current worries over Lehman's solvency.

What strikes me as odd is how apparently fragile and susceptible to counterparty risk our financial system is, a full ten years after the LTCM meltdown.

I notice that, although 'investment banks' are involved in recent troubles, it's always their trading desks which are the cause, through the use of over-the-counter, or non-exchanged cleared instruments.

It gives me great pause to wonder how we can continue to let our financial system appear to be hostage to one mid-sized trading operation failing to make good on its obligations?

Isn't the current environment one in which each trading operation is expected to manage the risk of its counterparties? Why should the Federal government have to intercede for so many questionable positions?

Perhaps what we should acknowledge is that, when instruments are traded without an exchange which requires deposits for positions, the entire system is liable to the degree of the worst party's risk management practices.

If one trading house exercises sloppy, inadequate risk management, and thereby loses money due to a counterparty's failure to perform, and, thus, sets off a chain reaction, then even the best-run, risk-managed party is at risk.

I suppose that, over the past 10-20 years, trading volumes ballooned in off-exchange instruments, and trading function managers, as so many financial executives, have not seriously considered the systemic component of counterparty risk in their derivatives and swaps positions.

Perhaps the lack of a serious default of a counterparty has blinded the risk-allocation and -assessment models used by many trading houses to the actual losses which would occur in that event.

This is quite troubling to me, because common sense would have you expect that Lehman's demise should not cause all that much loss. By now, one would hope that either writedowns are taken on the positions, by the counterparties, or collateral increases are required.

Why should the mere bankruptcy of Lehman cause such concern in the financial community, if it is composed of competent traders, trading and risk managers? Are we in such short supply of competent financial service executives that this is really an issue?

I don't recall this sort of concern when Drexel Burnham Lambert was pushed into dissolution. Why is it so different, and more urgent, now?

Have non-exchange trading markets really grown so large and risky that any counterparty's demise will cause a systemic disaster?

Sunday, September 14, 2008

Fannie's & Freddie's Subordinated Debt

I witnessed an interesting exchange on CNBC last week between Pershing Square Capital hedge fund owner William Ackman and PIMCO's bond fund manager Bill Gross.

Ackman had just finished enumerating the points in his proposed plan to address Fannie's and Freddie's plights. Notable among his ideas were to convert some bondholder debt to equity, along with issuing long-dated puts for the equity. But Ackman stated that the subordinated debt was never meant to be guaranteed by the Federal government, as the products of the two GSEs were.

Gross spoke following Ackman and clearly expressed his belief that the principal of the subordinated debt of the two GSEs, of which his bond fund holds large amounts, was, indeed, guaranteed.

And that was the further subject of Thursday's lead Wall Street Journal editorial, "Bailout for Billionaires."

It's one thing, and appropriate, for the Treasury to reiterate the guarantee on securitized instruments issued by Fannie and Freddie. It's an entirely different matter for it to now extend its risk-removing support to subordinated debt which carried a higher initial yield, thanks to its riskier status, relative to senior debt.

As the Journal editorial pointed out, in support of the view that investors generally believed the subordinated GSE debt to be unguaranteed,

"And, indeed, as investor anxiety grew this summer over the fate of the two companies, the spread between the price of Fannie subordinated debt and U.S. Treasurys widened enormously. Investors feared a sub-debt wipeout."

Meaning that investors did not consider the subordinated debt to be guaranteed.

Paulson's actions in support of the subordinated debt holders has caused some traders to waggishly joke that he's the Secretary for the Chinese Treasury, rather than, or in addition to, that of the United States.

Jokes aside, this was one aspect of the Fannie and Freddie takeover that was unnecessary, expensive and sent a shockingly bad signal to investors.