Saturday, October 18, 2008

Cramer On US Sovereign Investing

Leave it to Jim Cramer to accuse the US of sovereign investing, but get it wrong. And further claim it was his idea first. Then nearly break his arm patting himself on the back about it.

All yesterday morning, CNBC played clips of the grinning, bald former hedge fund maven claiming that he had personally first come up with the idea of the US Treasury investing in several commercial banks, so to restore investor, depositor and borrower confidence in them.

Cramer then pronounced this concept 'US sovereign fund investing.'

Sorry, Jim. You evidently don't understand the concept of sovereign investing.

The idea is typically for a wealthy country to organize a fund, by which they invest in businesses of another country. Hopefully, for long term profits.

Treasury's mandatory investment in nine large US commercial banks, and, subsequently, many smaller ones, is to provide stabilizing capital, against which the banks are supposed to write off or sell questionably-valued CDOs or loans.

The primary object of the investments is to provide capital which nobody else stands ready to invest. Whether taxpayers will profit, beyond the rate of interest paid on the preferred, is anybody's guess.

But conventional sovereign investing, it isn't.

Maybe you should read up on how foreign governments actually operate their sovereign wealth funds, Jim. I don't think they use them to avoid the dissolution of their own banking systems.

Friday, October 17, 2008

Oil Price Drop Is But A Footnote In The News

Who would have thought that when oil finally dropped below $70/bbl, it wouldn't be headline news?

It's a testament to the suddenness and depth of the current financial market crisis, and its wider economic effects, that plunging commodity prices have become a footnote in today's business news.

As we listen to the usual stream of economists and economist-wannabes forecasting a US recession for the umpteenth time in twelve months, it's worth noting something I heard on CNBC this morning.

One guest observed that $150/bbl oil didn't actually bring on a US recession last year. We may be in a recession by year's end, but, on current data, we are not.

With oil now below half the price of that which had most economists screaming that recession was 'already here,' etc., should we continue to expect a looming, deep US recession?

It takes little imagination to understand that when most Americans have seen a 30% drop in the value of their net worth which is invested in equities, and some have also seen the value of their home drop significantly, they will feel poorer. And as such, they will likely spend less until they don't feel they are getting even poorer, still.

Nobody actually knows how long or deep a recession into which we may have finally just entered will be.

There are still differences of opinion as to whether inflation will now be muted. Some say it will, due to commodity price declines and the rapid evaporation of trillions of dollars of asset values. Who would have guessed that a tonic for recent commodity price spikes would be the sudden loss of global dollars by the simple fact of equity values dropping like a stone last month and so far in this one?

It's a strange new world, indeed, with such rapidly-moving and overwhelming economic and financial forces at work.

With all the comparisons of our current economic situation to that of the US in 1929-1940, especially by one novice Presidential candidate, you might be tempted to expect a "lost decade" of economic growth in the US.

However, that's unlikely. In fact, I could, and would, argue that the same forces of technology and information which propagated such a sudden, huge impact on financial markets and worldwide economies will also work in reverse.

It's not 1929 anymore. Governments operate with more financial and economic information. So, too, do investors. Flows of capital, trade, etc., all move at the speed of electrons. The linkages of data, expectations and consequential actions are all much tighter and faster 80 years on.

If anything, any coming recession is likely to be milder and shorter than the average expectations of both economists and US citizens.

Current Market Volatility

Among the readers of my blog, I found that yesterday someone had come from this blog post, written in February of this year. Nevermind the novice level of the author's investing. What caught my eye was his view of my partner's and my development of a market volatility measure for use with options. He wrote, in part,

"I find C Neul’s description of how they found a new indicator of the market direction kind of suspect, in the way that one retrofits and backtests ideas against a particular sample to use as a new indicator of future direction. Then again, I’m not a fan of any kind of technical analysis, which this clearly is. But the surety of how he describes this measure (”standard deviation of daily total returns of the index”) as a way to make predictions about future moves is what I find least appealing — for a “skeptic”, he sure seems pleased with the new measure, that happens to fit his specific sample. Still kind of amazed that professionals do this, but I suppose if everyone took my stance the shell game would fall apart."

I learned quite a few years ago that any successful equity portfolio management process has to have some link to the market. If portfolio management is done in isolation, it inevitably leads to buying and holding equities when there is simply no way to earn positive total returns. Sometimes for periods as long as two or more years.

To avoid emotionally-based decisions, some sort of 'technical' indicator is a good idea.

In our case, we determined that our equity risk management tools were insufficiently sensitive for use with equity options.

Thus, we chose to develop new tools.

The nearby chart displays the recent levels of the trailing standard deviation of daily S&P returns, which we have found to be extremely powerful in predicting certain market conditions of interest to us, as we manage equity derivatives portfolios.

The measure aptly captures the meteoric rise in S&P volatility just since Labor Day. Note, if you will, that we developed the measure in February. Since then, it has continued to capture volatility and work in conjunction with our other risk measure.

So, contrary to the other blogger's contentions, it has worked ex poste, as well as ex ante.

Seeking historical context, I applied our measure to the S&P500 from 1950 to the present in additional research conducted just last month. That nearby chart shows that the crash of 1987 was even more volatile than our current market situation- so far.

Extending the analysis back to 1928, via the Dow Jones Industrial Average, I found that the market volatility for that crash exceeded even that of 1987.

All of which is to state that the current equity market volatility is the third-highest in 80 years.

For our equity derivatives portfolios, that means a change in allocation. Having the historical perspective of this measure since 1928, we were able to calibrate absolute levels of the measure which correspond to allocation decisions for our derivatives strategy.

Further, we have historically-based expectations of how long the current period of extreme volatility is likely to last.

Buckle up for an extended ride.

Thursday, October 16, 2008

Designing Banking & Finance Systems for Real Human Behavior

With this week's nationalization of US commercial banks, via Treasury's purchase of $250B of preferred equity in a collection of the country's largest publicly-held financial institutions, we have the occasion of a radical redesign in our banking and finance sector.

Rather than do this willy-nilly, would it not be more sensible to articulate a blueprint for how banking and finance will, going forward, be organized and regulated so as not to allow a repetition of the last few years' harmful practices?

I outlined some thoughts on this topic in this recent post. In that post, my remarks were geared toward the design of a safe, nationalized core banking sector in the US.

There is a concept that I have only heard John Bogle, founder of the Vanguard Group, espouse. Within it are the seeds of both the recent financial markets crisis and its solution.

Bogle has observed that, to use my words, because I don't have his exact quote,

'Banking and finance cannot, in aggregate, over time, grow faster than the economy of which they are a part. Banking doesn't provide sustained, increasing added value over time beyond the growth rate of the economy.'

When (dumb) banking executives, and/or politicians, attempt to grow parts of the financial sector too fast, risk is typically assumed out of prior or reasonable proportions.

Further, that risk is almost always underpriced. Especially because when the risk begins to rise, it rises so far and so fast that almost no prior pricing could have anticipated it, and, if it had, it would have been prohibitively expensive.

Why not redesign the core banking sector to be that part of our nation's finance which is to remain ultra-safe, with little or no risk taken, and no excess profitability, due to risk, allowed.

With technology and market concentration of banking, we have probably crossed an important Rubicon years ago. Ben Bernanke's answer to a question at yesterday's lunch at the Economic Club of New York, where he spoke, did not, to me, seem to acknowledge the obvious.

Last November, I wrote this post upon seeing a CNBC interview with perpetual doomsayer and former Salomon Brothers economist, Henry Kaufman, on his 80th birthday. In that post, I referenced this post, written two weeks earlier. In it, I contended,

"As recently as 1996, when I was Research Director for then-independent financial services consultant Oliver, Wyman & Co., which is now the financial consulting division of Mercer Management Consulting, there were five independent credit card issuers (First Card, MBNA, Advanta, and two others whose names now elude me), a number of mutual fund companies, and several mortgage banks (Countrywide & Golden West, to name two), and retail discount brokers (Schwab, Quick & Reilly).

In the decade since, commercial banks, contrary to accepted financial theory that an investor can diversify his/her own holdings better than a company can do it for him/her, sought these types of businesses to attenuate variation in their reported earnings, as well as pursue the mythical 'cross sell' opportunity amongst various retail businesses.

The results have not been impressive, as I noted in this post two months ago.

The price that US consumers have paid for financial services innovation and cost reductions over the past five decades has been the concentration of many financial services into fewer, larger entities, which concentration has increased risks to the banking and credit system.

Failures such as First Pennsylvania Bank, Continental Bank, SeaFirst, and numerous banks weakened by loan losses, which were acquired during the 1980s and '90s, such as BofA, Shawmut, First Interstate, and a clutch of Texas energy-lending dependent banks, provide examples.

So, in conclusion, I'm not at all certain that Kaufman's warnings are even correct. Most of our financial system's largest failures have been committed by non-diversified banks or financial services companies.

In fact, one of the few benefits, besides technological innovation, that recent consolidation affords is larger capital bases with which to absorb the effects of mistakes.

Looking back over nearly 50 years of US financial system innovation and evolution, I think one could fairly say that the benefits we have enjoyed have far outweighed the realized risks that have accompanied such changes."

At this point, I think Bernanke would do well to accept that the speed with which financial markets can process data and trade, and, thus, the degree to which they have relied on large investments in information technology systems and software have been a significant factor in the concentration of financial assets in just a handful of large US banks.

This will not change now. So, yes, I believe, contrary to Bernanke's assertion, that each of those banks into which Treasury has invested some of its initial $250B is, indeed, 'too big to fail.'

Thus, the point of the title of this post, by combining historical trends in banking with John Bogle's observation.

Real human behavior is for CEOs of publicly-held companies to seek growth. Growth in revenues, profits, assets, market value and total returns to shareholders.

When banking and finance companies do this, they tend, in the aggregate, to increase systemic risk, if they succeed in growing faster than the long run growth rate of our economy.

What happens next is what has occurred in our financial system since Congress passed the CRA and pushed Fannie and Freddie to pass through subprime mortgages lent to low-income homeowners.

One way to remedy this is to take the largest portion of the sector, i.e., core banking functions, and nationalize the heck out of it with both choking regulation and government (societal) ownership.

These are the key elements of our money and banking system which, in aggregate, are, indeed, 'too important- and big- to fail.'

The remainder of the finance sector- loan companies, investment banks, hedge and mutual fund companies, etc., may still exist. And will, on balance, be too small to have their failures threaten the entire US banking and financial system.

But our current financial situation begs us to observe and acknowledge the obvious. Banking behavior as usual will only return us, eventually, to this same point.

So let's reimpose Glass-Steagall, de facto. And nationalize the ownership of our large, core banks and banking functions. Finally, regulate those nationalized banking functions to not lose money, but to provide strictly-followed lending guidelines to provide credit to the credit worthy.

Anything less only invites further abuse of risk-taking in banking and finance sometime down the road. It happened in 1929, but was avoided by decent, if not perfect, regulation, until the late 1990s, when it happened again.

Without meaningful, serious separation of core banking from risk-taking finance, we'll get there again- eventually.

Wednesday, October 15, 2008

The US Banking System: Flawed Past, Nationalized Perfect Future?

John Steele Gordon wrote a wonderful little historical piece, entitled "A Short Banking History of the United States," in last Friday's edition of the Wall Street Journal. It's subtitle was, "Why our system is prone to panics."

Among his observations on the post-Civil War financial sector are these,

"Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together. Overwhelmingly they were small, "unitary" banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.

The reorganization of the Federal Reserve and the creation of the Federal Deposit Insurance Corporation hugely reduced the number of bank failures and mostly ended bank runs. But there remained thousands of banks, along with thousands of savings and loan associations, mutual savings banks, and trust companies. While these were all banks, taking deposits and making loans, they were regulated, often at cross purposes, by different authorities. The Comptroller of the Currency, the Federal Reserve, the FDIC, the FSLIC, the SEC, the banking regulators of the states, and numerous other agencies all had jurisdiction over aspects of the American banking system.

The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment. Instead Congress made a series of quick fixes that made disaster inevitable.

In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size.

While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence."

Steele makes two very important points about the US banking system that many people fail to grasp.

First, he notes its historically-rooted structure of many small banks, in contrast to the rest of the world.

As recently as last night, I was discussing the evolving current nationalization of the US banking sector with friends at my fitness club. In one conversation, with an erstwhile 20-year Merrill Lynch veteran, I contended that a rapid, near-total consolidation of core US banking functions- deposit-taking, credit card and mortgage lending, trust, transactions processing and DDA accounts- would be the best thing for this nation's long-term financial health and stability.

Why? Because, as my brilliant former boss, and SVP of Corporate Planning & Development at Chase Manhattan Bank, used to explain,

'Few executives are prepared and equipped to run an entire company, let alone the diverse types of businesses which are part and parcel of a money center bank. We (at Chase) are stuck with, for the most part, ex-lending officers and accounting functionaries, promoted beyond their level of expertise.'

He was right, as I explained in this recent post. And this one, from October of last year.

So we see, courtesy of Mr. Steele's concise historical lesson, that the US relied on the existence of thousands of capable, experienced, seasoned bank CEOs to operate our core banking system.

Unfortunately, we haven't even managed to get those qualities in our average money center bank CEO. How in hell would you have expected, in the past, or expect in the future, this situation to radically change?

It won't.

As long as most of our country's banking assets and business volumes are scattered among even hundreds of banks, with private, risk-taking management, our country will be susceptible to the same financial panics as befell us in 1929 and, again, this year.

Simply put, you cannot have a system dependent upon an illusive, nearly non-existent resource: the well-informed, experienced, competent bank CEO. There simply are not sufficient, qualified business people available to staff each of hundreds of US banks. So allowing that many banks to exist is to invite the next financial panic, courtesy of thousands of bad credit and investment decisions on the part of hundreds of inept, boneheaded, mediocre small- and medium-sized bank CEOs.

Far better to so rigorously nationalize core banking via draconian regulation of allowable businesses, lending standards, etc., and government ownership of preferred shares, as to reduce this sector to a barely-disguised government-guaranteed conduit for safekeeping savings and making consumer mortgage and revolver loans.

Steele's second point involves his articulation of a hoped-for future US banking sector that is well-capitalized, with diversified, large money center banks under coherent, apolitical regulation.

I agree with him on all but the diversification issue. Yes, there is the broad range of businesses inherent in a Glass-Steagall era money center bank- deposits, credit cards, mortgages, installment loans, trust, cash management and transaction processing. But not: brokerage, securities underwriting, proprietary trading, corporate financial advisory.

Further, each of the classical Glass-Steagall era bank functions can be largely reduced to automated, pre-determined, quantitative standards with little or no room for subjective judgment.

To achieve a truly safe, well-regulated US core banking system, I believe you need the following:

-Most US banking assets in a few ultra-large financial utilities: Chase, Wells Fargo, BofA, perhaps Citigroup.

-Heavy regulation which removes any and all risk-sourced profits from the core banking sector.

-Federal government guarantee of all core banking businesses, i.e., deposits, credit card balances, mortgage balances, trust accounts. In short, by forcible, draconian regulation of lending and deposit-investment practices, the government will be able to insure all banking activity, because it will all be reduced to ultra-safe, near-riskless levels.

-All financial instruments which are allowed to be traded will be mandated to be done so via regulated exchanges. As such, counterparty risk, collateral and settlement will be explicitly and transparently managed, to reduce risk of ripple-effects from one counterparty's failure.

-Certain financial instruments would be prohibited, such as the securitization of any collection of underlying assets. Exchange-traded assets of all types would obviate the need for such 'asset backed' securities, when any investor could freely shop an exchange to buy credit card or mortgage assets for diversification purposes.

What's left will be the traditional province of private finance companies, investment banks, private equity shops and fund management companies.

Credit-risk expertise, asset management skill and other uniquely-held financial-service-related skills will be freely marketed in the private sector, either with 100% equity capitalization, or leveraged with private capital.

That's a financial sector in which you could place trust. Core banking functions would be safe, heavily-regulated and totally guaranteed by society, i.e., our government. Riskier financial functions would be totally firewalled from core banking and well-capitalized. Trading of financial instruments would be safely confined to exchanges.

Tuesday, October 14, 2008

Some Observations On The Current Financial Market Crisis

There is so much one could write about the events of the last week in our financial markets. And, no doubt, in weeks to come, I'll touch on many of them, in retrospect.

This morning, however, I have a collection of reflections I'd like to convey.

The first is my reaction to an article discussing the MUFJ rescue of Morgan Stanley. In this morning's Wall Street Journal, there is a long piece purporting to describe how, now that it has linked itself to MUFJ, Morgan Stanley and it's embattled CEO, John Mack, can go about 'repairing' its financials and 'righting' itself.

C'mon, who are they kidding?

Mack mismanaged the one-time investment bank, now newly-minted commercial bank, into near-oblivion. If Morgan Stanley had been perceived by regulators as the same sort of buccaneers as Lehman, with an equally-dislike able CEO as Fuld, and as narrow a range of businesses, it, too, might already be out of business.

Is it too much to ask people to realize that, despite the fresh capital, the same boneheads are in place at Morgan Stanley? The gang that brought them to the brink of insolvency are now recharged with more billions to squander.

No, I'm not arguing that we tank the international financial system to punish Mack and his mismanagement team.

Rather, let's not all lose perspective with respect to the firm. A large, slow-moving, capital heavy foreign bank has rescued the brand franchise of a once-storied American investment bank. It would be surprising if Morgan Stanley doesn't meet the same fate as its erstwhile competitor, First Boston Corporation, now merely a fragment of CSFB.

The fact is, what were, some twenty years ago, fast-moving, lightly-capitalized underwriters, M&A advisers and corporate financial advisers, with smallish, client-oriented trading operations, became unsustainably-leveraged, thinly-veiled publicly-owned hedge funds.

Don't expect what is left of Morgan Stanley to be anything to write home about when it comes to future performance.

Now to my other thought for this morning.

Roughly 90 minutes ago, President Bush announced the expected headline measures that the US government will take, via the Fed, Treasury and FDIC, to join its European G8 and G20 allies in insuring inter-bank lending, business DDA balances, and forcibly taking non-voting, temporary equity positions in major banks.

Both Bush and his Treasury Secretary, Hank Paulson, emphasized how distasteful it is to them, personally, and, they believe, to most Americans for the government to be owning shares of otherwise-publicly-held companies.

It ostensibly flies in the face of our brand of free enterprise capitalism and free market ideology.

But, before we all visit a Jesuit retreat, self-flagellate, and wear hair shirts, let's remember how we got to this point.

Our financial markets are in the shape they are in because of government intervention and mandates on the free market.

We began nationalizing the financial sector when we created Fannie Mae and Freddie Mac. These institutions implemented Congress' force-feeding of capital markets with low-income borrower, low-quality residential mortgages. As time passed, Congress continually set the goal for securitized low-quality mortgages ever higher. As high as 50% of the GSE's pass-through volumes!

Then we have the CRA. Government mandated commercial banks to lend to poor credit risks for low-income housing. Again, we, through our government, already screwed around with our financial system.

We allowed our government to override private credit risk controls.

This isn't Act One of the nationalization of our financial system.

In reality, it's Act Two: The Cleanup.

What will Act Three be? Exit? Or 'fascism?' And I mean fascism, technically defined.

In any case, before we all moan and groan about this new nationalization of banking by a Republican administration, let's be honest.

Congress and two Presidents- Clinton and Bush- pushed our financial sector to make badly-considered loans for homes to people who were too poor to afford them.

That was the nationalization of our financial system.

Despite what many believe, 'Wall Street greed' simply fed into the system that the government had already set in motion.

Monday, October 13, 2008

Past Time To Close GM and/or Ford, Chrysler

The current financial markets panic has hit America's two remaining publicly-held auto makers hard.

Seen nearby are Yahoo-sourced price charts for Ford, GM and the S&P500 Index. The first chart covers 1977-present, while the second chart displays the last three months' performances.

My first predictions of a major sale/failure in the automobile sector were in this post and this post, exactly three years ago this month.

In the first post, I wrote,

"Judging from where GM and Ford appear to be putting much of their energies these days, I’d say we’re going to be shy at least one major US-based car manufacturer before the decade is out. It may involve a merger among onshore rivals, if Congress is afraid to let so many UAW workers lose their jobs at once through a total financial failure of GM or Ford. But I'm willing to bet there will be one less automotive CEO in Detroit when 2010 dawns."

I took credit for calling the Chrysler private equity acquisition with that post.

In the second post, I wrote,

"Lest you think that Lee Iacocca’s Chrysler experience demonstrates that a Big 3 automaker can save itself, let me remind you that it ultimately was acquired by Daimler-Benz. Iacocca didn’t save Chrysler, he merely delayed its day of reckoning by a decade or so.

I continue to believe that GM cannot save itself because its current leaders, beginning with Rick Waggoner, are products of the existing culture of 40+ years. It is not capable of creating lasting, profitable change for the long term, within two years, in how it designs, builds and markets vehicles. It may be acquired, or “merge,” to avoid an actual bankruptcy. But I still maintain that it will not be independent within two to three years from now."

This time, however, with the Wall Street Journal and CNBC reporting on hush-hush merger talks between GM and Ford, then Chrysler, my fuller vision is quite likely to be realized.

As the accompanying chart of some 30 years of performance illustrates, Ford and GM, the only two US car makers for which we have uninterrupted equity price series, both began a long, slow slide around 1999.

With this financial crisis nearly cutting off all auto purchase financing, it's quite likely curtains for at least one of these firms. Over the period, GM has actually lost net value, while Ford has managed maybe a doubling of share price, unadjusted for considerable inflation. The S&P has returned in excess of 1000%.

S&P has put both companies on credit watch, suggesting they are in danger of bankruptcy. Since they are consuming $1B in cash per month, and financing of even good credits is expensive and more difficult now than only a few months ago, investors should understandably wonder if both Ford and GM can survive as independent, solvent firms.

In a discussion with a friend and former senior executive of AT&T and other firms, as well as a former board member of at least one large technology firm, we agreed that both companies probably cannot, and should not, survive.

We both saw the horrific excess capacity in the sector. When I suggested that what should occur is that the profitable, growing models in both companies' product lines should be sold to healthier auto firms, and the remainder of the companies liquidated, he concurred.

We both felt that economic aid should be given to displaced workers, but not the companies themselves.

Let's face it. For at least three years, all three firms- GM, Ford and the once-independent Chrysler- have been living on borrowed time.

How much better for their shareholders would it have been for each of them to pursue a sale of profitable operations, and the closure of ailing ones, at least three years ago?

As it is, Ford and GM have lost half their value since June. How much more would investors have been spared if reality were to have been faced much earlier?

At what point is a board at least civilly liable for continuing to operate a publicly-held company that simply has no reasonable hope of consistently-profitable operations in the future? Especially when it was so obvious that the sector had- and has- excess capacity, and that Ford and GM were the high-cost producers with the worst designs of the lot?

It's high time that the salvageable parts of Ford and GM were sold to an auto company which can afford to run them, while the rest of the operations are closed while there is a small amount of shareholder value remaining. Or, if none is, they won't be so large a drain on American taxpayers and the firms' creditors.