Last weekend, I discussed a wide range of business and political topics with my business partner and a mutual acquaintance. The acquaintance has recently returned from living overseas for several years.
As such, he has a different perspective on some matters, including the popular business cable channel CNBC.
When I mentioned seeing someone on the channel, he quickly dismissed it as a joke outside of America, referring to it as an entertainment channel.
I actually agree with his assessment, and explained that I mostly watch/listen to it for some of the guests, and to learn of breaking news, rather than to pay attention to any- except perhaps 2 or 3- of the network's on-air personnel.
With this conversation in mind, I listened in shock to this morning's discussion among several guests, guest host John Sununu, and the ever-nonsensical 'economics reporter' for the network, Steve Liesman.
The subject was whether recent extreme equity volatility would drive an entire generation of investors away from investing in the equity markets.
As usual, Liesman's views were unsubstantiated and mostly irrational. He breathlessly claimed that seeing 10 percentage point moves daily in individual equity prices might cause current investors to flee that market forever, thus damaging America's capital markets in the process.
Fortunately, the other participants in the discussion were much more level-headed and realistic. One of them, an institutional equity investor, noted that equities are what they are, and maybe some investors shouldn't be buying and holding them, if what they really seek is a bond-like return.
That's a very fair point. In fact, only a few weeks ago, on CNBC, John Bogle, the venerable and sensible founder of the Vanguard Group, noted that his rule of thumb is that people should have their portfolio in fixed income in roughly the same percentage as their age in years. That way, he observed, they rely less on volatile equity returns as they near retirement age, but can take advantage of the long term, superior returns to equities, with greater risk, during the earlier years when those assets can be held relatively passively.
Only once did someone actually note that the current volatility levels are likely to be temporary.
To me, this was the really unfortunate aspect of the entire verbal exchange. Other than Liesman being in it at all.
My partner's and my proprietary equity volatility measure has been recently approaching levels not seen since the crash of 1987, and only a little further below the measure's all-time peak in October, 1929.
However, in both earlier crises, the extreme volatilities only persisted for a month or so. Each prior experience graphically approximates a symmetric, normally-shaped curve. By the following Februarys of 1930 and 1988, equity volatility levels had fallen to levels typically associated with long-run, healthy markets.
The truth is, the current intra-day and inter-day volatilities are unlikely to persist. There are real, identifiable reasons for the former right now. It is institutional selling to prepare for redemptions- of both mutual and hedge funds.
We know, too, that so long as equity values remain uncertain, and suspected to decline further, investors are continuing to move out of equities and onto the market's sidelines, in cash.
If you think about it, disciplined individual investors shouldn't be all that worried. Mutual or index funds relieve investors of the risks of competing with professionals, and individual investors shouldn't be timing the market, anyway.
Further, there are EFT counterparts for most mutual funds, allowing investors to execute sales instantly, rather than only at the market close price.
If current volatility were a constant feature of our equity markets, then, as capital allocators, they could not function. But recent, current, and probably near-term future equity market volatility is a direct function of a confluence of some of the worst financial market and economic conditions in more than 20 years.
Nobody in his or her right mind expects such volatility to either continue indefinitely, or to be the basis on which to choose investment vehicles over long time periods.
Friday, October 31, 2008
Bill Ackman's Ambitious Plans for Target
Yesterday's Wall Street Journal contained an article describing hedge fund manager William Ackman's ambitious plans to cajole the board and senior management of retailer Target Corp. into spinning its real estate into a separate REIT.
Ackman was stumping the plan on CNBC that morning, as well, assuring one and all that Target, as a tenant, would never default, so the REIT would be totally safe.
Here's what the Journal piece had to say about Ackman's plan,
"Mr. Ackman, whose Pershing Square Capital Management owns just under 10% of the Minneapolis-based retailer, says that Target has a huge real-estate company buried inside a retailer that isn't properly valued by the stock market. Target owns the land under 85% its 1,680 stores, the highest percentage of any retailer.
In a statement, Target said that it hadn't reached any conclusion on the proposal, but said its analysis of "similar ideas," conducted with advisers Goldman Sachs Group Inc., "raises serious concerns," including the validity of Mr. Ackman's assumptions about the valuation of Target and the separate REIT entity.
Target also said it is worried about the large expense of lease payments, which are subject to annual increases, plus the adverse effect the company believes the structure would have on its debt ratings, which presently stand at single-A. The retailer said it may respond to the plan "in the near future."
Other potential benefits to shareholders of a spinoff, he said, include a reduced tax burden for Target. A REIT is exempt from paying federal income taxes as long as it distributes 90% of its earnings to shareholders through dividends. For Target, foregoing those several hundred million dollars in taxes would boost cash flow and earnings, Mr. Ackman insisted.
He also argued that the combined values of Target and its REIT would likely be greater than Target's current market value because of the tax savings and the stability of Target as a tenant for the REIT.
If enacted, Mr. Ackman's proposal could cause debt-rating agencies to lower Target's credit ratings because of land transfers to the REIT, said Ee Lin See, a debt analyst with Credit Suisse."
As it happened, I ran into an old friend this morning at my fitness club. BW is a retired retail executive and consultant who spent his entire career in the business. I asked him if he had heard of Ackman's proposal. Not recalling his exact quote, I can paraphrase BW's response as follows,
'Yes, I read it in today's Journal. It's more grab and run. He'll drain the real estate value from Target, load it up with debt, and ruin it.'
Since I don't have operating experience in the sector, and BW does, I asked him, for argument's sake, how it was that a retailer could be so marginally profitable as to be driven into bankruptcy, over time, when forced to pay rent for land it now probably does not charge back for to each store.
BW explained the operating model for big box anchors like Target. Prior to ten years ago, he said, chains like Target were simply given the land beneath their stores by developers as an inducement to anchor a mall or shopping center. Such land, of course, has gained tremendously in value, albeit somewhat less so after the last twelve months.
Thus, he contended, all the major, older retailers operated without actually charging themselves for rent.
In response to my question about the effect of charging rent on Target's individual stores, BW did some quick math and estimated that a fair rent was roughly 3% of the total sales of a store, per year. He correctly estimated Target's gross margin to be roughly 35%. A quick look on Yahoo's page for Target gives a profit margin of about 4%.
Thus, adding rent into Target's cost base would, in fact, reduce its profitability quite a bit, on a percentage basis, from the current level.
So, essentially, Ackman is seeking to unlock and separately monetize years of real estate gains, while simultaneously making Target's operating model change to explicitly include the cost of leases in its income statement. Something it does not currently do. Nor, according to BW, do the other major retail chains so favored, as Target was, with gratis land for store locations.
Ackman would be able to reap gains from selling his fund's resulting REIT shares, and, then, also sell his fund's remaining Target operating company equity position, thus realizing instant profit from the underlying asset. It's a debatable question whether the new Target, stripped of low-cost land, would be as valuable over time. It might eventually lose as much, or more, than was monetized and siphoned out by the REIT.
I should also note that the Journal published a humorous piece in the past few days on this story involving a reporter who attended Ackman's New York presentation of the proposal.
Taken together- Ackman's CNBC appearance, the two Journal pieces and BW's comments- I find myself doubting that Ackman plans to continue holding Target equity in the proportion his fund currently does, statements on air notwithstanding.
This really does, as BW contends, look like the old 'lever them up and dump them' cash extraction of a classic leveraged buyout. And it appears that, rather than viewing their real estate as a passive accidental acquisition of no particular value to their operating model, Target's management realizes that it is, to the contrary, an important component of cost control.
Ackman was stumping the plan on CNBC that morning, as well, assuring one and all that Target, as a tenant, would never default, so the REIT would be totally safe.
Here's what the Journal piece had to say about Ackman's plan,
"Mr. Ackman, whose Pershing Square Capital Management owns just under 10% of the Minneapolis-based retailer, says that Target has a huge real-estate company buried inside a retailer that isn't properly valued by the stock market. Target owns the land under 85% its 1,680 stores, the highest percentage of any retailer.
In a statement, Target said that it hadn't reached any conclusion on the proposal, but said its analysis of "similar ideas," conducted with advisers Goldman Sachs Group Inc., "raises serious concerns," including the validity of Mr. Ackman's assumptions about the valuation of Target and the separate REIT entity.
Target also said it is worried about the large expense of lease payments, which are subject to annual increases, plus the adverse effect the company believes the structure would have on its debt ratings, which presently stand at single-A. The retailer said it may respond to the plan "in the near future."
Other potential benefits to shareholders of a spinoff, he said, include a reduced tax burden for Target. A REIT is exempt from paying federal income taxes as long as it distributes 90% of its earnings to shareholders through dividends. For Target, foregoing those several hundred million dollars in taxes would boost cash flow and earnings, Mr. Ackman insisted.
He also argued that the combined values of Target and its REIT would likely be greater than Target's current market value because of the tax savings and the stability of Target as a tenant for the REIT.
If enacted, Mr. Ackman's proposal could cause debt-rating agencies to lower Target's credit ratings because of land transfers to the REIT, said Ee Lin See, a debt analyst with Credit Suisse."
As it happened, I ran into an old friend this morning at my fitness club. BW is a retired retail executive and consultant who spent his entire career in the business. I asked him if he had heard of Ackman's proposal. Not recalling his exact quote, I can paraphrase BW's response as follows,
'Yes, I read it in today's Journal. It's more grab and run. He'll drain the real estate value from Target, load it up with debt, and ruin it.'
Since I don't have operating experience in the sector, and BW does, I asked him, for argument's sake, how it was that a retailer could be so marginally profitable as to be driven into bankruptcy, over time, when forced to pay rent for land it now probably does not charge back for to each store.
BW explained the operating model for big box anchors like Target. Prior to ten years ago, he said, chains like Target were simply given the land beneath their stores by developers as an inducement to anchor a mall or shopping center. Such land, of course, has gained tremendously in value, albeit somewhat less so after the last twelve months.
Thus, he contended, all the major, older retailers operated without actually charging themselves for rent.
In response to my question about the effect of charging rent on Target's individual stores, BW did some quick math and estimated that a fair rent was roughly 3% of the total sales of a store, per year. He correctly estimated Target's gross margin to be roughly 35%. A quick look on Yahoo's page for Target gives a profit margin of about 4%.
Thus, adding rent into Target's cost base would, in fact, reduce its profitability quite a bit, on a percentage basis, from the current level.
So, essentially, Ackman is seeking to unlock and separately monetize years of real estate gains, while simultaneously making Target's operating model change to explicitly include the cost of leases in its income statement. Something it does not currently do. Nor, according to BW, do the other major retail chains so favored, as Target was, with gratis land for store locations.
Ackman would be able to reap gains from selling his fund's resulting REIT shares, and, then, also sell his fund's remaining Target operating company equity position, thus realizing instant profit from the underlying asset. It's a debatable question whether the new Target, stripped of low-cost land, would be as valuable over time. It might eventually lose as much, or more, than was monetized and siphoned out by the REIT.
I should also note that the Journal published a humorous piece in the past few days on this story involving a reporter who attended Ackman's New York presentation of the proposal.
Taken together- Ackman's CNBC appearance, the two Journal pieces and BW's comments- I find myself doubting that Ackman plans to continue holding Target equity in the proportion his fund currently does, statements on air notwithstanding.
This really does, as BW contends, look like the old 'lever them up and dump them' cash extraction of a classic leveraged buyout. And it appears that, rather than viewing their real estate as a passive accidental acquisition of no particular value to their operating model, Target's management realizes that it is, to the contrary, an important component of cost control.
Thursday, October 30, 2008
Your New Bank: Goldman, Morgan Stanley or GMAC?
If I tell you that tomorrow I intend to become a steel company, will that actually make me a competitor of Posco and Nucor?
Of course not.
When Lloyd Blankfein and John Mack changed their firms from investment banks to Federally-chartered bank holding companies, did that actually make them commercial banks?
No.
And, parenthetically, despite Wednesday's Wall Street Journal piece detailing GMAC's bid for Federal aid via a bank charter, the auto maker's finance arm won't magically become a real bank, either.
In two separate articles that day, the WSJ discussed the prospects for all three firms as commercial banks, rather than their former incarnations.
GMAC, of course, is simply searching for a way to feed at Treasury's bailout trough, as if the direct Federal "loan" to its nearly-dead parent is not sufficient. To suggest the auto loan and mortgage finance company could really function as a full-service bank, and profitably, is ludicrous.
But it does highlight the ingenuity of Americans. When our government ladles out cash, we figure out how to qualify in a flash.
Goldman Sachs and Morgan Stanley have more options, because they aren't really dead yet.
Goldman's Blankfein displayed his chutzpah by offering to merge with Citigroup, if novice CEO Pandit would kindly step aside and let the veteran investment bank's management run things.
Rumors swirled about a Morgan Stanley-Citigroup merger, too, with the alleged common heritage of Citigroup's CEO and the investment bank supposedly greasing the deal.
Truth is, as the WSJ article about them hinted, but failed to describe in detail, merely saying they are now commercial banks does not, by any stretch, make Goldman Sachs and/or Morgan Stanley commercial banks.
Can you imagine a Goldman staffer guiding you through a consumer loan or credit card application? Handling your electronic transfer or opening a safe deposit box for you?
Me neither.
In fact, as the Journal piece suggested, these two late converts can't really be commercial banks in any meaningful, consistently profitable way, so long as they remain as bloated, publicly-owned hedge funds.
Sooner or later, the Fed will force them to shrink or spin off those assets which make them, well, too risky to be a commercial bank in these times. What's left at either company is essentially asset management, some trading and underwriting.
No credit cards. No mortgages. No consumer loans. No transactions processing businesses. No basic commercial loan businesses.
That's why Blankfein and Mack, being smarter than the average real commercial bank CEO, are looking to infect/invade an old-line money center or regional bank much as a virus invades its host.
Rather than buy and bolt on, for example, Capital One, a medium-sized deposit-taking bank, and some out-of-work mortgage, consumer and commercial loan officers, it would be far easier for Goldman to merge with the likes of Citigroup or even PNC. The former, ailing as it is, might accept the marriage as a way to further disguise its true lack of progress on returning to health, while the latter could be vaulted into the ranks of high finance overnight.
Either way, if Goldman and Morgan Stanley don't soon sell themselves to some decent-sized banks, or buy various consumer loan and deposit-taking operations, they will lose their independence as federally-chartered entities the harder way, in forced marriages arranged for them.
Of course not.
When Lloyd Blankfein and John Mack changed their firms from investment banks to Federally-chartered bank holding companies, did that actually make them commercial banks?
No.
And, parenthetically, despite Wednesday's Wall Street Journal piece detailing GMAC's bid for Federal aid via a bank charter, the auto maker's finance arm won't magically become a real bank, either.
In two separate articles that day, the WSJ discussed the prospects for all three firms as commercial banks, rather than their former incarnations.
GMAC, of course, is simply searching for a way to feed at Treasury's bailout trough, as if the direct Federal "loan" to its nearly-dead parent is not sufficient. To suggest the auto loan and mortgage finance company could really function as a full-service bank, and profitably, is ludicrous.
But it does highlight the ingenuity of Americans. When our government ladles out cash, we figure out how to qualify in a flash.
Goldman Sachs and Morgan Stanley have more options, because they aren't really dead yet.
Goldman's Blankfein displayed his chutzpah by offering to merge with Citigroup, if novice CEO Pandit would kindly step aside and let the veteran investment bank's management run things.
Rumors swirled about a Morgan Stanley-Citigroup merger, too, with the alleged common heritage of Citigroup's CEO and the investment bank supposedly greasing the deal.
Truth is, as the WSJ article about them hinted, but failed to describe in detail, merely saying they are now commercial banks does not, by any stretch, make Goldman Sachs and/or Morgan Stanley commercial banks.
Can you imagine a Goldman staffer guiding you through a consumer loan or credit card application? Handling your electronic transfer or opening a safe deposit box for you?
Me neither.
In fact, as the Journal piece suggested, these two late converts can't really be commercial banks in any meaningful, consistently profitable way, so long as they remain as bloated, publicly-owned hedge funds.
Sooner or later, the Fed will force them to shrink or spin off those assets which make them, well, too risky to be a commercial bank in these times. What's left at either company is essentially asset management, some trading and underwriting.
No credit cards. No mortgages. No consumer loans. No transactions processing businesses. No basic commercial loan businesses.
That's why Blankfein and Mack, being smarter than the average real commercial bank CEO, are looking to infect/invade an old-line money center or regional bank much as a virus invades its host.
Rather than buy and bolt on, for example, Capital One, a medium-sized deposit-taking bank, and some out-of-work mortgage, consumer and commercial loan officers, it would be far easier for Goldman to merge with the likes of Citigroup or even PNC. The former, ailing as it is, might accept the marriage as a way to further disguise its true lack of progress on returning to health, while the latter could be vaulted into the ranks of high finance overnight.
Either way, if Goldman and Morgan Stanley don't soon sell themselves to some decent-sized banks, or buy various consumer loan and deposit-taking operations, they will lose their independence as federally-chartered entities the harder way, in forced marriages arranged for them.
Washington Impedes A Financial Sector Recovery
Gordon Crovitz writes a weekly editorial column in the Wall Street Journal entitled "Information Age." On Monday, it was entitled, "Credit Panic: Stages of Grief," and it dealt with how are Federal government is actually prolonging the healing of our financial markets by its explicit denial of its own role in starting the mess.
Specifically, Crovitz writes,
"This matters because regulatory denial is suppressing confidence in markets, especially now that the country's financial capital is in Washington, not in New York."
Crovitz notes the House grilling of Greenspan and their attacks in hearings on rating agency executives, while ignoring their own culpability. He continues,
"Politicians of all parties thrive by shifting blame. Congress has not even held hearings yet in the area where it is most clearly responsible: social engineering through banking by pumping mortgages to unqualified borrowers via Fannie Mae, Freddie Mac and laws that require banks to make bad loans. Hearings are promised after the election."
Don't hold your breath on that one.
Citing Robert Higgs and Amity Schlaes' works, Crovitz reminds us of a still-ignored truth. That is, FDR prolonged the Great Depression with his 'regime of uncertainty.' Both authors have recently published works noting that confiscatory tax rates, crowding out of private investment by public fiat and takings caused private capital to flee the economy. This led to an extended Depression.
Rather than be lauded as the hero who pulled us out of the Depression, FDR was, in reality, a ham-handed economic mis-manager.
Crovitz maintains, reasonably, that Washington's failure to assure clarity and transparency in many of the modern financial instruments- swaps, derivatives and structured financial instruments- resulted in market-damaging uncertainty.
He closes by contending,
"A proper role for government is to require better disclosure of information. This would help balance risks and rewards. Just as in the 1930's, more transparent information would restore trust in financial markets, both in Washington and on Wall Street. If Washington can catch up to the private sector in admitting its mistakes, we can move beyond the credit crisis and forward to restore stability, with an end in sight to the current cycle of grief."
I believe Crovitz is correct. Unfortunately, I don't see it happening if the current Congressional majorities remain.
Specifically, Crovitz writes,
"This matters because regulatory denial is suppressing confidence in markets, especially now that the country's financial capital is in Washington, not in New York."
Crovitz notes the House grilling of Greenspan and their attacks in hearings on rating agency executives, while ignoring their own culpability. He continues,
"Politicians of all parties thrive by shifting blame. Congress has not even held hearings yet in the area where it is most clearly responsible: social engineering through banking by pumping mortgages to unqualified borrowers via Fannie Mae, Freddie Mac and laws that require banks to make bad loans. Hearings are promised after the election."
Don't hold your breath on that one.
Citing Robert Higgs and Amity Schlaes' works, Crovitz reminds us of a still-ignored truth. That is, FDR prolonged the Great Depression with his 'regime of uncertainty.' Both authors have recently published works noting that confiscatory tax rates, crowding out of private investment by public fiat and takings caused private capital to flee the economy. This led to an extended Depression.
Rather than be lauded as the hero who pulled us out of the Depression, FDR was, in reality, a ham-handed economic mis-manager.
Crovitz maintains, reasonably, that Washington's failure to assure clarity and transparency in many of the modern financial instruments- swaps, derivatives and structured financial instruments- resulted in market-damaging uncertainty.
He closes by contending,
"A proper role for government is to require better disclosure of information. This would help balance risks and rewards. Just as in the 1930's, more transparent information would restore trust in financial markets, both in Washington and on Wall Street. If Washington can catch up to the private sector in admitting its mistakes, we can move beyond the credit crisis and forward to restore stability, with an end in sight to the current cycle of grief."
I believe Crovitz is correct. Unfortunately, I don't see it happening if the current Congressional majorities remain.
Wednesday, October 29, 2008
Selling At The Peak: Blackstone's Schwarzman
In yesterday's post, I related some of the conversation I had recently with an acquaintance who works as a manager at one of the three rating agencies.
With respect to Blackstone's IPO, I found this post from a date just prior to the event, in June of 2007. The accompanying chart confirms this with a beginning date of BX's price chart in July of last year.
Besides fixing the date of the IPO, my post noted some of the strategies Schwarzman and his colleagues employed to quell any effective questions from financial analysts regarding the valuation of the firm's assets as it sold part of itself to the public. 
Here's the five year price chart for the S&P500 Index. The recent peak for the price series is clearly in mid-2007. There were two similar 'tops,' one in June, and the other just after September.
As he and I parted company, we were talking about the excessively short-term nature of investment bank compensation. On that theme, I mentioned Blackstone's IPO of last year.
Now, to be completely candid, I couldn't recall exactly when Steve Schwarzman took his private equity firm semi-public. I knew that I wrote a series of posts about the momentous event. But I couldn't accurately place in which month the firm sold its IPO in 2007.
This being the case, I was merely conjecturing when I told my colleague that I'd bet, if you looked, that Blackstone's IPO was at or near the top of the S&P500 Index.
Call me cynical. Or sceptical, which I think is more appropriate. Sometimes, they are the same. Like in this instance.
I know this sounds contrived, but it's really true. I was conjecturing without having checked either a chart of the last few years of the S&P or the actual date of Blackstone's IPO.
Besides fixing the date of the IPO, my post noted some of the strategies Schwarzman and his colleagues employed to quell any effective questions from financial analysts regarding the valuation of the firm's assets as it sold part of itself to the public.
Here's the five year price chart for the S&P500 Index. The recent peak for the price series is clearly in mid-2007. There were two similar 'tops,' one in June, and the other just after September.The next chart, a two-year view of the S&P500 Index price series, more clearly identifies the peaks as July and October.
Tuesday, October 28, 2008
More Trouble Ahead for the S&P Ratings Group?
Back in August- which now seems like an eternity ago- I wrote this post regarding two Wall Street Journal pieces of several weeks earlier. The articles focused on Terry McGraw, CEO of McGraw-Hill, and the company's evolving woes from its S&P ratings unit.
A quote from one of the WSJ articles which was pointedly repeated by some House member in a committee session last week involving rating agency executives was this pair of comments from an email, and its reply, between S&P staffers,
"We should not be rating it."
"We rate every deal......it could be structured by cows and we would rate it."
It seems that each major financial crisis has one or more signal phrases or quotes associated with it. Surely, this pair of email fragments is likely to be among those for this crisis.
Last night, I ran into an acquaintance who is a manager at one of the ratings agencies. In order to protect his identity, I won't divulge with which agency he is connected.
We had another in what has been a series of interesting discussions over the course of the summer and fall. This time, with last week's Congressional grilling of executives from his sector still fresh, our conversation seemed more emotional.
I suggested that Terry McGraw could well be on the way out in twelve months. On the basis of those August WSJ articles, alone, questions will be asked, and pressure will be applied to make S&P's parent pay a public price for its role in this financial mess.
My colleague noted that very few people realize just how powerful and unmovable, in the sector, S&P is. That they would have been insensitive to the evolving signs of stress in rated instruments, such as CDOs, because their market power is so great.
He told me the head of S&P's ratings unit during the past few years is already gone. Upon hearing this, I promptly suggested that this ex-S&P manager will, in all probability, wind up testifying before a Congressional committee next year, and will promptly roll and give up Terry McGraw as the instigator of the problem, due to pressure for growth and earnings.
My colleague agreed.
You'd have to be an idiot to not envision clever, eager young staffers for Democratic party Representatives and Senators compiling published material, e.g., those WSJ pieces, and assembling a fairly plausible theory that the heads of S&P, Moody's and Fitch pushed too hard for growth, abandoned prior ratings standards, and succumbed to pressure from their clients, the originating investment and commercial banks.
What was a bit surprising to me was my colleague's description of how investment bankers often successfully embarrass and humiliate agency analysts who cannot completely understand the complex instruments brought to them for ratings.
The result of this process has been, as is now clearly seen, the issuance of ratings by agencies on instruments which they either don't completely understand, or do understand, but yield to pressure from their banking clients, in exchange for fees.
My colleague and I then noted how this process insidiously aids the short-term focused bonus compensation at investment and commercial banks. It seems incomprehensible to many who do not work in financial services that what happened with the ratings of new CDO products can stem from something as simple as unbridled opportunism at issuing banks.
To understand this, consider the following example. If for a period of only three years, an investment bank's mortgage-backed securities business churns out record amounts of CDOs, bonuses can run into the low millions of dollars for quite a few mid-level managers. For most people, three years of $2-3MM bonuses, even after taxes, results in a sort of 'game over' financial position.
Regardless of the disposition of the enormous bonus pools paid out of the issuing profits on structured instruments rated by the agencies, the systemic damage was done.
Simply put, the issuing and trading profits on the most exotic instruments, which tend to be the most profitable, filtered their way through to the agencies which have been given special protections, in order to operate their oligopoly without anti-trust worries. Even in a sector with only three major players, someone will oblige an issuer flush with money, and provide the desired rating on an untested security.
As the largest of the ratings agencies, S&P is almost certainly going to become a target for Congressional fury. My colleague noted that more regulation is coming anyway. When I opined that perhaps protection from lawsuits would be removed, he quickly predicted that the business would vanish.
To which I replied that maybe that would not be a bad thing, or even a problem.
Do institutional investors really need ratings on large corporate credit? It's debatable. There's plenty of information available with which such sophisticated investors can assess risk.
The area where ratings really do provide value is in the municipal bond market. Of course, this is a sleepy, low-growth segment, which accounts for the push by MBIA, AMBAC and the ratings agencies into more exotic products in the first place, as I noted in this post.
Perhaps we'll have to see a radical transformation of the ratings business, now that it has publicly shown that it was for sale all along. Sort of like the tainted research of sell-side brokerages during the dot com equity bubble of a decade ago.
Not to mention, once it becomes clear to the public how the ratings business model works, the revulsion over how agencies are paid by the or issuer of the rated instruments.
Long ago, a friend who worked at S&P, but not in the ratings unit, told me a story about a multi-unit meeting he attended. At the meeting, one of the ratings staffers told what was obviously an old joke,
"What's the difference between piracy and the ratings business? Piracy is illegal."
Not a pretty picture for the average retail, or less-skilled institutional investor to envision.
It's a pretty sure bet that, one way or another, the ratings business, and some of its senior executives, are in for major changes in the years ahead.
A quote from one of the WSJ articles which was pointedly repeated by some House member in a committee session last week involving rating agency executives was this pair of comments from an email, and its reply, between S&P staffers,
"We should not be rating it."
"We rate every deal......it could be structured by cows and we would rate it."
It seems that each major financial crisis has one or more signal phrases or quotes associated with it. Surely, this pair of email fragments is likely to be among those for this crisis.
Last night, I ran into an acquaintance who is a manager at one of the ratings agencies. In order to protect his identity, I won't divulge with which agency he is connected.
We had another in what has been a series of interesting discussions over the course of the summer and fall. This time, with last week's Congressional grilling of executives from his sector still fresh, our conversation seemed more emotional.
I suggested that Terry McGraw could well be on the way out in twelve months. On the basis of those August WSJ articles, alone, questions will be asked, and pressure will be applied to make S&P's parent pay a public price for its role in this financial mess.
My colleague noted that very few people realize just how powerful and unmovable, in the sector, S&P is. That they would have been insensitive to the evolving signs of stress in rated instruments, such as CDOs, because their market power is so great.
He told me the head of S&P's ratings unit during the past few years is already gone. Upon hearing this, I promptly suggested that this ex-S&P manager will, in all probability, wind up testifying before a Congressional committee next year, and will promptly roll and give up Terry McGraw as the instigator of the problem, due to pressure for growth and earnings.
My colleague agreed.
You'd have to be an idiot to not envision clever, eager young staffers for Democratic party Representatives and Senators compiling published material, e.g., those WSJ pieces, and assembling a fairly plausible theory that the heads of S&P, Moody's and Fitch pushed too hard for growth, abandoned prior ratings standards, and succumbed to pressure from their clients, the originating investment and commercial banks.
What was a bit surprising to me was my colleague's description of how investment bankers often successfully embarrass and humiliate agency analysts who cannot completely understand the complex instruments brought to them for ratings.
The result of this process has been, as is now clearly seen, the issuance of ratings by agencies on instruments which they either don't completely understand, or do understand, but yield to pressure from their banking clients, in exchange for fees.
My colleague and I then noted how this process insidiously aids the short-term focused bonus compensation at investment and commercial banks. It seems incomprehensible to many who do not work in financial services that what happened with the ratings of new CDO products can stem from something as simple as unbridled opportunism at issuing banks.
To understand this, consider the following example. If for a period of only three years, an investment bank's mortgage-backed securities business churns out record amounts of CDOs, bonuses can run into the low millions of dollars for quite a few mid-level managers. For most people, three years of $2-3MM bonuses, even after taxes, results in a sort of 'game over' financial position.
Regardless of the disposition of the enormous bonus pools paid out of the issuing profits on structured instruments rated by the agencies, the systemic damage was done.
Simply put, the issuing and trading profits on the most exotic instruments, which tend to be the most profitable, filtered their way through to the agencies which have been given special protections, in order to operate their oligopoly without anti-trust worries. Even in a sector with only three major players, someone will oblige an issuer flush with money, and provide the desired rating on an untested security.
As the largest of the ratings agencies, S&P is almost certainly going to become a target for Congressional fury. My colleague noted that more regulation is coming anyway. When I opined that perhaps protection from lawsuits would be removed, he quickly predicted that the business would vanish.
To which I replied that maybe that would not be a bad thing, or even a problem.
Do institutional investors really need ratings on large corporate credit? It's debatable. There's plenty of information available with which such sophisticated investors can assess risk.
The area where ratings really do provide value is in the municipal bond market. Of course, this is a sleepy, low-growth segment, which accounts for the push by MBIA, AMBAC and the ratings agencies into more exotic products in the first place, as I noted in this post.
Perhaps we'll have to see a radical transformation of the ratings business, now that it has publicly shown that it was for sale all along. Sort of like the tainted research of sell-side brokerages during the dot com equity bubble of a decade ago.
Not to mention, once it becomes clear to the public how the ratings business model works, the revulsion over how agencies are paid by the or issuer of the rated instruments.
Long ago, a friend who worked at S&P, but not in the ratings unit, told me a story about a multi-unit meeting he attended. At the meeting, one of the ratings staffers told what was obviously an old joke,
"What's the difference between piracy and the ratings business? Piracy is illegal."
Not a pretty picture for the average retail, or less-skilled institutional investor to envision.
It's a pretty sure bet that, one way or another, the ratings business, and some of its senior executives, are in for major changes in the years ahead.
Monday, October 27, 2008
Art Laffer's Editorial In Today's WSJ
Economist Arthur Laffer wrote a notable editorial in today's Wall Street Journal entitled, "The Age of Prosperity Is Over."
It would be difficult to understate the sense of gravity that Laffer conveys in this piece. There's no way to adequately quote just a few of the passages and do the piece article justice.Perhaps one way to begin is to let the graphic accompanying the editorial, seen nearby, speak for itself. If I'm not mistaken, it is meant to portray the familiar 'Monopoly Man' in tatters.
Just the same, here are a few passages from Laffer's piece, to give you the main points in his argument,
"When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses.
No one likes to see people lose their homes when housing prices fall and they can't afford to pay their mortgages; nor does any one of us enjoy watching banks go belly-up for making subprime loans without enough equity. But the taxpayers had nothing to do with either side of the mortgage transaction.
But here's the rub. Now enter the government and the prospects of a kinder and gentler economy. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble, they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $130 billion in taxes, where the $30 billion extra is the cost of getting government involved.
If you don't believe me, just watch how Congress and Barney Frank run the banks. If you thought they did a bad job running the post office, Amtrak, Fannie Mae, Freddie Mac and the military, just wait till you see what they'll do with Wall Street.
The stock market is forward looking, reflecting the current value of future expected after-tax profits. An improving economy carries with it the prospects of enhanced profitability as well as higher employment, higher wages, more productivity and more output. Just look at the era beginning with President Reagan's tax cuts, Paul Volcker's sound money, and all the other pro-growth, supply-side policies.
The stock market is obviously no fan of second-term George W. Bush, Nancy Pelosi, Harry Reid, Ben Bernanke, Barack Obama or John McCain, and again for good reasons.
These issues aren't Republican or Democrat, left or right, liberal or conservative. They are simply economics, and wish as you might, bad economics will sink any economy no matter how much they believe this time things are different. They aren't.
The consequences of these actions were disastrous. Just look at the stock market from the post-Kennedy high in early 1966 to the pre-Reagan low in August of 1982. The average annual real return for U.S. assets compounded annually was -6% per year for 16 years. That, ladies and gentlemen, is a bear market. And it is something that you may well experience again.
Yikes!
Then we have this administration's panicked Sarbanes-Oxley legislation, and of course the deer-in-the-headlights Mr. Bernanke in his bungling of monetary policy.
There are many more examples, but none hold a candle to what's happening right now. Twenty-five years down the line, what this administration and Congress have done will be viewed in much the same light as what Herbert Hoover did in the years 1929 through 1932. Whenever people make decisions when they are panicked, the consequences are rarely pretty. We are now witnessing the end of prosperity."
Strong stuff, to be sure. And make no mistake, Laffer is an economic heavyweight. It is chillingly easy to see his predictions coming true with sickening results for the next 15 or so years.
Then, on the other hand, we have Brian Wesbury calling attention to 'internet time,' as I discussed in this recent post, which links to my original piece on Wesbury's observation, here.
To me, the question is whether Wesbury is correct, and voters will stop a second round of the socialization of the US economy- and society- which will make FDR and LBJ look like fiscal and social conservatives.
Or is Laffer correct, and US voters will cling to fear and government handouts, causing a long winter of economic sluggishness and the temporary- we hope- vanishing of the risk-taking, innovative economic behavior that so distinguishes the US economy?
I don't see Laffer's comparison of the current situation with Hoover from 1929-32. A much better one would be with FDR's NRA and, to some extent, the over-regulation of the US economy in the early 1970s- precisely when Laffer served in George Schultz's OMB. Perhaps, too, with elements of LBJ's large-scale, expensive social programs of the mid-1960s.
Laffer's piece does one really good thing. It reminds us of a possible, extremely bad economic result if the current financial and economic situations are resolved badly, with too much government control and spending.
Hopefully, reality will stop far short of Laffer's chilling prediction of doom. Perhaps due to the effects predicted by Brian Wesbury.
As I noted in a discussion with my business partner yesterday, no two financial or economic crises are ever identical.
In this case, the easily- and freely-available information both to and from average Americans, and, thus, among them, via the internet, short circuits much of the ability of government or a favorable, liberally-biased press to hide the truth.
Wesbury believes that this will create "real political pain" for the politician who gets it wrong.
Let's hope he's correct, so the full extent of Art Laffer's gloomy prediction never comes to pass.
Sunday, October 26, 2008
Sunday Odds & Ends
Here's the YouTube video of some 10 minutes of Alan Greenspan's testimony in front of a House committee on Thursday of last week. I wrote about his appearance here.
Of particular note is Greenspan's self-defense at minutes 3:45 and 9.
What's missing was Greenspan's ridiculous response to a question regarding his public support of ARM mortgages.
When asked about his public remarks, in the Q&A on Thursday, Greenspan actually said that, to understand his real feelings about ARMs, one should note that he personally has only ever held 30-year fixed rate mortgages. Thus, despite his public backing of ARMs as having the potential to lower borrowing costs for millions of other borrowers, the former Fed Chairman now claims you'd have to 'do as he did,' not 'do as he said.'
What's next? Will we learn that Fed board meetings were run like an 'Alan says' game?
In this weekend's Wall Street Journal, former senior Dow Jones executive and Pulitzer Prize winning author Paul Ingrassia wrote an extensive piece on the Detroit-based US auto maker's current straits.
Perhaps nothing conveys the trouble they are in as these two passages,
"It wasn't that American auto executives were always malicious and stupid while the Japanese were always enlightened and smart. Japanese car companies have made plenty of mistakes, most recently Toyota's ill-timed move into full-sized pickup trucks and SUVs. But just as America didn't understand the depth of ethnic and religious divisions in Iraq, Detroit failed to grasp -- or at least to address -- the fundamental nature of its Japanese competition. Japan's car companies, and more recently the Germans and Koreans, gained a competitive advantage largely by forging an alliance with American workers.
Detroit, meanwhile, has remained mired in mutual mistrust with the United Auto Workers union. While the suspicion has abated somewhat in recent years, it never has disappeared -- which is why Detroit's factories remain vastly more cumbersome to manage than the factories of foreign car companies in the U.S.
But to thrive, instead of just survive, Detroit will have to use the brains of its workers instead of just their bodies, and the UAW will have to allow it. Two weeks ago some automation equipment broke down at the Honda factory in Marysville, Ohio, but employees rushed to the scene and devised a temporary solution. There were no negotiations with shop stewards, no parsing of job descriptions. Instead of losing an entire shift of production, Honda lost just 150 cars. The person overseeing Marysville's assembly operations is Brad Alty, still with Honda after nearly 30 years. These days, instead of a Gremlin, he's driving a Honda Pilot -- made at a Honda factory in Alabama."
Paul makes a caustic remark about how crisis often breeds mistakes, which explains GM's pursuing a merger with the remnants of Chrysler. I think he's right on target.
Instead, he favors what I have suggested, which is the dismantling of the better GM brands into pieces which more successful car companies can absorb.
Of particular note is Greenspan's self-defense at minutes 3:45 and 9.
What's missing was Greenspan's ridiculous response to a question regarding his public support of ARM mortgages.
When asked about his public remarks, in the Q&A on Thursday, Greenspan actually said that, to understand his real feelings about ARMs, one should note that he personally has only ever held 30-year fixed rate mortgages. Thus, despite his public backing of ARMs as having the potential to lower borrowing costs for millions of other borrowers, the former Fed Chairman now claims you'd have to 'do as he did,' not 'do as he said.'
What's next? Will we learn that Fed board meetings were run like an 'Alan says' game?
In this weekend's Wall Street Journal, former senior Dow Jones executive and Pulitzer Prize winning author Paul Ingrassia wrote an extensive piece on the Detroit-based US auto maker's current straits.
Perhaps nothing conveys the trouble they are in as these two passages,
"It wasn't that American auto executives were always malicious and stupid while the Japanese were always enlightened and smart. Japanese car companies have made plenty of mistakes, most recently Toyota's ill-timed move into full-sized pickup trucks and SUVs. But just as America didn't understand the depth of ethnic and religious divisions in Iraq, Detroit failed to grasp -- or at least to address -- the fundamental nature of its Japanese competition. Japan's car companies, and more recently the Germans and Koreans, gained a competitive advantage largely by forging an alliance with American workers.
Detroit, meanwhile, has remained mired in mutual mistrust with the United Auto Workers union. While the suspicion has abated somewhat in recent years, it never has disappeared -- which is why Detroit's factories remain vastly more cumbersome to manage than the factories of foreign car companies in the U.S.
But to thrive, instead of just survive, Detroit will have to use the brains of its workers instead of just their bodies, and the UAW will have to allow it. Two weeks ago some automation equipment broke down at the Honda factory in Marysville, Ohio, but employees rushed to the scene and devised a temporary solution. There were no negotiations with shop stewards, no parsing of job descriptions. Instead of losing an entire shift of production, Honda lost just 150 cars. The person overseeing Marysville's assembly operations is Brad Alty, still with Honda after nearly 30 years. These days, instead of a Gremlin, he's driving a Honda Pilot -- made at a Honda factory in Alabama."
Paul makes a caustic remark about how crisis often breeds mistakes, which explains GM's pursuing a merger with the remnants of Chrysler. I think he's right on target.
Instead, he favors what I have suggested, which is the dismantling of the better GM brands into pieces which more successful car companies can absorb.
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