Friday, February 13, 2009

CNBC's "House of Cards" Program On Financial Excess

I just finished watching more than half of CNBC's special program, "House of Cards," written by, I believe, and starring David Faber.

The program was extremely well done. It captured various elements of the financial and real estate systems, regulators, their interactions, and the consequences of all of their actions over the past eight years.

Of particular effect, and interest, was the inclusion of European municipal investors in CDOs, the mortgage- and other debt-backed structured finance instruments, as well as lenders and borrowers of mortgage money fueling the manufacture of such instruments.

As I listened to the mayor of Narvik, Norway, accuse American banks, European financial products salesmen, and ratings agencies of misleading her, and her town council, so that they bought CDOs, I could not help but detect a strong odor of denial.

The woman clearly admitted that the financial products vendor told the town's council that CDO yields would be higher than that of safer instruments. They bought this lie, and even admitted, after the fact, that they had no idea what they actually had purchased. Neither did their banker, nor, the banker thought, did the salesman of the products.

If you're like me, by now, you are asking yourself how anybody can protect these clueless municipalities from buying instruments they don't understand. Or even actually know, in detail.

It's one thing to buy a AAA-rated American municipal or corporate bond. It's quite another to buy a newly-issued, untested structured finance instrument, also AAA-rated, the yield on which is higher than expected.

Several California home buyers admitted they neither understood, nor could afford their mortgages. Yet they still accused their lenders of guilt in lending them the money for their house.

A mortgage banker solemnly asserted that, although he knew low-doc and no-doc mortgages would blow up, he had to lend, or else he'd have to close down, as other lenders made such loans.

Of course, he had to close eventually, because the few low-doc subprime loans he made, when in default, wiped out his firm.

Even Alan Greenspan impassively claimed that he could not have popped the housing finance bubble if he'd wanted to, because Congress would have been unhappy with the resulting halt in low-income housing sales, as well as the consequential economic recession.

It seems everyone has someone else to blame.

But nobody seems to really take responsibility for their own part. Greenspan blames Congress. Congress blames mortgage bankers, securitizers, and regulators. Regulators blame a lack of funding from Congress. Investors blame rating agencies. Congress blames rating agencies. Rating agencies claim they did nothing wrong. Lenders blame borrowers and securitizers.

When Faber ends the program asking each person what they learned, and if they feel guilty of any wrongdoing, they all claim to simply be a part of a chain of players and events which, together, caused the problem. Nobody took responsibility for his or her part.

Even the mayor of Narvik somewhat disingenuously claimed that she had learned two things; not to trust financiers in Armani suits, and; if something seems to good to be true, it probably is.

The sad thing is, that second lesson is the very first lesson in finance. And why was the Narvik town council borrowing against the municipal power generation plant's future revenues to buy CDOs without professional advice in the first place?

But perhaps the most searing and revealing moment in the entire program, during the time I watched, was the last scene. Faber is closing his interview with the guy, whose name escapes me, who was head of structured financial product creation for Bear Stearns. The man wisely and propitiously left the firm just weeks before its demise, and now pursues photography. He clearly was not ruined in the aftermath of the failed investment bank.

When Faber asks him if he feels guilty for his role in the mess, the man moves to speak. But cannot. He looks away, snorts, shrugs, but Faber and the camera will not be denied.

Eventually, holding back obvious grief, guilt, and shame, trying desperately to decide, in an instant, whether to admit the truth on global television, or not, the man sniffs and says he was just part of a larger chain....yada....yada....yada......

It's a very poignant and sad moment. You can actually see this man choose denial, lying, and a loss of ethics in favor of avoiding responsibility for his and his firm's actions in the overall financial markets excess of the past decade.

There were and are many guilty parties. There's no doubt about that. But at the end of the day, I can't help but focus on two types of parties in particular.

Those who borrowed money to buy houses using mortgages they both did not understand, and could not afford. And those institutional investors, including small town mayors and councils in Europe and America, who bought what they believed to be high yielding structured securities, for less money than was expected, as I wrote about here, thinking they were getting extra yield for free.

Granted, those in the middle of the chain, between these two types of parties, committed fraud, excess, and errors of judgment. But none of it would have been sustainable without the uncoerced behavior of mortgage borrowers and structured financial instrument buyers. These parties received what they asked for.

What happened to them was, truly, just. They simply don't want to admit that, and take responsibility now for their prior actions. It's easier for them to blame somebody else.

Recalling Milton Friedman When We Need Him More Than Ever

These days, I'm probably not alone in missing the recently deceased economist Milton Friedman.

With so much seeming to go wrong in our economy, his voice of calmness, stability and personal responsibility is sorely missed.

For example, Friedman would have clucked at Alan Greenspan's ill-advised pumping of the money supply early in this decade, as well as the seemingly ad hoc flooding of more money via ever-lower rates under Bernanke for the past 15 months.

Instead, Milton would have counseled a steady growth in money supply at an automatic rate. This would have mitigated much of the housing boom excess and, thus, probably indirectly avoided the consequent real estate and mortgage-backed structured finance market collapses.

Along with his co-author, Anna Schwartz, it's quite likely Friedman would have correctly noted that liquidity was not the problem in our economy for the past year and a half. Rather, it was bank asset quality and solvency.

Finally, the Nobel laureate would doubtless have publicized the flaws in thinking behind the latest trillion-dollar "stimulus" package. Having close acquaintance with the economic facts of the Great Depression, Friedman would have argued for permanent tax cuts to affect the permanent incomes of taxpayers, rather than excessive government spending and temporary fiddling with tax rebates.

Further, he would have continued to champion government actions promoting individual freedoms, rather than mega-spending programs drawing even more power to politicians, and away from average citizens.

Maybe somebody can channel his spirit, pending his reincarnation.

Thursday, February 12, 2009

Readers "Express" Outrage At AmEx

On rare occasions, I follow up one of my posts due to reader comments. When a post is over a week old, the odds of comments on it being read by others declines markedly, absent the piece being found by direct searches.

Thus I found it interesting to draw attention back to this late January post concerning American Express' recent results and less-obvious actions regarding its customers.

Here are two comments on the anecdote concerning a colleague who was badly-treated by the credit card firm. The first comment contains an absolutely stunning account of credit management,

"Anonymous said...
Well they just did it to me. My credit line went from $13,000 to $1,800. It left one of my drivers stranded at a gas station out of town. Thank you Un-American Express."

And this one is on a par with the story in my post,

"Anonymous said...
My credit line was cut 40% for no reason. I haven't missed any payments and my business is growing. Bad leadership. Bad business."

Evidently, the credit limit shrinkage at AmEx is both real and widespread. Chances are good this will lead to even lower revenues and profits at the firm.

Anyone for shorting AmEx?

Carl Icahn On Boards, Governance & Compensation

Activist investor and former corporate raider Carl Icahn weighed in on executive compensation, boards and corporate governance again in this past weekend's edition of the Wall Street Journal. Building on the recent government-mandated restrictions on compensation for executives of banks receiving Federal investment, Icahn renewed his calls for corporate governance reform.

As he did in the editorial on which I commented in this post only a few weeks ago, Mr. Icahn writes scathingly of entrenched boards and executives. This time, he highlights his own organization, United Shareholders of America, urging readers to join it and him.

While I respect Mr. Icahn's accomplishments, attitudes and actions, the problem I continue to have remains what I wrote in the prior, linked post,

"It all sounds good, and very patriotic. But, really, just how do thousands of individual shareholders mount an attack upon a few members of the board of a large corporation?

Why isn't plain old share price the best investor weapon? Sell shares of companies you don't want. If enough shareholders do this, and other investors short the stock, the price will fall to a level that makes current management vulnerable; to creditors, predators, or simple liquidation, at which point some better management team swoops in to recover any salvageable value.

What's wrong with this scenario? Isn't it the ultimate in capitalist retribution? A poorly-run company simply loses value, until it no longer has capital with which to operate?"

I just don't see how shareholder maneuvering accomplishes anything, unless you happen to be able, like Mr. Icahn, to buy sufficient shares to challenge the board, gain a seat, etc.

But isn't this just exchanging one small group of controlling people for another? What if you don't happen to agree with Mr. Icahn on his choice of targets?

It just seems to me that really pure capitalism uses price- and little else- as the signal and weapon with which to discipline companies and their executives.

Isn't this process how it should work?

1. Company management entrenches itself while the board cooperates.
2. Management begins to enrich itself at shareholder expense, while business falters.
3. Business continues to weaken while executives continue to become wealthy.
4. Non-shareholders don't bid the company's equity up, while disgusted shareholders sell.
5. Equity price gradually, then more quickly, falls.
6. Executives can't raise fresh capital, losses mount, and firm becomes target for takeover.
7. Eventually, another company buys the ailing firm, or it files Chapter 11.

Short-circuiting this process via some sort of shareholder action seems, to me, beside the point. First, you're asking thousands of shareholders who don't know each other to agree on a common action.

It's one thing to want current management out. But what next? How do thousands of unacquainted company owners do this? They don't trust the board, but how do these thousands of individual owners assemble a workable new slate of directors?

It's feasible for Carl Icahn to do these things himself. He can amass large positions in target companies, assemble board candidates, and even articulate solutions for the company's ills. But that's not mass shareholder action. That's one wealthy activist or large fund manager behaving like Eddie Lampert.

How well is Sears doing since his takeover of the retailer?

Call me simple, but in my book, a liquid market with very low barriers to buying and selling shares is the best form of corporate governance.

Let equity prices do their work, and skip the heated arguments over more legislation and regulation over corporate boards and their actions.

Wednesday, February 11, 2009

Roy Smith On Investment Banking, Compensation & Greed

Former Goldman Sachs partner and current NYU finance professor Roy C. Smith wrote a lengthy piece in the weekend edition of the Wall Street Journal entitled, "Greed Is Good."

In his extensive piece, Smith paints the more complete and fair picture of the old Wall Street, a/k/a investment banks, compensation structure, in order to raise some warnings about the effects of the recent compensation caps, and predict some structural changes.

Among other points, Smith notes that many- perhaps thousands- of well-paid investment bankers at Bear Stearns and Lehman lost assets, jobs and companies. This, too, is part of the risk-taking environment which produced such lavish bonuses over the past few decades.

Smith also does a great job tracing the evolution of investment banking from when all of the firms were private partnerships. He, as I have done, notes the entry of commercial banks into traditional investment banking turf as the beginning of the end of the sector.

My mentor at Chase, Gerry Weiss, had predicted this years in advance. As the less-adept, more ham-handed commercial banks began to underwrite securities, margins shrank, volumes had to increase and instruments had to become more opaque in order to justify spreads and maintain revenues and profits.

Eventually, everybody levered up, and the once-private investment banks, having mostly gone public with the deregulatory "Big Bang" of the 1970s, mostly used other people's money to run much more risky businesses, while paying themselves healthy bonuses in good years.

Smith points out, with which I agree and have also stated, that the logical consequence of the recent vaporization of publicly-held investment banks, is a return to boutique, private partnership investment banking. The compensation caps really won't, by themselves, cause talent to leave the commercial banks for the private investment banks.

But they will set a tone that will probably trickle down. And, anyway, investment banking at a commercial bank simply isn't the same as doing it at a pure investment bank, even with the abolition of Glass-Steagal.

Smith endorses the practice of making large compensation payments vest over some years, in order to make them conditioned on continued profitability. Again, a topic on which I have written, in one form or another, for years. Specifically, I've recommended that large components of senior executive compensation be tied to outperforming the S&P500 over a five year period, in arrears. Thus, if performance lags, the payment in any given year for the prior five-year period shrinks. This is the sort of idea now gaining currency in the remaining publicly-held institutions having to grapple with this dilemma.

I like Smith's sense of history. He notes how the regulatory backlash to the 1920s and market crash of '29 resulted in relatively low financial services compensation until the 1980s. Which, by the way, was about the time the previously-privately-held investment bank partnerships began to swell with public money and pay more lavishly.

On the subject of the systemic risks taken by most, if not all, of these banks, which eventually came home to roost via mortgage-backed CDOs and such, Smith and I agree that, in the future, it's likely that such risk will be minimized only by the existence of many smaller investment banks, rather than a few large ones.

Even now, as I discussed with a Morgan Stanley employee at a social function this past Sunday, quite a few large hedge funds and private equity shops, not to mention the explicitly-identified boutique investment banks, stand ready to re-enter the riskier areas of underwriting and trading in the coming months and years. As private firms, they have no shareholders ranting at annual meetings, need justify their compensation to no external parties, and can only grow at the rate at which their private capital allows, plus judicious borrowing.

As Smith notes, the industry will reinvent itself, and, in fact, already has. My various posts about Blackstone and other private equity shops noted this as far back as the 2007 IPO of that large private equity enterprise.

In truth, as usual, what we see happening with compensation, regulation and risk management of the remaining former-investment banks-cum-commercial banks, Goldman and Morgan Stanley, and the crumbling commercial banks, Citigroup and BofA, is simply the tidying up of the worst-performing, hind-end of the sector. The better players and their capital departed those publicly-held firms over a decade ago, the better to ply their trade in stealth and away from excessive governmental intervention.

Though he didn't write that, I believe Mr. Smith would agree with me on that last point.

Tuesday, February 10, 2009

Starbucks Muddled Marketing Messages

Yesterday's Wall Street Journal carried a rather surprising article about Starbucks. It seems they have actually been offering some marketing promotions as long ago as last summer, wherein the purchase of a morning coffee led to a discount on an afternoon beverage purchase.

Who knew? As I noted in this post from last April, CEO Howard Schultz and his marketing chief, Michelle Gass, seemed rather confused about what was ailing their firm. They thought it was only their own strategies, and not competition. Somehow, Dunkin' Donuts' and McDonalds' explicit targeting of premium coffee drinkers escaped Schultz' and Gass' notices.

I was amazed to read in yesterday's piece that prices between Starbucks and its two main competitors, McDonalds and Dunkin' Donuts, have narrowed. That, in some instances, on a per-ounce basis, Starbucks is actually less expensive than Dunkin'.

Further, in a total about-face from removing food from their menu, Starbucks is now offering a food-and-coffee combo at a discount. But when asked about simply cutting coffee prices, Gass replied,

"Today, no. But never say never."

I guess the food reversal proves this out. But what I wonder is whether Schultz, Gass and their colleagues actually have any sort of larger marketing and product strategy in mind? Or are they just making these tactics up as they go along?

My own guess is the latter. How could they have reversed on providing food if they had done research and looked at their own customer buying information in the first place? It's not the sort of misstep you typically make if you are a data-driven marketer.

But it does smack of a sort of image- and mission-oriented marketing and business philosophy for which Howard Schultz is well known.

Unfortunately, that sort of business focus can lead to tragic mistakes, as market, customer and competitive realities are tuned out, in favor of 'the mission.'

I suppose a shareholder could be grateful that, as the nearby chart indicates, the company's equity price has pretty much tracked the S&P500 Index for the past six months. After all, this must have been a rocky period for the coffee giant, what with consumer luxury spending declining.
The question would seem to be, though, can Starbucks really manage to breakout above the index, and for a long time- several years? Because if it can't, then it has simply become another fallen star whose prospects for consistent, profitable growth are gone, and for whom competition and a saturated market spell mediocrity for the foreseeable future.
Sad to say, statistics and Schumpeterian dynamics suggest that it will be the latter.

Monday, February 09, 2009

Paul Romer's "New" Bank Scheme

Stanford Institute for Economic Policy Research senior fellow Paul Romer wrote a succinct piece in Friday's Wall Street Journal arguing for the the creation of new banks, rather than allocating Federal assets to shore up existing, crippled banks. It is reminscent of the Journal's similar article by Dennis Berman back in November, about which I posted here.

I didn't think much of Berman's idea then, and I don't feel Romer's prescription is actually any better. Or different, for that matter.

But Romer points out why a new bank might be better than Federal support for a crippled one, i.e., no messy valuation problems going forward.

That brought me to Anna Schwartz' comments in the interview with her in the Journal back in October, which elicited this post.

Schwartz asserted, correctly, I believe, that the current problem, unlike the Depression, is not liquidity, but discerning which banks are healthy. Investors won't buy into banks whose assets are of questionable value.

Thus, putting the two streams of thought together, one arrives at the unmistakable conclusion that, whether by straightforward write-offs, or modified mark-to-market policies reflecting actual economc value, impaired assets should be properly valued, insolvent banks closed and/or merged, and the results allowed to either decrease excess banking capacity, or allow existing, healthy banks to take up the slack.

Either way, it's really unclear now why we need Federal investment in banks, short of an explicit nationalization policy. Having had time, since September's bank panics, to see that the largest US commercial banks now fall into one of two groups.
Citi and BofA sell at as much as a 70% discount to their values back in September of last year. Wachovia and WaMu don't even exist now.
Chase and Wells Fargo track the S&P fairly closely, indicating less concern over their viability and asset valuations.
Doesn't this indicate that banking, in general, is not at risk. Just the two most problematic commercial banks.
If the Feds simply enforced sensible valuation at Citi and BofA, then determined capital adequacy, and closed either or both, if necessary, we'd probably be out of the woods, with respect to commercial banking stability, right now.
If more capacity is required in the sector, we'll know by growing loan profit margins and growth rates. And fresh capital will naturally seek out these businesses and compete the excess profits away. Without undue goverment manipulation and interference.