Federal Coercion: The BofA-Merrill Case

The story of Hank Paulson's and Ben Bernanke's coercion of and threats to BofA CEO Ken Lewis, if he dared tell shareholders of Merrill Lynch's losses, or attempted to scuttle the closing of the Merrill deal, is gaining more credibility with each new article in the media.

My good friend and colleague, B, with whom I had lunch this week, took pity on Lewis for basically being a stooge.

If what I read in Thursday's Wall Street Journal was true, I personally feel that all three people- Paulson, Bernanke, and Lewis- should be prosecuted for the appropriate violations of US law.

Lewis had no backbone. He should have done the right thing for his shareholders, blown the whistle on Bernanke and Paulson, and, if necessary, lost his job in the process. Instead, he cowered in fear and kept silent. He seems to be guilty of a violation of Sarbanes-Oxley, as well as simple violation of his fiduciary responsibility as BofA CEO.

Paulson and Bernanke seem to be guilty of using coercion with Lewis, inducing him to violate his responsibility to his shareholders, and to violate Sarbanes-Oxley. Can they not also be indicted for this?

I'm no fan of needless prosecution of senior government officials without cause. But, in this case, I think what was allegedly done to Lewis, if proven true, deserves harsh punishment for all involved.

If this goes unaddressed, it will be understandable that investors continue to sit on the sidelines, rather than risk their capital in a business environment characterized more by organized crime tactics than the rule of law.

The Capital Strike

There were several interesting exchanges on CNBC's Squawkbox program this morning.

There have been stories this week, both on cable news, and in text media, regarding GE executives Jeff Immelt, CEO, and Jeff Zucker, head of the media business, holding a meeting recently to read the riot act to on-air personalities who have been voicing views that were too conservative and critical to the current administration.

Thus, I was surprised to hear Mark Haines lashing out at the administration for not allowing financial companies to repay TARP money as they wished. Haines held firm in his stated belief that the Treasury enjoys having control and influence over banks, and has no plans to relinquish their ability to coerce these institutions.

Separately, Rick Santelli skewered liberal puppet and economic idiot Steve Liesman on the subject of the stress tests. Liesman attempted to portray Santelli as preferring a pre-1930s banking system in which deposits were lost amidst bank failures. Santelli, however, simply pointed out that the stress tests were about two years too late, and by the same people who missed the problems the first time around. And, as he has consistently held, Santelli supported Anna Schwartz' position that insolvent banks should be closed, so that markets would know, by the simple act of survival, which are sound.

As if he was some student toady of the faculty which had assured him protection, Liesman remarked, during Santelli's final comments,

'Just let him go....'

Taking it all in, I wonder how much longer Santelli and Haines have on the network.

Add Joe Kernen to that list.

In another discussion, he asked why anyone in their right mind would invest in banks when, on one hand, the sitting president is coercing them into making more bad credit card loans, while the same president's Treasury Secretary is threatening banks with his 'stress test.'

Kernen went on to note the insanity of excoriating banks for having made bad loans, and taken government funding, only to now complain that the surviving banks aren't making enough loans. He finished by observing that a parade of sovereign wealth funds have lost nearly all of their late-2007 investments in various US financial institutions, e.g., Citigroup and Merrill Lynch, to name just two.

Even the more liberal Becky Quick and Carlos whathisname nodded in assent when Kernen asked why any intelligent person with capital would commit it to any US financial institutions in the current environment.

To complete the scene, one of the program's guests, Donald Trump's daughter, Ivanka, rather young and with no particular length of business experience, echoed Kernen's views and asked why anyone would risk capital in a climate of such capricious Congressional temperament?

The overall image I took away this morning is a strong sense of a genuine, FDR-era capital strike in the US economy. Thanks to inconsistent and thuggish governmental intervention, cancellation or violation of contract law, violation of its own Sarbanes-Oxley regulations (e.g., BofA's CEO Ken Lewis directed by Treasury Secretary Hank Paulsen and Fed Chair Bernanke to keep silent on the Merrill Lynch losses and not inform his shareholders prior to the acquisition approval vote), contrary direction to banks to lend, but not make bad loans, and the AIG bonus flap, no sane investor would think to participate with government for the foreseeable future in any financial sector investments.

The Folly of The Fed's Bank Stress Tests

Today is apparently the day on which various US banks are privately told their Fed "stress test" results. I haven't yet written on this topic because there were many other more interesting ones at hand. However, given what's transpiring today, it seems appropriate for me to finally address this topic.

To me, the whole process is a political charade. There are at least three bank examination processes which already exist among the Fed, FDIC and OCC. Such examinations were supposed to have been adequate for the past few decades. Since neither new people, nor organizations, have been used, just what will have changed in this process to make it better than what were supposed to be appropriate in the past?

If these new stress tests supplant or augment inadequate prior examinations, then why were these new style tests not used in the past?

Is the new stress test not a prima facie admission by Congress and prior administrations of both parties that their regulation and oversight of banking was inadequate?

Does this not, in part, absolve bankers of being the prime cause of our recent financial system difficulties?

One guest on CNBC this morning noted an interesting time sequence. He observed that the stress test results are to be released prior to the deadline for the GM funding negotiations. Will not, he asked, the stress test results be used to coerce Chase and other banks into being more forthcoming in caving in to federal government demands for bondholder acquiescence in the negotiations?

Of course, the two more liberal-leaning CNBC anchors gasped and looked shocked- SHOCKED!- that our federal government would ever behave in such a manner.

But it is, sadly, entirely believable, and probably true.

Some argue that governmental assurance, via these stress tests, that banks are sound, will result in more inter-bank lending.

I doubt it.

After the tacit admission of regulatory ineptitude, and the specter of the Congress letting Fannie and Freddie run wild, what sensible bank CEO is going to trust any governmental assessment of private sector solvency?

Volcker v. Kohn On Inflation

Last weekend's exchange between legendary former Federal Reserve Chairman Paul Volcker and current Fed Vice-Chairman Donald Kohn at Vanderbilt University was reported in this piece in the Wall Street Journal.

Any time Paul Volcker weighs in on monetary policy and/or the Fed, I tend to listen. The Journal article reported as follows,

"Former Fed Chairman Volcker, who along with Kohn was at a conference honoring former Fed governor Dewey Daane, questioned how the Fed can talk about both 2% inflation and price stability.

In the minutes of its January policy meeting, the Fed said that officials' long-run inflation forecasts reflect what they think is consistent with the Fed's dual mandate "for promoting price stability and maximum employment."

It then said that "most participants" thought 2% inflation, as measured by the price index for personal consumption expenditures, "would be consistent with the dual mandate."

"I don't get it," Volcker said, leading to a lively back-and-forth between the two central bank heavyweights.

By setting 2% as an inflation objective, the Fed is "telling people in a generation they're going to be losing half their purchasing power," Volcker said. And if 2% is the best inflation rate, and the economic recovery lags, does that mean that 3% becomes the ideal rate, he asked.

Kohn responded that by aiming at 2%, "you have a little more room in nominal interest rates ... to react to an adverse shock to the economy." "

Do the math, and you see Volcker is correct. A 2% inflation rate results in a nearly 50% rise over 20 years. Volcker then asked whether, in difficult economic times, the rate might drift up to 3%? Kohn cited the alleged problem-free experiences of other inflation-targeting central banks as proof that his position is both correct and safe.

It is at this point that I find myself alarmed, as I trust Volcker more than Kohn. And, frankly, don't find other central bank experiences to be quite on a par with that of the US.

But what's really alarming is that this source cites Bloomberg as reporting some additional thoughts of Volckers,

"“I don’t think the political system will tolerate the degree of activity that the Federal Reserve, in conjunction with the Treasury, has taken,” Volcker [said]

... U.S. lawmakers from both political parties have expressed concern in recent months that the central bank has overstepped its authority by creating several emergency credit programs aimed at reviving lending and ending the recession.

“I think for better or for worse we are at a point where the Federal Reserve Act, after all that has been happening in the last year or more, is going to be reviewed,” Volcker said. "

You have to understand Volcker's aversion to Congressional meddling with the Fed. Although, as a Journal article from last year noted, the Fed is a creation of populist forces early in the last century, as the Progressive movement crested with a series of Constitutional amendments in the 1910s, it has notionally and theoretically been independent of Congress.

More than any other Fed chairman, Volcker actively both tamed inflation and fended off Congressional pressure during a period of intense economic pain. It is not an overstatement to claim that, due to Volcker's inflation-fighting prowess and strong resistance to Congress, the US has enjoyed nearly 30 years of low inflation.

That Volcker is now worried about the Fed's independence, thanks to the unnecessary activism under Bernanke and Geithner, worries me. As bad as the Fed's design was, in effect parceling out monetary authority to Fed banks whose presidents are chosen by local banks and businesses across the country, it's far better than allowing Congress direct control over the nation's monetary policy.

Particularly at a time when the federal government is essentially controlled by a single, populist-leaning party. In far less economically stressful times, Congress has threatened to hold hearings, pass legislation and generally exert more direct control over the Fed. For example, we had the senseless 1978 Humphrey-Hawkins bill, the product of a misguided and naive Senator from 'progressive' Minnesota, to thank for diverting Fed attention from simply fighting inflation. Though technically expired, Congress continues to behave toward the Fed as if full employment is an equally-weighted responsibility of the Federal Reserve system, with inflation.

How much worse could it get? I don't even want to go there. But if Volcker's worried, I'm worried.

Whither Commercial Banks- Again?

Friday's Wall Street Journal featured a surprisingly illogical and, frankly, misrepresented editorial by David Smick, who was described as CEO of Johnson Smick International, entitled "Europe Is No Model for Our Banks."

The heart of Smick's contentions appear in this passage, early in his piece,

"The Krugman Democrats opt for nationalizing today's troubled banks. The Summers Democrats counter that dramatic bank restructuring, including nationalization, could collapse the system. Instead, the Summersites favor turning big banks into something similar to local electric or water companies -- heavily regulated, unimaginative public utilities.

Given their recent spree of arrogance, stupidity and greed, bankers deserve as much. But would it be in America's best interest for banks to be talent-deficient utilities?

Our largest 10 banks control 75% of total bank assets. They channel pensions and other investable assets as well. If these banks start acting like utilities, they'll take far fewer investment risks. That will lead to less investment in business expansion, lower economic growth and higher long-term unemployment.

Few want to admit it, but economic prosperity and job-creation depend on financial risk-taking. Because of the credit crisis, we are moving from an era of reckless financial risk-taking to an ironically more dangerous era of virtually no risk-taking."

I'm afraid Mr. Smick misunderstands how modern money center banks actually work. First, they aren't the incubators of venture capital and job-creating innovation he seems to think they are. Their recent risk-taking was not in the area of portfolio lending. And his citation of "pensions and other investable assets" refers to the rather stodgy money management units of banks, which, again, are not typically making loans to startups.

I don't know in what alternative universe Mr. Smick studies commercial banking, but it pretty clearly isn't one containing the US economy or banking sector.

Smick writes, near the end of his editorial,

"If the banks become public utilities, innovation is at risk of drying up. That's what happened in Japan in the 1990s when policy makers focused on saving existing banks in lieu of creating healthy, financial risk-taking.

America has traditionally been the world's hothouse of innovative risk. The long-term consequences of losing that position could be catastrophic."

His last statement is true, but has little to do with America's commercial banks- especially the largest ones. He is referring to venture capital and private equity, but not to commercial banking as practiced in recent decades by our money center banks.

Granted, another recent editorial put fear into the hearts of some friends of mine, and me, when we learned that the current administration wanted to 'stress test' the debt involved in venture capital-backed startups. That is worrisome. Venture capital firms don't typically allow for much debt in their funded companies, nor do most banks, as the article noted, extend much more than receivables-backed operating financing.

However, Smick misses all this and mistakenly worries that acknowledging the moribund nature of lending at our large commercial banks will somehow change venture capital funding.

We have some challenges in our financial sector at present, but they aren't what concerns Mr. Smick.

I don't even understand how his ill-conceived and mistakenly-reasoned piece made it into the Journal.

Investment, Capital & Current Economic Recovery

I read two articles in the Wall Street Journal in the past two days that have me pondering, again, the condition and probable or appropriate future for US commercial banks.

The first Journal piece to cause me to return to this topic was Peggy Noonan's rambling weekly column in the Saturday edition. A colleague found it virtually unreadable, but pushing the notion that some sort of 'black magic' has now rendered America poor and ripe for a cultural return to simple times and universal Calvinism and/or Puritansim.

Then I picked up yesterday's Journal to read a silly piece in the Money & Investing section alleging that some investors, including noted James Paulsen of Wells Capital Management, see a positive outlook for the US economy and its banks. The article reported,

"Mr. Paulsen of Wells Capital expects consumers to begin borrowing more heavily against their homes and expects economic growth recovering amid a pickup in consumer spending and exports. Even if growth doesn't return to where it was, he says, the improvement should be enough to pull stocks up from their depressed levels."

Honestly, it's very difficult for me to envision, in the current environment of unemployment, credit card limit reductions, and depressed housing prices, that there will be a growth in borrowing against home equity. Or that banks would even lend on that basis.

The alternate view, as represented in the Journal piece, is that governmental intervention in fixed income markets has hopelessly tainted valuations and falsely colored markets as healthier than they would be with only private investment.

All of this matters, because so many people seem to believe that the financial system is the key economic sector and component that must be 'fixed' in order for the US economy to recover.

I don't happen to share this view. In fact, thanks to Depression-era changes in banking, now, more than ever, bank failures are not a big deal. They simply represent the failure of the business model of a company which happens to take federally-insured deposits.

That so many view the health of banks as a priority contributes to the Peggy Noonan school of 'black magic' belief.

As a colleague and I discussed these topics over the weekend, we engaged in a rather easy, step-by-step analysis of just how and why debt capital has evaporated from the global economy in the past two years, and how this constitutes a nearly-unprecedented deleveraging from which there is no easy, fast return.

To understand what began to happen in July of 2007, consider this example. Say a Citigroup SIV or Bear Stearns leveraged mutual fund has been created. These happen to be real examples. In each case, generally speaking, what was done was the following, albeit on a larger scale. The financial firm seeded a fund with $1B, and issued debt from the fund for another $9B, using the $10B to buy CDOs. The mortgage-backed instruments comprising the CDOs were assumed to have a robust future of rising value, thus providing a positive return to investors who purchased shares of the fund. The debt was relatively short term, being retired and reissued perhaps every 90 or 120 days.

If CDO values had, in fact, continued to rise, then fund shares would have risen in value, debt would have been repaid and reissued, and all would have been well.

But, instead, CDO values fell, as mortgage delinquencies and defaults began to rise. In fact, CDO values became so suspect that the debt-holders chose not to repurchase debt of the fund. To make a long story short, the fund's organizer, either Citigroup or Bear Stearns, did, in fact, have to essentially plug the funding hole, either because it was legally obligated to, or faced some serious consequences to its image if it hid behind the limited liability which it first claimed, as Bear Stearns initially did.

The accounting effects are simple and, despite Noonan's column, not at all 'magical.' The fund's value fell, so a loss had to be recorded. Suppose the value of the assets declined by 30%. The sponsoring bank's equity was wiped out, followed by a loss on the debt the bank had to supply to the fund. When the bank had to repay the outstanding debt at face value, it essentially owned the fund. The loss of value above the equity cushion resulted in the effective loss of value of the debt which the bank recorded on its books as having lent to the fund, in the amount of 20% of the fund's initial value.

Shareholders in the risky mutual fund held shares worth something like 30% less than their initial value. Since the bank had to fund the full amount of the $9B of debt paid off to creditors, but has to realize a net value of $7B in the fund's equity and debt positions, it had to take a $3B loss on realized value, either in its equity directly in the fund, or debt lent from equity.

Magnify this several hundred fold, and you see why late 2007 saw many then-existing large US commercial and investment banks, e.g., Citigroup, Merrill Lynch, Bear Stearns, Morgan Stanley, and Lehman Brothers, taking, together, hundreds of billions of dollars of writedowns in equity to reflect losses for which they had to account.

Because investment and commercial banks are allowed to use leverage far above that typically seen in non-financial companies, their expansion into vehicles like those described above allowed them to attract cash into debt securities funding such vehicles. This represented a private monetization of capital by levering bank equity on the order of 8- or 9-to-1x.

When the debt wasn't repurchased by investors, and the banks had to inject more of their own equity to repay it, they took outsized losses, in proportion to their apparent, initial exposure.

Throughout all of this, of course, depositors funds, up to the federally-insured maximum, were safe. If bank equity could not cover those deposits, then the FDIC would provide the balance, and, if necessary, after that, federal funds would be used to make depositors whole.

The rest of the bank's assets would typically be loans, which could simply be sold in the event of closure of the bank. Other businesses and operations would be transferable to other financial institutions, with losses being absorbed by equity shareholders in the bank and, then, debt holders.

To me, in retrospect, and at the time, I find the conception of the TARP to have been flawed and mistaken. It was never necessary, when we had the necessary tools for disposal of failed financial institutions readily at hand. Expansion of the FDIC staff and perhaps a revival of an RTC-style entity to manage and sell failed bank assets could more easily, and with less risk, have been afforded to simply close and process the detritus of financial institutions which had unwisely expanded apparent private capital by creating highly leveraged vehicles to hold structured financial instruments.

This effective shrinkage of leveraged capital, and the resulting evaporation of financial institution equity, has had a dramatic effect on the risk capital available to our economy at the current time. I doubt that some stimulus spending by the federal government, nor the purchase of assets by the Fed, will magically cause investor cash to suddenly flood into financial instruments of greater risk, thus instantly underpinning higher levels of economic activity at this time.

It's not magic at all. It's very sensible and understandable. Our financial institutions took unwise risks which came back to bite them much more forcefully and expensively than they ever imagined. Thus, their capacity to function as lending institutions has been affected. Some failed, some were purchased while still operating, and the net effect has been a loss of lending capital at this time in our economy.

I don't see anything having occurred in the past few months, or even weeks, to give one reason to believe that such capital is now on the verge of re-entering the US economy to drive activity back up to levels of a few years ago.

Oracle's Acquisition of Sun Microsystems

In a surprise- at least to me- move, software giant Oracle today announced its acquisition of Sun Microsystems.

I understood IBM's attempt to scoop up some talent and market share in the form of the ailing and faded server vendor.

However, I confess to having little understanding of what cogent business reasons Larry Ellison has to buying a hardware vendor.

It can't be for the Sun software, as that could easily be licensed, or bought more cheaply in bankruptcy. But Oracle isn't a hardware vendor.

The nearby, Yahoo-sourced chart shows just over 30 years of equity price performance of the two firms, along with the S&P500 Index. It's quite impressive to see that Sun was almost Oracle's performance equal as recently as nine years ago. But tech's demise in the next few years proved too much for Sun.

While, in retrospect, Oracle has a surprisingly monotonic trend, with the early 2000s as an exceptionally positive bubble, Sun's equity price fell as fast as it had risen.

Perplexingly, on-air staff at CNBC were crowing about how this merger shows that the technology sector may be leading the economy out of recession, and had virtually nothing negative nor questioning to offer on the deal.

Here's my sense of this deal. Just in case 'cloud computing' requires vertical integration, Larry Ellison wants to own a server manufacturer. I think that's about it.

After all, Ellison and Oracle have no hardware manufacturing or design experience, to my knowledge. How is the firm supposed to do better with Sun than the ailing firm's own experienced managers? Sun may have made some strategic mistakes, but one assumes they at least know how to crank out the boxes they built.

What is Oracle going to add to that? I suppose there may be some sort of administrative cost savings. But these types of diversifying moves generally result in the acquirer being spread rather more thinly, and sometimes even losing focus on their main business, while trying to avoid losing more money on the acquisition.

The reports on CNBC had Oracle claiming that the Sun acquisition will be accretive to earnings relatively quickly. Of course, that claims rests on assumptions and business plans which were not divulged along with the claims.

Common sense tells me this is not the best move for Oracle. But, of course, time will tell.

Dis- and Misinformation About Healthcare Reform On GE's CNBC

This morning's CNBC programming featured a 'debate' between an advocate of market-oriented healthcare reform, whose name I do not recall, and liberal Democrat, former governor of Vermont, former chair of the DNC, former presidential candidate and, finally, onetime/sometime medical doctor, Howard Dean.

For reasons not entirely clear to me, absent politics, about which more a little later, Howard Dean seems to appear on CNBC quite a bit these days. He's not a businessman nor an economist, but he is fairly frequently brought in to comment on such matters.

Frankly, it's not at all clear why simply being a medical doctor in the past qualifies Dean to comment on the US healthcare situation.

Dean provided substantial dis- and misinformation about the current administration's intention to offer government-provided healthcare insurance in opposition to private insurer-provided products.

Specifically, several recent Wall Street Journal editorials have noted a variety of flaws with the proposed government-offered insurance. Among them, as I recall, are these,

-Government-provided health insurance will tend to be underpriced, because the programs' losses will be just another part of the large federal deficit. Thus, allowing this is tantamount to unfair price competition.

-Government-provided health insurance will be capable of using free or low-cost, unmonitored promotional channels, such as social security and unemployment check stuffers, to name just two.

-Existing private plans are shackled by regulations preventing cross-state marketing or offering of insurance, plus unwieldy state-based oversight and, lastly, onerous coverage requirements legislated by the states and/or federal government.

One of the recent lead Journal editorials provided quite a bit of depth to the analysis, concluding that any government-offered plans would have grossly unfair advantages, while hiding the true costs of the plans from their buyers.

Dean's remarks this morning on CNBC amounted to, to paraphrase them, the following,

'You can't believe those insurance companies. Conservatives are afraid of a fair fight in the market between private insurers and government-backed plans. Let's let people choose their insurance- that's the fair thing. And government-backed insurance will be cheaper because it won't have as many administrative or marketing expenses.'

Frankly, I seriously question Howard Dean's expertise on these points. For instance, who among us really believes that our federal government does anything less expensively than it is done in the private sector? And Dean simply ignored the issue of taxpayer subsidization of under-priced insurance. Don't Medicare and Medicaid give us chilling examples to avoid?

So, to my earlier question, why does CNBC so frequently feature Mr. Dean on topics about which he doesn't seem to have any expertise?

As I've noted in some recent posts, I try very diligently to keep politics out of this blog, preferring it to be the focus of its companion political blog. But when the news about a business sector is all about government intervention, e.g., finance, autos, and healthcare, it's impossible to do that.

I cannot help but sense that GE's CEO, Jeff Immelt, is consciously using his company's media business, NBC/Universal, to be a bully pulpit with which to curry favor with the current administration. From 'ecoimagination' to slanted views on healthcare insurance, GE seems to be trying to portray itself as an agreeable, accommodating business partner for government.

GE's medical technology unit surely has a major stake in the coming battle over government-offered health insurance. If spending levels decline and care is rationed, won't GE sell fewer expensive imaging systems and related, or even unrelated, medical products and services?

Perhaps. But being viewed by the federal government as an obstinate, determined foe of that institution's plan to socialize healthcare could easily earn GE a punishment of being effectively shut out of future federal provisioning of its healthcare plans and services.

Could GE be subtly, or not so subtly, tilting its coverage of the healthcare insurance debate by featuring champions of the government solution, despite their questionable credentials? Such as Howard Dean?

It was very clear this morning that Howard Dean was allowed to get away with vague, unsubstantiated claims about the administration's proposed healthcare plans, while launching equally-unsubstantiated assaults at private sector insurers.

There's something very troubling to me about seeing the major business cable news network engaging in such obviously biased and politicized 'coverage' of such an important economic issue.

GE's Pathetic Performance

The weekend Wall Street Journal contained information on GE's first quarter performance results. I've written so many posts about GE and the inept management and misleadership of its CEO, Jeff Immelt, that it's not worth my linking to them. Just click on the appropriate labels.


For years, I have argued for splitting up this pointless conglomeration of different businesses, and this past quarter is yet more evidence of the wisdom of my position.


The headline on the Journal article makes my point succinctly- "GE's Net Tumbles 35% on Finance-Unit Woes."


Basically, shareholders are getting punished for the real fundamental and market-based technical issues involving the finance unit, obliterating any positives which may have resulted from any of the four other units, were they free-standing entities.



The accompanying Yahoo-sourced price chart of GE and the S&P500 Index for the past three months demonstrates that, once again, holding the needlessly-diversified conglomerate cost shareholders returns they could have earned, with less risk, in the index.



There was a notable caveat in the results, in that mark-to-market values are not contained in the quarter's performance, but will be included next quarter.



Even the Wall Street Journal noted, in an article last month, questions among analysts regarding GE's mortgage portfolio. Their reserve adequacy was doubted. Reserves, which, if GE were a regulated bank, might have to be increased dramatically.



There just seems to be no end to Immelt's mismanagement of the conglomerate that should not even exist any longer.