Friday, November 20, 2009

Goldman, AIG, Geithner & The Repaid Collateral

Wednesday's Wall Street Journal featured a very damning article concerning Treasury Secretary Tim Geithner's mishandling of the payment of collateral to Goldman Sachs for its AIG positions last year, as head of the New York Federal Reserve Bank.

In article entitled "Report Rebuts Goldman Claim," following only days after the Journal published Goldman's assertions that it never needed those payments, and was completely and safely hedged on its AIG exposures, the piece states,

"A government report throws cold water on that claim."

It continues,

"Goldman was among the largest beneficiaries of a decision by the Federal Reserve Bank of New York to bail out insurance giant AIG in September 2008 at the height of the financial crisis. A revamped rescue package in November led to Goldman and 15 other banks being paid in full for $62 billion worth of insurance contracts they had with AIG to protect against losses tied to mortgage assets."

At the time, Geithner, as head of the New York Fed, was responsible for determining what to do regarding the various failing investment and commercial banks in the city, as well as administering the AIG situation.

According to the Journal article,

"The government auditor's report broadly found that the New York Fed left itself little room in negotiating with the banks for a better deal for taxpayers."

Hard to improve on that succinct finding, it is?

No wonder two Republican Representatives spoke out bluntly at yesterday's hearing in Washington related to the TARP, demanding Geithner's resignation. Well, that's not strictly true. One asked Geithner to resign, the other reiterated his opposition for Geithner to have ever been confirmed as Treasury Secretary.

Regarding the specifics of the report, the Journal piece notes,

"Goldman's trading position with AIG centered on $22.1 billion of such insurance the firm had purchased from AIG. In a separate series of trades, Goldman itself had sold protection against losses on the same securities to other trading firms.

The problem for Goldman: If AIG collapsed and markets continued to swoon, Goldman would have had to make payments to the other trading firms and been unable to collect on protection it had bought from AIG.

Underlying many of these credit bets was a mass of mortgage debt, securities backed by pools of subprime home loans and commercial real-estate debt, and then more complicated securities also linked to mortgages. The packaging of all those securities helped fuel the U.S. housing boom and subsequently sparked the credit crisis.

Goldman was among the largest beneficiaries of a decision by the Federal Reserve Bank of New York to bail out insurer AIG in September 2008 at the height of the financial crisis. Above, the headquarters of Goldman Sachs in New York.

Goldman has said it was insulated against a material loss by an AIG default. And the audit pointed out that Goldman in fact was protected against some losses. For example, the firm had collected $8.4 billion of collateral, cash or a liquid equivalent, from AIG. Separately, Goldman took steps to try to buy insurance against insurance by purchasing protection against an AIG default.

But the audit raised questions about Goldman's calculations. Goldman believed that it controlled $4.3 billion in assets, pools of fixed-income securities that require complex computer modeling to design and understand, that would have been used to counter an AIG default. The securities are called collateralized debt obligations, or CDOs.

The audit said, however, that given the fact that the market for those securities had tanked in November 2008, and that an AIG default would have sparked a rout, Goldman would have had a difficult time obtaining value for those assets.

"It is far from certain that the underlying CDOs could have easily been liquidated, even at the discounted price of $4.3 billion, the audit found.

The audit also said Goldman would have faced the same problem of declining market value for another pool of assets valued at $5.5 billion had AIG defaulted. The bottom line: The audit said those assets that Goldman held would have been worth a lot less had AIG failed."

This directly contradicts information which Goldman has been dispensing for some time alleging that it could have realized the roughly $10B of value in the two pools of AIG-related assets.

As if to highlight the lack of transparency surrounding the TARP's implementation and, then, later accounting for those actions, the Journal reported,

"A spokeswoman for the special inspector overseeing the Troubled Asset Relief Program wasn't available for comment. The New York Fed said it "acted appropriately" in its dealings with AIG trading partners."

No surprises there, eh? The New York Fed is in deep damage control mode, covering Geithner's and it's own asses. The TARP special inspector knows a good, long civil service job when s/he sees it, and isn't talking, either.

It seems that many people are now choosing to recall last year's events radically differently than they actually occurred. Now Geithner's former employer clams up about the AIG disbursements and Goldman contends it was never in dire straits, but, evidently, exchanged its investment banking license for a commercial bank one, just for kicks.

And the taxpayers aren't being clearly told how Geithner's fumbling resulted in their paying Goldman $10B to cover the investment bank's own errors in judgement.
Despite the clear evidence from the government's own inspectors that Goldman badly needed those troubled, AIG-related assets to be made good, the firm continues to dissemble.

It's pretty clear that Geithner was vastly out-maneuvered and out-muscled by Goldman. Now, both the administration and the Fed want to cover this up. This is why it is folly to allow government to become deeply involved in business, whether successful or failed. Instead, the Constitution provided for bankruptcy, and it remains the best option for sorting out this sort of mess and dissovling failed enterprises.

Thursday, November 19, 2009

Santelli & Wolfman On Inflation On CNBC

Check out this video.

CNBC's Rick Santelli and his colleague, a Chicago pit trader known as "Wolfman," remind us all of Friedman's quote,

"Inflation is always and everywhere a monetary phenomenon."

Leaving aside Liesman's typically idiotic comments, it's a provocative discussion, is it not?

Melissa Francis, Larry Kudlow, Wolfman and Rick Santelli "get it," i.e., they understand that inflation is a monetary phenomenon, not simply this month's CPI.

Santelli astutely points out that there is always some price disinflation in any recession, and, thus, that is not the same thing as monetary inflation.

Diane Swonk and Liesman don't "get it."

Santelli also notes out that, while the carefully-massaged CPI may not be roaring yet, imported commodities, which require dollars to purchase, and gold, are soaring. Then Kudlow chimes in near the end to note that measured US price indices are, in fact, beginning to rise faster, as reported in recent months.

Some Scary Comments on CNBC This Morning

I sat down to read the Wall Street Journal with a cup of coffee this morning and was greeted with some truly horrifying remarks on CNBC.

Two people, TARP oversight committee chair Elizabeth Warren and AutoNation CEO Mike Jackson nearly scared me to death with their creative rewriting of last year's financial meltdown and consequential government intervention.

Warren, who is a lawyer by training, not an economist, recalled a non-existent past by claiming full economic revival of the US economy as the TARP's original mission. Though she cited then-Treasury Secretary Hank Paulson's "frozen pipes" comments, regarding the financial sector, Warren asserted, with a straight face and that professorial scowl behind the funny glasses, that this really meant completely returning the economy to a healthy state.

Thus, she implied, her testimony before Congress later today will almost certainly support extending the TARP.

During the discussion with her, current Treasury Secretary Geithner's intentions to extend the slush fund were shown onscreen. Warren sort of punted, only saying the TARP funds should be saved if there weren't 'good ways to spend it.'

My goodness, in what alternate universe does Warren live?

Well, Harvard, I guess. Silly me.

Because no thinking person who is of her age can possibly think any government administration, Republican or Democrat, won't swear that they have 'good ways to spend' a few tens or hundreds of billions of dollars.

Warren then, of course, excoriated the nation's financial institutions for finally coming to their senses, as mentioned by Doug Dachille a few days ago on CNBC, as I described in this post, and returning to more historically prudent lending standards.

To hear Professor Warren, financial institutions are now senselessly hoarding government money, when they should be giving it away to any and all comers.

Weighing in with kindred views was AutoNation's Mike Jackson. A perennial cheerleader for government intervention, Jackson credited the dubious "cash for clunkers" with providing an important economic boost this past summer, and declared that, if not for TARP, the US would still be in a depression, not exiting a recession.

Then Jackson carefully stated that, of course, the economy isn't really out of the woods yet, so we, of course, still need massive government intervention and lots of cheap money.

Neither Warren, nor Jackson, showed the slightest understanding that the US economy cannot return to health so long as the only source of growth is printed government money dispensed at zero interest rates, along with generous government guarantees for any business in danger of failing.

On that point, it was clear that Elizabeth Warren is completely clueless. Jackson is simply behaving as any expedient businessman would, elbowing his way to the trough of free government largess while it lasts, and calling for more whenever possible.

On another note, the CNBC morning program interviewed one of Obama's top financial backers and general good old buddy, John Rogers, of Ariel Investments, to let him talk his funds' investment books.

In a somewhat casual aside, Rogers mentioned something that I found pretty shocking, but not in so scary a manner as the earlier comments about which I wrote above.

Rogers was asked what equities he held, and, in more probing questions, which, if any, technology issues any of his funds had bought.

He replied that they had bought Dell some months ago, when, like many equities, it's price was depressed due to general market conditions, just to ride it back up, as it was presumed to track "the market." In effect, Rogers accidentally revealed a rather clever way that his firm and, I would bet, many other mutual fund groups get paid for effectively investing in an index.

Rogers made it clear that his analysts didn't favor Dell for any specific reason. No, they bought it because it was expected to just track, say, the S&P, on the way back up. If Rogers group had just bought an S&P index fund, investors would howl. It's inappropriate for an active manager to charge fees for putting your money into any sort of passive fund, especially if it is an index vehicle.

But a more clever way of doing the same thing is to just select a small group of equities with betas near 1, or judged to be of sufficient size and quality to reasonably mirror equity index performance. Then the manager can earn fees for essentially passive, defensive moves calculated to simply match the index.

Just goes to show how active you should be in watching the investments of actively-managed mutual funds.

Wednesday, November 18, 2009

Boeing's Latest Dreamliner Glitch: The Risk of New Aircraft Development

Friday's Wall Street Journal carried an article detailing the last derailment of Boeing's 787 Dreamliner.

From the end of the article, we learn,

"Boeing executives are under intense pressure to get the Dreamliner aloft. The plane is now more than two years behind schedule, and Boeing last quarter took a $2.5 billion charge related to development costs associated with the program. These delays have cost the company hundreds of millions of dollars in concessions and penalties to its customers, though the company still has orders for 840 Dreamliners."

Looking at the company's equity price for the past five years, compared to the S&P500 Index, it's easy to see that, by only matching the index, Boeing's equity has not delivered returns which compensate for its risk.

Since we know from the Journal piece that the Dreamliner is two years overdue, this price chart illustrates how investors began to punish Boeing's equity around the time that this delay became apparent, i.e., mid-2007. Since that time, the company's equity price has fallen in absolute terms, as well as relative to the index.

While this most recent article discussing the plane's problem with metal bolts inside the composite wing structure causing delamination was the impetus for this post, my broader question, spurred by the article, is how Boeing could have better-prepared for such a huge technological leap in designing and producing the Dreamliner.

The second price chart tracks Boeing's equity price, compared to the S&P500, since 1962. This spans the eras of the vaunted 707 and, later in the 1960s, the 747.

Boeing bet the company both times, successfully. First, it moved from propeller-driven aircraft to jet propulsion, then from narrow-body to the gigantic wide-bodied 747.

It seems that the company's equity price soared, both in absolute and relative (to the index) terms, as the 707 proved itself by the late '60s. Then investors withdrew until the 747's impact became significant after the stagflation of the early 1970s. For two decades, in which Boeing designed and produced new planes without substantial technological breakthroughs or risks, its equity price soared ahead of the S&P.

Even with the recent battering of the stock's price, Boeing's equity performance isn't yet too far below its two-decade trend.

Never the less, one gets the impression that Boeing just isn't a good investment during periods of introduction of significant new technology. Its total return performance is clearly inconsistent at these times, and there doesn't seem to be any realistic way for the company to mitigate this.

Between the nature of the firm's customers and their frequent struggles with profitability, those customers' tendency to play the firm off against Airbus, and the connection of its well-being with long duration economic cycles, even in good times, Boeing doesn't exhibit the sort of explosive outperformance one would seek in a growth equity.

It goes to show why, though we may respect and favor the products a company, like Boeing, produces, it's not always possible to find compelling reasons to expect consistently superior total return performance from the firm's equity.

Tuesday, November 17, 2009

Ken Chenault's State Of Denial On CNBC

I caught some of American Express CEO Ken Chenault's happy talk on CNBC this morning.
In my prior posts on the company, found under its label along the right side of the main page, I have catalogued some of the outrage that Chenault triggered by his firm's summary severing of account relationships with long time, non-delinquent customers.
This morning, he was all smiles and reporting falling chargeoffs.
But if you look at the nearby, five-year chart of Amex's and the S&P500 Index's prices, you can see that the firm has been struggling for nearly two years with anemic performance.
As long ago as early 2006, the company's return had begun to trail the index, and it's never recovered.
Thus, simply blaming last year's credit crisis is disingenuous.
It also begs the question of how Chenault's knee-jerk credit withdrawal decisions may have inflicted long term damage on American Express' brand name and earning power going forward.
Chenault confirmed that, despite having taken refuge in a commercial banking license, when his firm took federal cash to avoid bankruptcy, it has no plans to become a full service banks. Instead, he spoke of regionally-based growth through, one supposes, credit card relationships.
Isn't this more proof of excess capacity in the financial services sector? And, perhaps, that Amex should have been closed or merged with a healthier, broader financial utility?
Instead, all Chenault hopes for is to regrow charge card volumes and customers. Granted, it may be better than moving headlong into physical branch banking or other activities in which the firm has little or no experience or expertise. But simply changing direction on credit provision doesn't seem that creative, or worthwhile, in the greater scheme of US banking, does it?
I wonder how realistic that is, in view of Amex's recent shedding of so many paying, charging customers only a few months ago?

Doug Dachille On CNBC This Morning

This morning's guest host on CNBC has been the very lucid and insightful Doug Dachille.

For the first time in nearly a year, since the beginning of the various federal government bailouts, I heard someone articulate the same view that I've had. That is, Dachille said, explicitly, that what we have had occur in the past year is the substitution or replacement of private capital with public, government-supplied capital.

On the subject of leverage, Dachille echoed my own thoughts in this post from January of this year. In it, I wrote,

"However, within this recession is a secular trend of economic shrinkage that will not be reversed by anything but a return to higher leverage. Thus, no amount of unleveraged economic 'help' will reverse these losses and the accompanying fall in GDP growth.

Seen from this perspective, the only way in which a new, massive Federal stimulus package can provide 'recovery' is to substitute government-issued obligations to return US societal economic leverage back to the dangerous, unsustainable levels at which it was before the current crisis.

How is it that leverage undertaken by the private sector, and judged imprudent, can now be replaced with government-sourced leverage, in the form of either: 1) more printed money, or 2) increased sale of government debt, without creating even more risk by spending the money in less accountable, measurable ways through political channels?

The simple fact is that, for the US economy to lower its capital leverage, and adjust to that lower leverage level, some jobs and business activity will have to simply vanish and not return. Whatever economic level we enjoyed, from which our current recession guideposts are measured, it logically follows that we cannot return there anytime soon unless we collectively decide, as a society, to try to raise financial leverage back to what it was.

If we decide this is unwise, then we have to accept that unemployment will be higher, and business activity levels lower, as the marginal, leveraged activities have been eliminated with the fall in financial leverage.

Any Federal programs which seek to, in a carefully identified and measured way, "fix" the economy beyond this normal cyclical impact, will be a disguised attempt to reflate our economy with added leverage through public debt and spending, rather than private resources and channels."

Dachille went on to observe that the US economy, being overleveraged for years, had been growing unsustainably fast. When asked if bank lending was too conservative, Dachille replied that it had, finally, returned to 'normal,' prudent credit standards.

In contrast, he noted, now public funding was too plentiful, having driven down rates to zero. He then provided a really interesting insight, i.e., that as, if and when banks do begin to lend again, the Fed will lose its free funding of its enormous asset purchases, and have to begin selling those assets. This will drive prices of those fixed income instruments, such as mortgage-backed bonds, down, effectively raising interest rates.

Overall, Dachille communicated a sense that the current US economic 'recovery' is somewhat false, predicated, as it is, on continued excessive leverage.

Of all the pundits I've heard for a year, Dachille is the only one with sufficiently clear understanding of the credit markets to simply see federal, state and local funding for what they are- the replacement of excessive private capital creation and lending with public funding.

As such, he pointed out, there is a real danger. When households provide capital, it is from their savings or credit against assets. When governments provide capital, it is from future tax receipts.

If the public funding goes wrong, he warned, it can only be repaid through much higher taxes.

The only thing missing, in my opinion, in Dachille's comments, was to note that government-supplied capital is politically-allocated, which is much different than how individuals allocate investment capital, thus distorting the economy.

But, in a way, he got to the same point by labelling the current US economic situation as unreal and distorted by so much public investment. That we really don't know what real growth or risk is when the Fed floods markets with zero-interest money.

Taken together, Dachille's remarks suggest an economic situation which simply can't be good in the long term, no matter what short term liquidity has done for equity markets in the past few months.

Monday, November 16, 2009

The Chaos At J&J

I recently had the opportunity to speak at length with a Johnson & Johnson employee concerning the recent massive layoffs at the firm. Some 7-8,000 employees were shed from the 117,000-person workforce at the large, diversified pharmaceutical firm.

Reading through the article which was the first result of a Google search on the term "J&J layoffs," I was struck, humorously, by this passage,

"J&J has long been touted as being one of the best-managed companies in the S&P 500. It's no surprise then that Chairman and CEO William C. Weldon is trying to maintain that image. "Johnson & Johnson has long adhered to a broad-based operating model and set of sound management principles that have driven our success," Weldon said. "Today, we are announcing a series of actions and plans designed to ensure that our company remains well-positioned and appropriately structured for sustainable, long-term growth in the health care industry." "

According to a friend with whom I recently discussed J&J's recent job cuts, this is all myth.

The conversation began when I commented that I assumed, given her silence on the subject, and general upbeat attitude, that she was unaffected. She confirmed that, while she had escaped, her secretary had not. For rather obvious reasons, I'm not going to divulge any details sufficient for a random senior J&J executive to identify her.

Suffice to say, though, that when I asked about the nature of the cuts- surgical vs. indiscriminant- she confirmed that it was the latter.

The layoffs were, in classic large-corporate fashion, sprinkled throughout the hundreds of operating units at the sprawling health care-related giant. To give some sense of the inanity of the company's actions regarding treatment of its research staff, she related the following tale.

A researcher of her acquaintance had her original area of study curtailed, but was offered the chance to remain with J&J by totally changing her field of study, and moving to a nearby state. Despite the woman's husband being on the faculty of a well-respected university, she consented, and they moved. The woman's husband managed to secure another faculty position in a nearby city in the new location.

Just six months later, the woman's new research assignment was also terminated. This time, they offered her another, unrelated job in the same geographic area. In order to maintain some stability for her and her husband, the researcher took the new position.

It, too, was eliminated, within the year. With no other option at J&J on offer this last time, she was dismissed from the company.

My friend bemoaned the generally harsh treatment of the company's research talent. Modest salaries and no bonuses, while senior executives not actually involved in value-adding positions received lush bonuses.

She mentioned that, only a few months ago, a recently-hired woman who had been given a multi-million dollar bonus retired at age 50.

When I related some stories from my earlier career, at AT&T and Chase Manhattan, my friend began to see the recent J&J moves as just average corporate incompetence.

I used the phrase "endemic," and she immediately seized on that, lamenting that the company just seemed schizophrenic in its management style. A senior level executive would say one thing, while the reality of what was occurring two levels below was in direct contradiction.

Then there was the discussion about budget padding. She opined that, while she was quite busy, her boss, who is talented and competent, has little to do. One of them, she mused, is redundant.

I offered that this is common practice in corporate America. A senior executive keeps redundant people on staff for several reasons. One is Hay points. When your own compensation depends upon the size of your group, you fight for budget and staff, regardless of your actual need.

Then there is forward-looking protection. If you run too lean, and have to cut staff, your performance is imperiled. If, however, you keep a few extra people around with important-sounding titles, then you always have at least one staffer to offer when everyone has to "give at the church" in mass layoffs.

My friend nodded her head energetically in agreement.

I then made a generalized statement, from my own experience of some 25 years, that many companies, from the outside, look omnipotent, well-run and unstoppable. Then you get inside and, within months, realize that their successes were mostly accidents. That management is the same as in other large, ponderous, blundering entities. Good results are a product of enough lucky occurrences among many groups to appear as seamless, superior management.

She again agreed, adding that this was pretty much her own experience at J&J. Having worked at smaller competitors in the past, she has seen the varied faces of risk as an employee.

She remarked,

'In a smaller pharma company, you are more at risk to the company's success, but at least you always know exactly where you stand. It's run leaner, so everyone knows just what is happening.'

Now, as is typical in a large corporate environment, she feels powerless. Though dedicated, intelligent and, from what I gather, quite competent, she knows that continued employment at the firm is, in large part, a matter of luck.

The recent job cuts were in no way reasoned nor calculated, other than the topline number. Down in the trenches, it was like a lightning strike or tornado. Capricious and sudden, with no obvious basis for selection of the victims.

Sorry to say, her stories made me feel a bit more comfortable. Large corporate America is the same, some 15 years on, as it was the last time I wrestled with such issues.

In my case, a very productive and interesting position at then-named Andersen Consulting was changed overnight from a research directorship focusing on the performance of financial institutions into an internal finance/accounting job.

Needless to say, I immediately began looking for another job.

Despite the outward signs of steady, calculated and focused management at J&J, with the recent layoffs as evidence of a focus on containing costs while maintaining performance, the internal reality seems much different.