Friday, December 31, 2010

Confusion Over Apple As An Investment

I've noted with interest this past week's flurry of comments about Apple as an investment for 2011.

In my own equity strategy, which is outperforming the S&P for the year by roughly 25% to 11%, Apple would now be a holding in four of the currently active six portfolios. Apple trails the index slightly in two recently-formed portfolios, and outperforms in the other two.

While I can't predict with certainty, I'd expect that Apple will be part of the January 2011 equity portfolio, as well.

The nearby price chart for Apple, Google, Microsoft and the S&P500 Index reveals how dominantly the former has outperformed the latter three entities, Google and Microsoft being two of the more popular alternates in the technology sector.

What surprised me somewhat is how comparatively anemic Google's performance has been, when viewed with Apple's. The S&P's and Microsoft's track records for the past five years isn't all that unexpected.

Listening to many pundits, it's tempting to believe that Apple's performance is a purely technical feat, with a parabolic curve that must descend soon.

However, on the several bases in my quantitative equity portfolio selection process, Apple probably has some life left in it. Moreover, I've seen broad consensus on prior growth equities be wrong. For example, in 1998, Dell was viewed as overpriced and unable to sustain its then-torrid fundamental growth. It ended the year as one of the S&P500's top ten total return issues, so I was thrilled to have followed my portfolio selection process and held Dell for the entire year.

Ironically, as I observed back in the late 1990s, the bulk of the analyst community views equities in aggregates, often with some technical perspective. Thus, the individual merits of many attractive equities are lost amidst broad comparisons and conventional 'rules of thumb.'

Thank God for that.

As I consider why Apple, with its lofty share price and steady march upwards in price since January of 2009, may continue to outperform the S&P500, several reasons come to mind.

One, of course, is the firm's clear, successful focus on consistent innovation and evolution of well-received products. Those products have achieved high brand preference status. Additionally, they are typically in price ranges that have made them less vulnerable during the recent US recession and continuing economic weakness. With Steve Jobs' continued leadership, the firm may outperform expectations for a little while longer still.

And, finally, there's something which many investors fail to grasp. That is, even broadly-followed, popular firms can outperform. What is required is unexpected excellent performance. Firms like Microsoft, Dell, Kolhs, in the past, and, currently, Apple, have achieved this. It can never last forever, but it can often outlast ill-informed, generically-based expectations.

What Google does seems to be less unique with time, while Microsoft has been mismanaged for over a decade, with no sign of significant change in that important parameter.

The bottom line for me is that I don't subjectively select equities. But I can and often do interpret why my quantitative approach selects those equities which appear in portfolios. And from post hoc, informal inspection, it's easy for me to see why none of the recent portfolios have held Google or Microsoft, while many have included Apple.

Thursday, December 30, 2010

Is Case-Shiller Now Portending The Dreaded "Double-Dip" Recession?

After months of being informed by many economists and pundits that risks of the much-feared "double dip" recession were nil, S&P's David Blitzer now states otherwise.

"There is no good news in October's report," said David Blitzer, chairman of the committee that released the Standard & Poor's/Case-Shiller home-price index. Citing expired tax credits for homebuyers and a lackluster national economy among the causes, Blitzer said "on a year-over-year basis, sales are down more than 25 percent and the month's supply of unsold homes is about 50 percent above where it was during the same months of last year."

The Case-Shiller index plunged unexpectedly, posting some price declines. Spinning this trend out, property values are set to slide, with more foreclosures to add to the backlog currently residing on the balance sheets of major commercial banks.

Slice it any way you wish, housing price declines mean less household net asset value and potentially lower spending levels.

Thus, the feared recessionary impact of the recent Case-Shiller data.

It adds more complexity to the already murky economic picture for early 2011.

On one hand, you have robust S&P500 earnings and balance sheets heavy with spendable, investible liquid assets, coupled with newly-legislated, extended tax rates.

Then, again, you have high unemployment, a continued bloated federal deficit, and state and municipal financial woes.

With that uncertain backdrop of conflicting influences, this week's Case-Shiller Index news landed with a worrying thud. It's hard to believe it bodes well for the US economy in the months ahead.

So much for all the Pollyanna pundits of 2010 assuring us that residential real estate woes were in the rear view mirror.

Wednesday, December 29, 2010

Scepticism On Tax Data

Yesterday I wrote this post concerning how sceptical one must be when listening to private sector supporters of administration alternative-energy policies.

Thanks to an excellent Wall Street Journal editorial last Thursday, 23 December, by Alan Reynolds, entitled Taxes and the Top Percentile Myth, we now know that similar scepticism must be exercised concerning taxpayer data, as well.

Specifically, Reynolds debunks an oft-cited study purporting to reveal that the wealthiest US taxpayers also earn a disproportionate share of "income." The term "income," Reynolds notes, is the Achilles Heel of the study.

Reynolds begins,

"Despite the deficit commission's call for tax reform with fewer tax credits and lower marginal tax rates, the left wing of the Democratic Party remains passionate about making the U.S. tax system more and more progressive. They claim this is all about payback—that raising the highest tax rates is the fair thing to do because top income groups supposedly received huge windfalls from the Bush tax cuts. As the headline of a Robert Creamer column in the Huffington Post put it: "The Crowd that Had the Party Should Pick up the Tab."

Arguments for these retaliatory tax penalties invariably begin with estimates by economists Thomas Piketty of the Paris School of Economics and Emmanuel Saez of U.C. Berkeley that the wealthiest 1% of U.S. households now take home more than 20% of all household income.

This estimate suffers two obvious and fatal flaws. The first is that the "more than 20%" figure does not refer to "take home" income at all. It refers to income before taxes (including capital gains) as a share of income before transfers. Such figures tell us nothing about whether the top percentile pays too much or too little in income taxes.

In The Journal of Economic Perspectives (Winter 2007), Messrs. Piketty and Saez estimated that "the upper 1% of the income distribution earned 19.6% of total income before tax [in 2004], and paid 41% of the individual federal income tax." No other major country is so dependent on so few taxpayers."

Reynolds has pointed out a critical problem with the Piketty and Saez study, i.e., they don't use appropriate measures. Instead, they use inflated, pre-tax income for the wealthy, while using pre-transfer payments income for those at the other income extreme. He continues,
"A second fatal flaw is that the large share of income reported by the upper 1% is largely a consequence of lower tax rates. In a 2010 paper on top incomes co-authored with Anthony Atkinson of Nuffield College, Messrs. Piketty and Saez note that "higher top marginal tax rates can reduce top reported earnings." They say "all studies" agree that higher "top marginal tax rates do seem to negatively affect top income shares."

What appears to be an increase in top incomes reported on individual tax returns is often just a predictable taxpayer reaction to lower tax rates. That should be readily apparent from the nearby table, which uses data from Messrs. Piketty and Saez to break down the real incomes of the top 1% by source (excluding interest income and rent).

The first column ("salaries") shows average labor income among the top 1% reported on W2 forms—from salaries, bonuses and exercised stock options. A Dec. 13 New York Times article, citing Messrs. Piketty and Saez, claims, "A big reason for the huge gains at the top is the outsize pay of executives, bankers and traders." On the contrary, the table shows that average real pay among the top 1% was no higher at the 2007 peak than it had been in 1999.

In a January 2008 New York Times article, Austan Goolsbee (now chairman of the President's Council of Economic Advisers) claimed that "average real salaries (subtracting inflation) for the top 1% of earners . . . have been growing rapidly regardless of what happened to tax rates." On the contrary, the top 1% did report higher salaries after the mid-2003 reduction in top tax rates, but not by enough to offset losses of the previous three years. By examining the sources of income Mr. Goolsbee chose to ignore—dividends, capital gains and business income—a powerful taxpayer response to changing tax rates becomes quite clear.

The second column, for example, shows real capital gains reported in taxable accounts. President Obama proposes raising the capital gains tax to 20% on top incomes after the two-year reprieve is over. Yet the chart shows that the top 1% reported fewer capital gains in the tech-stock euphoria of 1999-2000 (when the tax rate was 20%) than during the middling market of 2006-2007. It is doubtful so many gains would have been reported in 2006-2007 if the tax rate had been 20%. Lower tax rates on capital gains increase the frequency of asset sales and thus result in more taxable capital gains on tax returns.

The third column shows a near tripling of average dividend income from 2002 to 2007. That can only be explained as a behavioral response to the sharp reduction in top tax rates on dividends, to 15% from 38.6%. Raising the dividend tax to 20% could easily yield no additional revenue if it resulted in high-income investors holding fewer dividend- paying stocks and more corporations using stock buybacks rather than dividends to reward stockholders.

The last column of the table shows average business income reported on the top 1% of individual tax returns by subchapter S corporations, partnerships, proprietorships and many limited liability companies. After the individual tax rate was brought down to the level of the corporate tax rate in 2003, business income reported on individual tax returns became quite large. For the Obama team to argue that higher taxes on individual incomes would have little impact on business denies these facts.

The overall points Reynolds so clearly makes are that the declared incomes of the wealthy are responsive to tax rates, and much corporate income flows through individual returns for many businesses. Thus it's neither fair nor correct to classify all 1040 form income as 'personal.'

Reynolds concludes his instructive piece by noting,

"The Piketty and Saez estimates are irrelevant to questions about income distribution because they exclude taxes and transfers. What those figures do show, however, is that if tax rates on high incomes, capital gains and dividends were increased in 2013, the top 1%'s reported share of before-tax income would indeed go way down. That would be partly because of reduced effort, investment and entrepreneurship. Yet simpler ways of reducing reported income can leave the after-tax income about the same (switching from dividend-paying stocks to tax-exempt bonds, or holding stocks for years).

Once higher tax rates cause the top 1% to report less income, then top taxpayers would likely pay a much smaller share of taxes, just as they do in, say, France or Sweden. That would be an ironic consequence of listening to economists and journalists who form strong opinions about tax policy on the basis of an essentially irrelevant statistic about what the top 1%'s share might be if there were not taxes or transfers."

It's almost comical how simple is Reynolds' identification of this major flaw in Piketty's and Saez' work. Yet many in the current administration apparently swear by the study. Even the president's own chief economist seems to have fallen prey to similar measurement mistakes.

It goes to show how important it is to, as a grad school professor taught me, critically read such articles to ascertain the quality of the research before giving it credibility. In the case of Piketty's and Saez' taxation-related work, it's clear that many have come to rely on the study's incorrect conclusions without even understanding how it measured the rather nebulous concept of 'income.'

Fortunately, Alan Reynolds was up to the task of deconstructing the earlier, flawed study and providing instructive guidance on how to actually interpret the phenomenon under examination.

Tuesday, December 28, 2010

On Scepticism & EPA Policy Support by Utilities

The lead staff editorial in one of last week's Wall Street Journal editorials teaches scepticism when one hears private sector support for EPA energy policies.

Specifically, the EPA is issuing new pollutant rulings aimed at coal-fired plants. The intended result is to force the mothballing of large amounts of comparatively inexpensive existing electricity generation capacity.

Guess who the supportive private sector utility execs are? Why, the leaders of predominantly non-coal-fired utilities, of course. Folks who have bet on other technologies, like John Rowe of Exelon. NextEra, a wind- and solar-power generator, is also lining up behind the EPA.

Clearly, one has to take private sector endorsements of government policy with a grain of salt. They are unlikely to be altruistic or without an agenda.

Instead, we see the age-old game of one group of executives getting behind a political issue and piling on those who are less-advantaged.

This is hardly the way our society should be allocating capital or choosing winners and losers in the energy generation sector.

Monday, December 27, 2010

Auditors Now Blamed for Lehman Collapse

Thursday's Wall Street Journal reported that Ernst & Young has now been charged with civil fraud in the collapse of Lehman Brothers in late 2008. As the defunct firm's auditors, E&Y is being accused of helping Lehman hide the consequences of its lethal excesses.

Observers are accusing auditing firms of going easy on valuation methodologies used by their clients. In the case of PricewaterhouseCoopers, both AIG and Goldman Sachs used the firm, yet posted differing values for the same swaps on their respective balance sheets.

Auditors, for their part, contend that they are only to assure that proper processes are in place, not that those processes are actually used correctly.

It's not a complete surprise that things have come to this. Perhaps it's more surprising that it took so long. After Arthur Andersen was improperly attacked by the US and driven to bankruptcy, the remaining large auditors know they are in government crosshairs anytime a firm goes under for reasons that have anything to do with its accounting and/or financial statements.

However, at least one hedge fund bear, which, if memory serves, was David Einhorn, was on to Lehman's financial statement problems just by analysis of those published items. It's not like any investor didn't have reason to question what was going on.

I think the larger issue is, again, expecting poorly-compensated auditors doing SEC-mandated work to surface every corporate financial impropriety. As with so much government regulation, all the SEC-required statements have done is falsely assure naive investors that audited statements which don't expressly find problems are, in fact, a clean bill of health.

How much more meaningful if no statements were required, and those that were published had to pass truly useful standards.

Thursday, December 23, 2010

Boone Pickens' Wind Plans Go Horribly Awry

There have been two recent editorials in the Wall Street Journal regarding the folly of wind power as a major component of US energy policy. A lead staff editorial on 23 December discussed a number of questionable aspects of federal wind power energy policy. The 23 December piece, by Robery Bryce, entitled A Wind Power Boonedoggle, lampooned Boone Pickens' vaunted alternative energy policy, announced 30 months ago, featuring wind power.

I wrote posts here, here and here concerning Pickens' "policy." Now it seems his extensive wind farm investments have fallen afoul of the low price of natural gas.

Bryce wrote in his editorial,

"The Dallas-based entrepreneur, who has relentlessly promoted his "Pickens Plan" since July 4, 2008, announced earlier this month that he's abandoning the wind business to focus on natural gas.

Two years ago, natural gas prices were spiking and Mr. Pickens figured they'd stay high. He placed a $2 billion order for wind turbines with General Electric. Shortly afterward, he began selling the Pickens Plan. The United States, he claimed, is "the Saudi Arabia of wind," and wind energy is an essential part of the cure for the curse of imported oil.
Voters and politicians embraced the folksy billionaire's plan. Last year, Senate Majority Leader Harry Reid said he had joined "the Pickens church," and Al Gore said he wished that more business leaders would emulate Mr. Pickens and be willing to "throw themselves into the fight for the future of our country."
Alas, market forces ruined the Pickens Plan. Mr. Pickens should have shorted wind. Instead, he went long and now he's stuck holding a slew of turbines he can't use because low natural gas prices have made wind energy uneconomic in the U.S., despite federal subsidies that amount to $6.44 for every 1 million British thermal units (BTUs) produced by wind turbines. As the former corporate raider explained a few days ago, growth in the wind energy industry "just isn't gonna happen" if natural gas prices remain depressed."

So much for predicting the rise of one energy source by hoping for scarcity of another. And it's sort of funny, because, separately, Pickens has been stumping for natural gas-powered vehicles. So I guess one windfall threw another of his energy bets for a big loss.

Bryce went on to note how well-subsidized wind power has been,

"Despite wind's lousy economics, the lame duck Congress recently passed a one-year extension of the investment tax credit for renewable energy projects. That might save a few "green" jobs.

But at the same time that Congress was voting to continue the wind subsidies, Texas Comptroller Susan Combs reported that property tax breaks for wind projects in the Lone Star State cost nearly $1.6 million per job. That green job ripoff is happening in Texas, America's biggest natural gas producer.
Today's low natural gas prices are a direct result of the drilling industry's newfound ability to unlock methane from shale beds. These lower prices are great for consumers but terrible for the wind business. Through the first three quarters of 2010, only 1,600 megawatts of new wind capacity were installed in the U.S., a decline of 72% when compared to the same period in 2009, and the smallest number since 2006. Some wind industry analysts are predicting that new wind generation installations will fall again, by as much as 50%, in 2011."

According to Bryce, Pickens is moving his wind turbines to Canada, where mandatory alternative energy legislation requires utilities to buy power he'll generate up there with his new toys.

All of this makes you wonder just how much of Pickens' vaunted plan was a way to drive federal subsidies for his investment strategies, doesn't it?

Meanwhile, in the earlier Journal staff editorial, the writers note how much less efficient wind power is, in terms of megawatts/worker production. It "takes at least 25 times more workers to produce a kilowatt of electricity from wind as from coal."

The cost to taxpayers for each wind-related energy job was estimated at $475K in the editorial. There's no way private industry could accommodate such expensive job-creating investments. Only government, taxpayer-funded subsidies would be so foolishly squandered.

I think the larger story here is that Pickens' wind-based defeat exposes his eagerness to benefit his investors at the explicit expense of taxpayer subsidies, while never effectively responding to charges that his alarm over the US oil import bill is unjustifiable on purely economic bases.

Wednesday, December 22, 2010

Demographic Stress Tests

For some time now, I've been convinced that US government employee unions and various social wealth transfer schemes, e.g., Social Security, Medicare and Medicaid, will have to accept significant reductions in promised benefits due to unchecked growth in said benefits due to unrealistic contract terms and poorly-designed programs.

On the weekend after Thanksgiving, Nicholas Eberstadt of the American Enterprise Institute and Hans Groth, senior director for Healthcare Policy & Market Access for Pfizer Europe, wrote Time for 'Demographic Stress Tests,' an editorial in the Wall Street Journal which describes some of the potential consequences if my expectations are not realized.

The editorial paints a dark picture, beginning,

"Financial crises can erupt suddenly and unexpectedly. Demographic pressures, by contrast, gather slowly and predictably—but over just a generation they can transform the economic and social landscape irreversibly.

Such a transformation is already underway in the developed world. Twenty years from now, Western economies will be characterized by stagnating populations, shrinking work forces, steadily increasing pension-age populations, and ballooning social spending commitments. These demographic changes will mean major increases in public debt burdens and slower economic growth, as savings are diverted from investments and innovation that enhance productivity."

For example, they write,

"The U.S., meanwhile, can expect to see continuing population and manpower growth between now and 2030, thanks to relatively high birth rates and a robust inflow of immigrants (roughly half of them legal). America will remain the most youthful Western society, although its 65-plus population will be about 19% of the total, up from 13% today.

Nevertheless, entitlement liabilities—especially the unfunded liabilities in the health-care system—are on course to skyrocket in the decades ahead. The country's recently enacted health reform will make the burden heavier.

At present, the ratio of gross U.S. public debt to GDP is nearing 100%, and the country is running annual deficits of around 10% of GDP. The Congressional Budget Office projects gross public debt to be 200% of GDP by 2020, and the BIS sees it hitting 300% of GDP by 2030. By the BIS estimates, restoring the U.S. public debt burden to 2007 levels would require budget surpluses of 2.4% of GDP for the next 20 years.

Maintaining economic growth in the face of these demographic trends will require rethinking current approaches to work and retirement, pension and health-care policies, and government budget discipline."

Music to my ears, most assuredly. I've become certain that, for the US to avoid fiscal calamity on a society-wide scale, the 1930s- and 1960s-era social safety net programs, all sharing design flaws, must soon be seen as a temporary taking leave of economic senses by a country careening between deep despair and post-war elation. They will have to be halted, dismantled, or severely capped, to be replaced by more restrained, individually-based, defined-contribution, rather than defined-benefit approaches.

Eberstadt and Groth provide similar statistics for other countries, including Germany and Japan, which, together with the US, the authors note comprise "half of the West's output and nearly 30% of the world's GDP."

All three are projected to experience public debt/GDP ratios of over 200% in just twenty years. Japan's would hit 600%. These are stunning numbers, when you are used to the US running no more than about 50% on this ratio in past decades.

The authors suggest, in conclusion,

"Thanks to the recent financial crisis, we're now familiar with the concept of the "financial stress test" used to evaluate the soundness of banks and allied institutions. A "demographic stress test" for Western economies is now in order, so that voters and their elected representatives can cope with aging populations and declining work forces.

Such an exercise would assess how manpower availability, labor force participation rates, aging and budgetary commitments would, over the next 30 years, affect key measures of national economic well-being like growth and productivity, fiscal balances, and government debt. It would also indicate the extent to which adverse "baseline" costs and consequences could be mitigated or offset by changes in lifestyle, personal behavior and public policy. These could include, for example, later retirement thanks to healthy aging, increased attention to preventive health care, enhanced personal savings, and adjustments to health and pension schemes.

Every Western country will have to determine how to pursue a future that is grayer but healthier and more affluent. The sooner we pay serious attention to the demographic challenge, the likelier we will be to meet it successfully."

Even these pundits avoid what ought to be obvious to objective observers of these predictions. Most large Western country pension, social safety net and health care schemes will have to be radically redesigned and reduced in scope and cost. There's just no way, after several decades and generations in which expectations have been so heavily affected by citizens' knowledge of social benefits replacing their own savings, that younger, working citizens can or will sustain these obligations.

Who in their right mind expects people to work from 21-70, then live for another 15-20 years at similar standards without having saved substantial amounts of their prime years' compensation? Especially when you add in the demographics of shrinking young Western populations- except for the US- which make the burdens so much more heavy?

Reading a non-partisan, cold-eyed piece like Eberstadt's and Groth's really opens your eyes to the magnitude, across most of the West, of the size of the shortfall and drag on economic activity that old, ill-conceived social spending obligations for pensions and health care will have in a comparatively short time.

More than in past years, we are now, for many countries, on the cusp of moving irrevocably into financially dangerous territory if we continue to allow badly-designed, unsustainable social programs to remain in place.

Tuesday, December 21, 2010

The Euro-Based Changes In The EU

This past weekend's Wall Street Journal featured a half-page editorial by Brian Carney & Anne Jolis entitled Toward a United States of Europe. It's amazing to me how relatively little attention this major change is receiving in US business and other mainstream media.

Most of us Americans don't really understand the specific limits of the original Treaty of Lisbon which gave birth to the European Union. Among them was, with the birth of the Euro and the European Central Bank, to quote the Journal article,

"each member state would be responsible for looking after its own budgetary and borrowing needs. Going forward, the euro zone's members will stand as guarantors of each others' national debts."

Thus, the title of the editorial, because there is joint responsibility among the EU members for all sovereign liabilities. Very much the same effect as Alexander Hamilton's original plan for the United States government's assumption of all debts of the thirteen member states.

Rather troubling, however, for the Euro and the EU, is the fact that the politicians aren't giving this massive change its due, ramming it through as a "limited treaty change."

On the contrary, France's Finance Minister, Christine Lagarde, said,

"It's a major adjustment. We violated all the rules because we wanted to close ranks and really rescue the euro zone."

Further, Lagarde said that the original Treaty "was very straightforward. No bailing out."

I recalled, with interest, early on in the Euro's existence, that France and Germany were two of the first members to violate the currency union's economic guidelines regarding budget deficits and/or deficits. The rules were, as Lagarde admits, flouted from the very start.

Carney and Jolis cite Germany's one-time Bundebank head, the venerable Hans Tietmeyer, writing,

"that monetary union required 'the degree of solidarity characteristic of a nation.' "

That's a big jump for the EU member states. Unlike US states, most of which have some sort of balanced-budget requirement, however loosely-enforced or defined, formerly sovereign states in the EU were, only decades ago, issuing their own currencies, and running budget deficits even now.

The editorial's authors make the insightful point,

"Economic competition is to be replaced by consultation and cooperation. Whether that is an improvement is doubtful, but it is also, in a sense, beside the point. Europe has chosen its path. The common currency will stand or fall based on the ability of the EU to impose ever-more intrusive spending and taxation oversight on the euro zone's members. Does Europe have the necessary solidarity for that to succeed where less coercive measures have failed in the past?"

The transition from common currency to facilitate individual competitive advantages among the EU members, to its use to enforce top-down budgetary and taxation policies, is a sea-change. Even the US does not have this wrinkle in its Constitution.

The EU's members are much more ethnically distinct, and more recently, than are US states. I've always thought that this reality would prohibit a truly-shared fiscal and monetary union in the EU.

Now I guess we'll see whether I, and so many other observers, are correct. The effects of Euro failure aren't clear, but one has to suspect, if the establishment of the Euro brought so many benefits, its disappearance would reverse those, and bring new costs for the member states and businesses operating therein.

Monday, December 20, 2010

The Sudden Emergence of Contentions of 'the End of Savings Glut'

I have read two separate articles in the past week concerning a contended coming 'end of savings glut.' One piece, by David Wessel, appeared in the Wall Street Journal, while the other was in a recent edition of The Economist. Both cite McKinsey & Co.'s McKinsey Global Institute as the source of their articles.

Seeing McKinsey's institute cited twice in a week on the same topic makes me suspicious that the consulting giant is once again gearing up its media machinery to stoke demand for projects based on yet another shocking 'finding' from its 'institute.'

I recall when McKinsey created its institute many years ago. At the time, I was with Andersen Consulting, now Accenture, which, belatedly, I believe, created their own allegedly-separate research arm, as well. Back then, it was relatively easy to identify McKinsey's 'institute' concept as simply a way to refashion certain publicly-releasable elements of their confidential client work, the better to get free media attention and put forth an image of doing independent research. I said as much to senior executives at Andersen at the time, but it took quite a few years for them to come around to the McKinsey concept.

Whether this latest shocker from the consulting firm is the result of its deliberate consideration of the question, or simply an agglomeration of various client work elements, is not clear. Or even if it's mostly some deductions made from combing through available OECD information. Reading the two derivative articles suggests it could easily be the latter.

Rereading those pieces, I find myself rather unsurprised by McKinsey's alleged 'findings.' It doesn't take a genius to see that wealthier developing nation consumers will both attract more investment to build infrastructure to serve their evolving needs, as well as provide some savings from their accelerating incomes.

Are the estimates of global investment, savings, and growth from McKinsey accurate? I don't know. Why should they be any more accurate than those of other pundits, researchers and observers?

Here's a sample of Wessel's interpretation of the McKinsey report,

"The global savings glut could easily become global savings dearth. And that would mean substantially higher interest rates.

If long-term rates, adjusted for inflation, returned to the 40-year average, McKinsey estimates, they would be 1.5 percentage points higher, a big jump from the current 3% or so yield on 10-year Treasurys. And rates could go up more if emerging markets try to step up infrastructure and other investments faster than U.S. and other rich countries increase their overall saving, which could be an unwelcome brake on global growth."

Funny, I thought the US is dissaving to the tune of a trillion dollars of federal deficits per year, plus various municipal pension funding gaps in the tens of billions.

The fuzzy forecasts for various constructs- savings, investment, economic growth- combined with whether various rates rise, or fall, makes the whole notion of declaring a savings shortages a joke.

I'm not saying their won't be an 'end of savings glut,' nor that their won't be a rise in rates. But so much depends upon the movement of many inter-related factors that it's really just impossible to know, isn't it?

But, then, that's probably McKinsey's objective. To create some newly-imagined risks of uncertainty, the better, well, to go hire those supposedly-smart folks who wrote that study. Just in case there's new uncertainty.

This is classic consultant marketing. I can well-imagine the hours of conference-room sessions at McKinsey dreaming this one up. Corral a bunch of publicly-available statistics, use a lot of beach-time among under-employed junior staffers, and demonstrate the possibility of some shocking headline. Doesn't really matter what the headline is, so long as it's a shocking departure to something current. Change is news, change brings risk, and perceived new risk just might bring in some new assignments to assess various companies' risks to these new, possibly-changing facets of the global economy.

And McKinsey is doubtless counting on getting their share, or more, of those assignments. Regardless of whether there is going to be a dearth, or glut, of global savings on the horizon.

Friday, December 17, 2010

John Cochrane On The Euro & European Bank/Country Bailouts

Back on December 2nd, University of Chicago finance professor John Cochrane wrote a scintillating piece in the Wall Street Journal entitled 'Contagion' and Other Euro Myths.

I appreciate Cochrane's insightful, clear analyses of global economic and financial phenomena, and his recent piece is no exception.

I have long contended that much of the damage of the recent global financial sector crisis was a function of poor balance sheet management, evidenced by over-reliance on short-term borrowing, and Cochrane confirms this. He writes,

"The big culprit in all of this is short-term debt. There would be no crises if governments had issued long-term debt to match long-term plans to repay that debt.

Governments like to roll over short-term debt for exactly the same reasons Bear Stearns and Lehman Brothers did: It looks cheaper- at least until the crisis comes. But buying insurance is always expensive."

Cochrane correctly notes how short-term financing decisions are, in effect, a bet on an ability to rely on markets for continuing pricing and demand. Which is, of course, mistaken. Just like the pricing of mortgage-backed assets during the 2007-08 crisis, sovereign debt becomes problematic when issuers have assumed that markets will always have an appetite for roll-over issuances at affordable prices. In that crisis, you may recall, special-purpose SIVs backed by Citigroup had to be bailed out by the parent when they failed to roll over their short term borrowings due to the unexpected plunge in the assets held in the vehicles.

It's always the same. Funding decisions in low-rate environments veer dangerously short-term in nature, then become problematic as frequent trips to the market make the entity hostage to volatile investor sentiments.

Cochrane makes more excellent points in his piece. He notes that it would be better for Europe's national governments to directly and explicitly bail out their banks, rather than unnecessarily involve the currency union in bailout out an entire country. He further notes that either a blanket, "ironclad guarantee," or clear rejection of any bailout, would calm markets. By choosing the middle path, taking a case-by-case approach, the EU and IMF have magnified investor uncertainty and market volatility.

Finally, Cochrane draws obvious parallels between the European debt crisis and a looming potential one in the US. Specifically, he notes the financial instability of many US states, and the Fed's similarity to European banks in loading up on short-term financing, via QE2. And, similiarly to the ECB, which is buying suspect European sovereign debt, the Fed is buying questionably-valued paper, too.

Cochrane dispels the myth of contagion in Europe, replacing it with sound analysis of the true causes of the debacle, and better alternatives to resolve it.

Thursday, December 16, 2010

The Latest On GE & Its Failed CEO Immelt

The Wall Street Journal featured GE's Tuesday outlook in its Ahead of the Tape column earlier this week.

Paul Glader wrote of the company's failed CEO Jeff Immelt,

"And investors are cautious about his ability to reorient the company given questionable acquisitions in areas such as homeland security, commercial real estate and subprime mortgages during his first 10 years as chief executive."

Isn't it stunning to realize that GE's board has allowed Immelt to destroy shareholder value for so long without lifting a finger to punish or replace Immelt? The nearby price chart for GE and the S&P500 Index since 1960 illustrates how atrociously bad Immelt's performance has been.

He assumed command of the firm from Jack Welch in September, 2001. Simply by observing the distance that GE's blue line was above the index's green one at that time, compared with now, one sees how much of the firm's cumulative value built over 40 years has been eliminated through Immelt's incompetence.

Glader gives a few faint compliments to Immelt in an intervening paragraph, then closes with this cautionary note,

"Still, Mr. Immelt has a long road to travel to convince investors there is more value for them in holding GE's stable of disparate businesses than directly investing in growth markets themselves."

If you read my prior posts concerning Immelt's dismal performance, under that the Immelt label, you'll see how he's already reaped so many tens of millions in cash, plus the usual options, that Immelt really no longer can be assumed to rely on current or future GE compensation for his financial needs. He's now in it mostly to salvage his reputation, if that's even now possible.

Just viewing the magnitude of Immelt's disastrous tenure at GE, and the company's board's complacency, no investor should feel safe owning GE for anything other than a timing play. In my prior posts, I've argued that GE need no longer exist as an entity, being primarily the last of a once-common breed of conglomerates which no longer have a viable financial raison d'etre in a world of ultra-low equity trading costs.

As a long run equity investment, it's been among the worst an investor could choose since Immelt took over as CEO.

Wednesday, December 15, 2010

Going Easy On Citi's Vik Pandit

Last weekend, according to the Wall Street Journal, was the third anniversary of Vikram Pandit's elevation to CEO of the ailing US bank Citigroup.

The nearby price chart of large US banks Citi, Chase, BofA, Wells Fargo and Goldman Sachs illustrates how miserably Pandit's institution has performed under his leadership- if you can use that word.

While all of the banks have been more or less flat for a year, Pandit's Citi plunged far lower during 2008. If you don't blame him, saying he inherited that downdraft, then you certainly can't say he did any better than any other bank since then.

In fact, it would be fair to say he essentially did nothing, and Citi benefited from a sector-wide easing of pressure on share prices.

Remember, if you will, and as I noted in posts at the time, like this one nearly two years ago, that Pandit was very slow on the trigger to change anything at Citi,

"For Vik Pandit, it's too little, too late. As the price chart for Citigroup in yesterday's post illustrated, the bank has lost nearly 80% of its equity price in the past twelve months. Surely, as others have also noted, Pandit would have gotten much more value for his shareholders had he done this early last year, rather than now.

This is precisely the sort of long term damage that results from in-denial, head-in-the-sand approaches to the actual condition of a business. By insisting on keeping Citigroup's unwieldy, difficult-to-effectively-manage business assortment intact, Pandit simply destroyed more shareholder value faster than he would have otherwise.
For this, alone, it should be time for him to go. And what more convenient time for the board, than in tandem with the guy who mistakenly hired Pandit, Bob Rubin."

The Journal, and others, are all saying Pandit has "made it," "survived," etc. Truth is, Pandit was the wrong man for the job, hand-picked by the guy who helped ruin Citigroup, Bob Rubin.

It's far from clear, from the lack of any stories concerning what Pandit ever did during the past three years, that 99 other people couldn't have "achieved," and I use that word very, very loosely, the same results at Citi to date.

It never fails to amaze me that CEOs like Pandit get time and allowances for failure or lackluster performance to which their lieutenants would never be entitled.

Next, we'll be hearing that Jeff Immelt, GE's hapless CEO, will be judged a success because, after nearly a decade of failure to perform for shareholders, he might eke out a one-time outperformance of the S&P.

From my perspective, Pandit is simply another fortunate guy who was given a job in which he hasn't done much, therefore receiving accolades for not having noticeably done more damage. However, of all the banks in that chart, only Goldman Sachs decisively outperformed the S&P for the period. None of the other banks have CEOs who were capable of delivering market-beating performance for their shareholders. But I don't believe I've read that any of those CEOs returned their large compensation packages due to those failures.

Monday, December 13, 2010

A Farm Belt Asset Bubble?

Thursday's Wall Street Journal's lead staff editorial was entitled The Farm Belt Boom.

In yet another piece of a larger inflationary mosaic, the piece detailed the recent dramatic rises in land prices in the US farm belt. For example,

"The Federal Reserve Bank of Chicago reported in November that farmland values across the upper Midwest have jumped 10% since 2009. The year-over-year increases were even more dramatic in some states- 13% in Iowa, 11% in Indiana......Land fever is running rampant."

The Journal editorial credits global crop prices, but also adds this cautionary information,

"But the price surge has been so rapid and so broad across nearly all commodities.....that it can't merely be a function of new demand for specific grains.

This is where monetary policy comes in. As the greenback declines amid easy Fed policy, commodities rise in value. Farmland booms have typically coincided with periods of Fed easing, such as the 1970s and the late 1980s. It's no accident in our view that the latest commodity price surge began this summer when the Fed's talk about another round of quantitative easing began in earnest.

The problem comes if the boom is an artificial, money-fed bubble."

Which echoes my recent post discussing the risks to banks of the low-rate environment,

"One is, obviously, the greater probability of asset bubbles, against which loans may be made, in low-rate environments. We just saw this over the last seven years. Now rates continue to hover at record lows.

The second aspect involves risks versus rates. At ultra-low rates, projects of marginal merit appear to be worthwhile and may be funded. Yet they are precisely the most vulnerable loans, once rates begin to move upwards towards more normal, sustainable levels."

Somewhere, banks are lending to buyers of this expensive farmland. At some point, if and when this commodity price boom softens or turns south, the typical outcomes will obtain, i.e., over leveraged landowners, bankrupt farmers and insolvent banks holding worthless loans on now much-less valuable farmland.

As the Journal piece concludes,

"We hope Fed Chairman Ben Bernanke is right when he says asset bubbles and price spikes in commodities are nothing to worry about. Of course, he said the same thing about housing and oil in the last decade. We're not predicting an imminent bust, but we do hope someone at the Fed is watching prices grow in farm country."
Scary, isn't it? We're not two years on from the financial meltdown caused by an overheated mortgage banking sector, exacerbated by low rates, and the Fed is still biased toward keeping them ultra-low.

Friday, December 10, 2010

More Idiocy On CNBC

I try to refrain from commenting on some of the lunacy I see on CNBC, but every so often, the level and frequency of the idiocy simply demands it.

A few days ago, Maria Bartiromo was interviewing Byron Wien. Wien was advocating that people buy equity in Indian companies and some other developing/developed country. Bartiromo confirmed that he did not mean mutual funds, and Wien confirmed this.

Then Bartiromo responded, with a clear tone of confusion,

'So you mean investing directly in the companies?'

Wien replied, with a sort of air of slight impatience, that, yes, that is what he had meant.

'So viewers should buy these firms on the local Indian and (other country) exchange?'

Wien, by now getting a little exasperated, confirmed this, and added that some were listed on the NYSE, so people could buy them there, too.

Then Bartiromo moved to Wien's apparently well-known annual list of his unexpected developments for the next year. She noted how three of last year's had widely missed the mark, and Wien tried to cover his errors by saying something like,

'Yes, I was early on those calls.'

Bartiromo then earnestly intoned,

'So do you think they'll come true in 2011?'

Now, at this point, you have to be brain dead not to realize that Wien devises a new list every year, right? So what do you think he would say about last year's predictions, relative to the coming year? Of course he told the hapless CNBC anchor that he makes up a new list, so those old predictions weren't relevant now.

Ever unflappable by her obvious misunderstanding of Wien's annual list, she babbled something inane, then finished by saying, to closely paraphrase,

'Thanks Byron. We'll be waiting for your 2011 list, as you're always so often on the mark with those predictions.'

You can't make that sort of remark up, can you? The combination of qualifiers is, on their face, ludicrous. Further, Bartiromo began the topic by pointing up three of Wien's recent big misses, giving a viewer the sense that Wien's hunches are typically way off the mark.

She can't get basic interview questions and replies straight. She manages to give viewers opposite senses of what she then tries to assert about a topic or guest. Then Bartiromo can't manage to use the English language properly on air.

Why the hell is she still on CNBC? Sadly, the fact that she is marks the network as having low standards for most of its reporting and on-air staff.

Then, this morning, I watched Mark Haines beat up a very sensible conservative guest, who commented on the current tax rate debate in Washington, using completely nonsensical logic.

Anyone with a brain knows that tax rate changes provoke behavioral changes in businesses, consumers and savers. It's known as dynamic scoring, and the CBO still doesn't use it. That's why you can read so many articles in the Wall Street Journal by eminent economists such as Alan Reynolds, Robert Barro, Brian Westbury,, cataloging the CBO's large predictive errors when forecasting revenues to be raised by tax rate hikes, or lost by rate cuts.

But Mark Haines will have none of it. Instead, he pilloried the guest, saying that if he decried Congressional spending, then he had no right to argue for a tax cut, because 'that's just like spending.'

Haines is evidently too dense to understand that Congress really spends what it says it will, whereas forecasts of government revenue gains from personal rate hikes on the wealthy never meet expectations. It's simply not a zero sum game, as explained by economists who calculate the total income of some top percentile, such as 5%, and compare it to annual federal spending. It's never enough. It never comes even close to making a difference.

What government forecasters continue to ignore is the change in the amount of economic activity due to tax rate changes, on which incomes are earned and taxes paid. When rates are cut, economic activity surges, incomes rise, and taxes do, as well.

It's not about higher rates, but lower rates which bring forth more economic activity.

You'd think that after, what, two decades on air at CNBC, listening to this debate, Haines would have learned the facts?

But you'd be wrong to think that. Instead, like Bartiromo, CNBC leaves in place an also-ran on-air personality.

Which is why I neglect what most of the CNBC staff say, excepting Rick Santelli, Trish Regan, Joe Kernen,  and Michelle Caruso Cabrera. I just listen and watch mostly for the news.

Low-Rate Environments & Bank Profitability

Yesterday's Wall Street Journal finally published an article detailing how low interest rate environments hurt bank profitability.

My banking education dates from my first days at Chase Manhattan Bank in the early 1980s. Schooled on asset-liability management and repricing, I recall quite clearly that low-rate environments are worse for bank lending and asset management profitability than higher-rate environments.

Evidently, that hasn't changed in thirty years.

Thus, since 2008, banks already pressured by bad mortgage-related loans, securities and derivatives began to be squeezed by the Fed's lower interest rate policy.

The Journal story provides details of various banks and asset managers coping with slimmer margins. What the piece doesn't discuss is two other important phenomena which add to lower overall profitability of this environment.

One is, obviously, the greater probability of asset bubbles, against which loans may be made, in low-rate environments. We just saw this over the last seven years. Now rates continue to hover at record lows.

The second aspect involves risks versus rates. At ultra-low rates, projects of marginal merit appear to be worthwhile and may be funded. Yet they are precisely the most vulnerable loans, once rates begin to move upwards towards more normal, sustainable levels.

This will leave banks holding more problem delinquent and/or defaulted loans. It's a major reason why so many banks reportedly aren't lending now in the first place.

Of course, idle capital which is unlent is employed in money markets, which now is about the same as cash, i.e., the classic Keynesian liquidity trap.

Welcome to the world of low-profit banking so long as Helicopter Ben continues to hold rates near zero.

Thursday, December 09, 2010

Barnes & Noble + Borders: William Ackman Plays Modern-Day JP Morgan

Tuesday's Wall Street Journal featured an article describing hedge fund manager William Ackman's bid to reprise J.P. Morgan's historic industrial reorganization role with his bid, as an owner of Borders, to merge that firm with Barnes & Noble. The story noted,

"The threats posed to the big store chains were underscored Monday, when Google Inc. unveiled its new online bookstore, a retailing venture that adds a major player to a crowd of digital sellers that includes Inc. and Apple Inc.

A hedge fund managed by Borders investor William Ackman is now offering to finance a bid of $960 million in cash, or $16 per share, for Borders to buy the much bigger Barnes & Noble, which put itself up for sale in August. Mr. Ackman, whose Pershing Square Capital Management LP holds 37.3% of Borders shares, made his offer in a regulatory filing that became public Monday.

The past year has been rocky for Barnes & Noble. In November 2009, the company adopted a "poison pill" antitakeover defense after activist investor Ronald Burkle and his Yucaipa Cos. purchased nearly 20% of its stock. In August, the retailer put itself up for sale. Mr. Burkle launched a nasty proxy fight for board representation, a bid that was defeated in late September.

A marriage of the two book behemoths could lead to some significant cost savings through economies of scale. Barnes & Noble also has proven to be a more adept operator, with skills that it could be applied throughout a single, combined chain. But a combination of the No. 1 and No. 2 bookstore chains in the U.S. would face headwinds, including antitrust scrutiny and Borders' own shaky finances."

I guess since Ackman already has such a large stake in Borders, conventional concerns regarding whether the merger's cost savings can really offset changing consumer behaviors with respect to bricks and mortar book retailing may be moot. He has to minimize damage to his existing investment, short of simply bailing out.

The Journal article went on to identify the most likely reason that Ackman wants Borders unified with its large competitor,

"Mr. Ackman's proposal may be a bet on Barnes & Noble's rapid investment in digital bookselling, built on its Nook e-reader device and e-book offerings. Recently, the retailer introduced a Nook Color reader, and claims to have captured about 20% of the digital book market, which Forrester Research says could more than triple to $966 million in revenue this year. Borders sells e-books through a bookstore powered by Kobo Inc., a Toronto-based e-retailer in which it is an investor.

Observers say Mr. Ackman's bid for Barnes & Noble may be an attempt to help Borders survive. But because Borders is facing even bigger challenges than Barnes & Noble, it may not be seen favorably as an acquirer."

This makes sense, of course, for Ackman and Borders. But why would Barnes & Noble allow itself to be low-balled for its more valuable asset, its burgeoning online reader business? Won't other bidders keep a realistic, market-based value on that which will prevent Ackman from stealing it on the cheap?

The story provided some detail on past merger ideas for the two firms, explaining,

"The idea of joining the two companies has been floated before. In May 2008, Barnes & Noble assembled a team of executives and advisers to study the possibility of acquiring Borders, which had put itself up for sale. But in August of that year, Barnes & Noble decided against making an offer.

Mr. Ackman had also pursued the idea. In November 2008, Mr. Ackman, then the second largest investor in Barnes & Noble, with a bit more than 10% of the stock, tried to get the book giant to buy Borders, arguing that the combined business would be stronger than either operating independently. He also owned more than 11% of Borders at the time.

His efforts were rebuffed by Barnes & Noble, however, which was concerned about inheriting Borders' real estate portfolio and lengthy store leases. Mr. Ackman later sold his Barnes & Noble stock. It is unclear whether he owns any shares today."

It's unclear to me why Ackman has so diligently and doggedly pursued either physical book retailer over the past few years. With Amazon and Google targeting the space, and Apple's recent iPad adding to the mix, it wouldn't seem to be an easy product/market in which to earn substantial gains by maneuvering with the remaining two, damaged retailers, would it?

Ackman has a track record as a smart investor. But, then, so did Ed Lampert before his plunge into owning retailers K-Mart and Sears.

Nearby is a price chart for Borders (BGP), Barnes & Noble (BKS), and the S&P500 Index for the past five years.

Why on earth would anyone have bought into these turkeys even as long as three years ago? Their underperformance has only increased since then.

I suppose Ackman has a very short-term, 'turnaround' sort of mentality that seeks a quick, abrupt rise in share price from an unexpected reorganization, followed by a hasty exit from his positions.

Somehow, though, JP Morgan's steel-sector integrations of a century ago seem to have involved an industry with much more growth and opportunity ahead of it than Ackman's book retailers have.

I'm just not seeing the logic to this situation for Ackman, other than desperation to rescue some value from his 1/3+ ownership of the worse-performing, lesser-sized turkey in the sector. Is Ackman hoping, if successful, to sell the Nook business and eventually realize real estate gains from the resulting moribund combined bookselling business? He tried that when he approached Target, but was rebuffed. Here, he is already heavily invested, and the prospects are dimmer, so his motivations might be heightened.

Jeffrey Kindler Leaves Pfizer

Jeffrey Kindler's recent departure from the CEO position at Pfizer has drawn fresh attention to the company's recent performance.

As the nearby chart comparing Pfizer's, Merck's and the S&P500 Index's prices indicates, the story hasn't been a good one for Pfizer shareholders.

Kindler took over as CEO roughly 4 1/2 years ago. Back then, based on initially-equal notional starting points in January of 2006, the firms' share prices were comparable.

Not anymore. Merck has handily outperformed Pfizer, and the S&P. So it's not as if Kindler's firm is in a sector where such performance is impossible.

The Pfizer CEO was described as under immense pressure and unable to cope. Given that even the S&P500 has outperformed it, Pfizer's board is taking reasonable action.

One wonders why Kindler was the choice for CEO back in 2006 and why, as Merck pulled away by early 2008, the company's board wasn't responding with more alacrity?

Now, the board not only has a senior-level vacancy to fill, but its record in filling it for the past half-decade should give investors pause concerning whether the next CEO will be any better.

Wednesday, December 08, 2010

Dick Parsons' Misleading Remarks In This Morning's CNBC Interview

I caught some of Citigroup chairman Dick Parsons' interview with Becky Quick this morning on CNBC. The interview seemed like an exercise in futility, as Quick lobbed softballs at Parsons, and he replied with some misleading and almost delusional responses.

Parsons' off the cuff numbers on Citi's TARP bailout made light of the real risk undertaken by taxpayers. Of course, now, it looks like a great profit- something like $12B on $48B. But this obscures the capital flows and sources of the profit. That is, existing shareholders were just about wiped out, while subsequent "profit" to the government came from the markets. It's very difficult to assess a proper risk-adjusted return for the deal, since the government has unique characteristics as an investor, including the ability to rig market and economic conditions to favor its investments.

Further, Parsons delusionally claimed that the government never interfered with the firm's operation. What was the special compensation czar's job? Did I miss something over the past few years when Ken Feinberg  was fighting with commercial banks over compensation levels? Does anyone really believe there wasn't behind-the-scenes arm twisting of banks which had taken TARP funds?

Then, in a completely surreal moment, Parsons began to lecture Quick on how banking works. How banks intermediate savers and borrowers. I guess this stuff is news to Dick, and he assumes nobody else watching CNBC knew these important details, either. But he then went on to claim, on that basis, that banks were 'special,' at the 'heart of the economy,' and could not be allowed to fail!

Wow. How convenient, Dick. Your predecessor, Bob Rubin, helped leverage and direct Citi into the mortgage-backed mess, it should have gone bankrupt, its parts sold to other banks, and you claim that your, and, by extension, all large, globally-connected banks must be saved.

Anna Kagan Schwartz correctly noted over two years ago that the problems with the US financial sector in late 2008 were solvency-based, not liquidity-based. Closing losers like Citi would have improved counterparty trust throughout the sector. Propping it up with printed government liquidity simply prolonged and rewarded incompetent bank managements and their boards.

So now, we have faulty, inept managements continuing to function along with better banks, when we had an opportunity to weed out the bad managers and allocate, by market mechanisms, their salvageable businesses to better-managed competitors.

But, of course, Parsons is in a delusional, self-serving mode now. As chairman of Citigroup, he has to distort and misrepresent that bank's and the meltdown's realities, in order to justify the firm's current existence.

J Crew Goes Private: More Self-Dealing & Unethical Corporate Governance

The story emerging around J. Crew Group's sale of itself to private equity groups TPG Capital and Leonard Green & Partners, and CEO Mickey Drexler, is distinctly unpleasant. How it portrays corporate governance and unethical behavior of certain parties is another black eye for corporate America.

According to the latest Wall Street Journal piece on the subject,

"The details of the J. Crew deal show how top management kept a number of key details from the company's board, while a TPG executive serving on that board eventually engaged in direct purchase negotiations with the company.

TPG, Leonard Green and J. Crew declined to comment."

As if this wasn't bad enough, Goldman Sachs, which originally advised J. Crew on,

"management's review of strategic alternatives other than a sale....had switched sides, working as a financial adviser for the TPG group that included Mr. Drexler. Goldeman declined to comment."

The private equity groups and Drexler discussed a buyout "for about seven weeks" before notifying J. Crew's board. During that time, the Journal article states that senior managers were brought in to make board presentations about the company's condition. This means the private equity bidders for the company were essentially being given all of the company's confidential information, unbeknownst to the directors not involved in the buyout.

Upon reading, in the Journal, and hearing, on CNBC, these various details, I immediately thought of the similar case of Kinder Morgan's buyout a few years ago. And at least one other pundit made the same connection.

The Journal article provided further details of how Drexler wouldn't work with any other buyer, and the buyout group's intimate knowledge of J. Crew's situation allowed it to make an offer calculated to satisfy the board, meaning, that the offer wouldn't be unnecessarily high.

Obviously, the big losers in this situation are the shareholders.

The nearby chart shows J. Crew's recent performance versus that of the S&P500 Index. The retailer has done better than the index over the period. It isn't completely clear why the firm's management or board would consider it to be so in need of a private equity rescue.

But what is pretty clear is that the private equity groups who ultimately agreed on a $43.50/share deal felt they were getting a bargain. So shareholders were implicitly being roughly handled.

Why? It seems that, with Drexler unwilling to work for other buyers, and having allied himself with the TPG-Green  bid, he was acting against the interests of the shareholders in whose interest he allegedly served as CEO and a board member of J. Crew. Depriving shareholders of his services, after having been compensated for learning the details of the firm, seems unethical. If Drexler did such a bad job that the firm had to be sold to a private buyout group, why was he necessary if the firm wished to remain public? If he was so key and successful, why was it being sold to a private group?

The logic is neither clear, nor sensible. Instead, about the only way it seems plausible is because Drexler and the TPG representative on J. Crew's board gained sufficient knowledge of the firm's operation and prospects, coupled with Drexler's alliance with that buyout group, to give them leverage over future prospects of the firm as a publicly-held entity.

Like the Kinder Morgan deal, it smacks of insider, self-interested dealing at the expense of shareholders. This undermines long term faith by investors in the publicly-held firm model. Perhaps investors would be wise to note whether private equity firms have representatives on boards.

One also wonders why and how the board of J. Crew let itself be put in this position? And if there were not other remedies available, such as removing the TPG-affiliated board member, and Drexler. Instead, they were evidently rewarded for their questionable ethics and behavior by being awarded a buyout price based on insider knowledge and unique leverage over the firm.

Tuesday, December 07, 2010

The Fed's Rescue Details

Many pundits and media personalities are expressing outrage after reading details of the Fed's assistance to various private entities during the 2008-09 financial meltdown.

Of particular mention in a Wall Street Journal article was the Fed's aid to money-market funds, while a CNBC discussion highlighted the otherwise-frozen commercial paper market.

It's disconcerting to read of Goldman Sachs borrowing a total of $600B from the Fed. Obviously, loan totals over the period would be staggering.

Since, as the Journal article notes, "it is tough to see how the Fed will ever convince investors it won't again ride to the rescue when required," can we not at least expect the Fed, Treasury, and perhaps Congress, in concert with financial sector players, to devise better ways of providing said insurance during financial crises?

Is it not feasible for the Fed to sell insurance, rather than simply lend trillions? Can't some market-oriented solution utilize risk-pricing so that institutions may acquire protection, but at prices related to their risk and in consequence of their mistakes?

Or perhaps, through significant rewriting of the deeply-flawed Dodd-Frank bill, provide clear, objective, quantitative tests, failing which will send a firm immediately into Chapter 11, while passing would allow it access to temporary federal aid, though priced according to risks measured in said tests?

Anna Kagan Schwartz went on record first, back in 2008, noting that the crisis was, in reality, one of solvency, not liquidity. But Paulson and Bernanke provided a solution to a liquidity crisis.

What would the proper solution have been for a solvency crisis? Wouldn't it have been, as Schwartz suggested, more orderly closing of insolvent institutions, thereby relieving counterparty pressure on the remaining institutions, which then would be judged safe and solvent? Wouldn't that take far less capital from the Fed, and create far less panic in the first place?

Given the immense scale of the Fed's bailouts of 2008, and the increasing indebtedness of the US, and possible pushback by global investors the next time the Fed tries to blithely expand its balance sheet so quickly and to such a large extent, it seems prudent to develop less capital-intensive, more discerning methods of avoiding financial panic and complete breakdowns short of simply lending out hundreds of billions, to trillions of dollars to one and all without any regard to the riskiness of the situation at each institution.

We have some time, hopefully, before the next incident of such widespread financial catastrophe. Surely there are suitably-capable minds available. Can't we expect our government's institutions to engineer better financial crisis solutions pre-emptively, rather than simply repeat the awkward and questionable practices of the Fed and Treasury during the recent financial crisis?

Monday, December 06, 2010

New Directions In Econometric Modeling

Last Tuesday's Wall Street Journal featured a lengthy news story discussing the work of many new arrivals to the econometric modeling scene. Some of the recent entrants into the field use distinctly atypical approaches.

At first, some of what I read struck me as silly. Indeed, the story quotes NYU economics professor Mark Gertler as saying,

"It strikes me as not productive to say that all we have done is a complete waste. The profession is extremely competitive. If you have a better idea, it's going to win out."

Well, yes, but only over other equally-flawed and potentially limited-in-scope approaches which are all developed by economists who studied the same historic approaches.

One of the things I found distasteful about the prospect of taking a PhD in Marketing at Penn years ago was the requirement to take various econometric modeling courses. The Journal piece notes one of the new modelers, one Mr. Farmer, observing that modern "dynamic stochastic general equilibrium" models have become so complex and over-specified that convergent solutions are often impossible to satisfy all conditions and variables.

One engaging newer approach is that of using 'agents' to describe economic activity, rather than reduce all economic activity to equations of various Keynesian-era variables. Other ideas borrow from psychology and lean toward the work of Amos Tversky and Daniel Kahneman, a Nobel Laureate for his work on risk.

Another suggests approaches used for weather, traffic and epidemics, focusing on many discrete inputs, rather than a few simplifying equations and variables.

Gertler's comment brings to mind the entire question of what such models are built to do, and how they perform in terms of prediction errors. So long as one can explain a logical trail from inputs to predictions, does it really matter, other than to Gertler's sensibilities, and those of his kind, that the models aren't conventional econometrics?

I should think not. Speaking from experience, taking a fresh approach to a problem, using tools and perspectives from another field, can allow one to capture aspects of a the problem that conventional, existing approaches simply miss, out of ignorance. I've found this to be the case in my equity strategy work. Coming from a marketing and strategy background, my modeling approach to equity performance and selection is quite different than those of typical finance-trained people. And has resulted in better performance than most similar, publicly-tracked funds.

Reading the Journal story provides some shocking insights regarding what isn't included in many of the current models, e.g., central bank actions and the finance sector, generally.

After rereading the piece and reflecting on it, I think I'm more inclined to be welcoming and excited by the arrival of a group of new and varied modeling techniques onto the econometric scene.

Certainly the past several years of ineffective retreaded Keynesian-type models have produced nothing impressive.