Friday, March 26, 2010

Vik Pandit's Tight Corner: Restructuring Citigroup

Yesterday's Wall Street Journal featured a front page article bemoaning ailing Citigroup's CEO's troubles in shedding problematic businesses.

Vik Pandit made the usual excuses, painted the usual rosy future picture, and tried to avoid facing the fundamental truth.

That truth is, precisely at the time businesses are in their worst shape is when you can't typically sell them. And, small world that it is, most of the buyers are least able to pay more than current, depressed values for them.

GE ran into this issue last year with some of its newly-unwanted businesses. Now, Citigroup can't find buyers, at prices it wants, for some credit card and private equity businesses.

Of course, being significantly government-owned, Pandit wants time to wait for prices to rise. In the meantime, he'd like to be allowed to simply ignore the consequences of having built badly-performing businesses.

What would normally happen in this situation is one of two things. Either one or more competitors would offer to take over and break up Citigroup, or creditors would force their way onto the board to get the restructuring moving, perhaps by simply shutting some businesses.

Time is the luxury weak, troubled businesses don't have, or get. If there were no time limits, every business would eventually wait out valuation issues. But, well, time is money.

Pandit wants a reprieve from either selling or closing businesses, because either of those would permanently bring the low valuations home to shareholders' equity for good, and permanently lock in the losses.

You have to wonder why Citigroup is even allowed to continue its existence in a sector with excess capacity.

Thursday, March 25, 2010

Ocado Ltd.'s Grocery Strategy

I've always had a special affection for the grocery business. Perhaps it's because my second job, as a teenager, was working for Matarelli's Grocery in Peoria Heights, Illinois.

Matarelli's was a literal corner grocer. Situated across from the Pabst Brewery, it received a steady stream of shift workers buying food for lunch, as well as many upscale housewives dropping off shopping lists or picking up orders.

The store was run by two elderly Italian spinsters, and their brother. It was a great job for many reasons. Their management style was decidedly "Theory Y," working us hard but fairly. If you knew to ask not, "may I go home now," but, "do you have more work for me to do," the sisters would send you home early, but pay you until closing.

They hired two delivery boys each year, with the job passing down to two new seniors at the Catholic high school I attended. If you happened to know the prior two guys, you had a decent shot at this dream job.

Working at Matarellis meant alternating weekends and working half the after-school afternoons during the school year. In summer, it was alternate weeks. We stocked shelves, carried orders to cars, stored the weekly distributor's massive deliveries, drove to pick up produce, and, best of all, drove the store's station wagon on deliveries.

This last part was, by far, the best aspect of the job. As a 16 year-old, we were being paid to drive someone else's car up to three times per day. The tips were fantastic, and I learned a lot about people's daily lives, as we were in so many kitchens on delivery runs.

Thus, I was fascinated by Tuesday's Wall Street Journal piece concerning UK grocer Ocado.

Though it initially looks similar to the failed San Francisco grocer, Webvan, founded and run so ineptly by some former Andersen Consulting execs years ago, Ocado seems to be better-grounded in customer needs.

The article notes that the firm does very well in Britain because of the country's bad weather, limited parking and ubiquity of high-speed internet access.

The company invested in proprietary warehouse picking systems, virtually automating the order-assembly process. This is very much more advanced, but along the lines of a concept a colleague and I had a few decades ago, when we worked together at Chase Manhattan Bank.

Now, however, online orders make the customer's side of the process easier and cheaper. Ocada has made great strides on its side, as well.

The Journal article concludes by comparing Ocada with its US counterpart, Freshdirect. When I noticed former Citigroup EVP, Lotus and Priceline CEO Rick Braddock is now the latter's CEO, it made me even more confident this business has finally arrived.

Both Braddock and the finance chief at Ocada stress sustainable profitability now, not merely logistical skills. It may take a little time, but one can't but help think this is a trend that we'll see more of in the future.

Jack Welch On CNBC Tuesday Morning

Former GE CEO Jack Welch made an appearance on CNBC's Tuesday morning program.

Welch's comments on the economy are somewhat suspect now, since he's been gone from the daily grind of running a company or business for almost a decade. His insistence that there was a very sharp "V-shaped" recovery wasn't very convincing at all.

Instead, he sounded much more credible criticizing the recently-passed health care bill.

Calling the CBO's evaluation "a sham," he bluntly said that he, and everyone else, knows this bill's provisions will cost much, much more than promised, and in no way could ever actually save the nation any money at all.

Toward the end of his appearance, he then launched into an area in which I don't think he has any qualifications, and with which he is totally out of touch- politics.

Welch claimed that, with so much government money sloshing around, there would be a recovery by November, and Republicans would make only typical, average gains in the House and Senate mid-term elections. Further, Welch claimed people would simply forget the health care bill bribes and tawdry manner of passage, on such narrow margins in both chambers.

I don't believe Welch is aware of the incredible anger growing in the larger part of the voting citizenry.

However, true to its liberal slant, CNBC immediately prepared clips of Welch's political forecasts for use on subsequent programs that morning, and on other websites. Curiously absent were his criticisms of the bill's fiscal tricks and lies.

Well, some things never seem to change. CNBC thinks Welch is relevant anymore, and continues to stump for the liberal political class, rather than report the truth.

Wednesday, March 24, 2010

A Local Retreat For Starbucks

Last fall, I wrote this post describing the woefully inept customer service ethic at my local Stop & Shop grocery store.

Earlier this week, while visiting the store for some minor items, which I continued to do in the wake of that post, I noticed the most significant change since the fall. Or, really since the store completed its upgrade to "Super" Stop&Shop.

The in-store Starbucks kiosk/cafe is closed.

Considerable money and effort were expended on this feature. The kiosk was a handsomely-paneled, freestanding wood structure which emulated the ambiance of a Starbucks retail location. Stop & Shop employees were painstakingly trained as Starbucks barristas. A broad selection of Starbucks items, paraphernalia and coffees were on display for sale outside the kiosk.

Earlier this week, as I briefly visited the store for a few produce items, I saw massive sheets of brown paper covering the kiosk. Strips of tape cordoned off the area. It looked like the entire structure was being packed up for return to the coffee roaster.

I can't help but think this is more evidence of the overall weakness of Starbuck's strategy and management. The extreme overreach, if you will, of the brand down market to average-income Americans.

Not being privy to the business arrangement between Starbucks and Stop&Shop, I can only surmise the terms. But, certainly, Starbucks paid some royalty to the grocer for the space and/or sales volumes. Or, perhaps Stop&Shop operated it as a licensed business, paying the employees and booking the profits, while paying a percentage of the gross or net to the coffee giant.

Either way, the two must have been splitting the too-meager profits.

As I recall, the hours of the kiosk weren't the same as the store, which remained open until 11PM. Even during the hours it was open, I seldom saw more than two people at the Starbucks kiosk.

Perhaps this was simply part of the large retrenchment of Starbucks locations in process during the past year. But, given the captive grocery customers, you have to wonder what this portends for Starbucks' future growth. Evidently it just isn't penetrating beyond the upper-income segments, especially in this recession.

Continuing Avoidance of Responsibility For Fannie By Paul Kanjorski

Yesterday morning on CNBC, Pennsylvania Democratic Representative Paul Kanjorksi exhibited yet more avoidance of responsibility for the mess at Fannie Mae and Freddie Mac.

With a straight face, Kanjorski accused 'Wall Street firms' of being culpable for the last several years of the housing finance bubble, totally excusing Fannie's and Freddie's involvement. What's more, Kanjorski actually said that Barney Frank had 'admitted he was wrong' to push the GSEs to buy mortgages made to ever poorer borrowers.

So, Kanjorski implied, everything's okay with Barney and he's to be held in high esteem.

Unbelievably, Kanjorski then said he personally favors creating 'hundreds' of little GSEs, so that having only a few go bust through securitizing bad mortgages wouldn't be so systemically crippling.

Called on to defend having any governmental role in housing finance, Kanjorski excoriated private lenders and mortgage pipelines for 'only being interested in the most profitable' parts of the business.

Let's see.

Fannie and Freddie bankrupted themselves at Congressional direction by securitizing bad mortgages. The result was to have far too many homes built and money lent on such homes. Because GSE's didn't have a profit motive.

Now Kanjorski is saying things would be worse if we had a financial sector in which housing was built and financed only because it was profitable for various vendors to do so.

If you wonder why there is so little business news outside of Washington anymore, Kanjorski exemplifies the reason.

Private enterprise, profit-driven economic activity and the sane, restrained economic system that develops are not trusted, nor wanted, by Washington's power brokers.

Instead, though they won't say it to us clearly, the Washington powers that be believe in nationalizing as much of our economy as possible, as soon as possible, e.g., GM, GSEs, TARP banks, AIG, health insurance and care.

Tuesday, March 23, 2010

Collusion By Private Equity Customers

This morning's Wall Street Journal featured a rather surprising article in the Money & Investing section.

It seems that CALPERS and other large, pension-related, asset-rich entities, all members of the Institutional Limited Partners Association (ILPA), have explicitly met to formulate a set of 'principles' which they will demand private equity funds adopt.

In response, several private equity shops are exploring a lawsuit on anti-trust bases.

The Journal piece ends with what is probably the most sensible point, which is a quote from an attorney expressing the view that the federal bench isn't going to go to bat for the likes of Henry Kravis.

While almost certainly true, it is, also, beside the point. Justice is supposed to be blind, and if the private equity groups have a case, well, then, they have a case.

But they really don't.

The ILPA may meet to draft common principles. But who said that's the entire market for private equity funding? In fact, if anything, the ILPA is probably doing themselves a favor by potentially excluding themselves from private equity deals.

After all, look at Cerberus. Great job with GMAC and Chrysler, guys. Isn't that John Snow, former Treasury Secretary, overseeing those embarrassments?

The situation here is really quite simple.

Over the past few decades, private equity groups became overwhelmed with funding. Their activity levels, and the prices of their acquisitions, soared. In time, Blackstone even went partially-public, enriching its partners at previously unheard-of levels.

If that's not a sign of an overheated market, what is? And ILPA members were very likely in the vanguard of the rush to overfund private equity groups.

Now, having become disappointed with results, these institutions are crying foul and developing "principles."

By the way, last time I looked, CALPERS had done a very fine job of screwing up on its own with a reckless land investment scheme that's gone sour at a huge cost to the entity's assets.

Here's what will actually happen in years to come.

First, the ILPA will try to hold private equity groups to the newly-restrictive terms. The vaunted "principles" center around, as you'd expect, pricing. Terms such as fees, disclosure and investor oversight.

Second, a few ailing private equity groups will cave in, to preserve funding. But the better firms won't.

Third, the better-performing private equity groups will be pursued by ILPA members who will toss away their newly-created terms in order to get a piece of the best returns in the sector.

That's how these cycles always work. Hedge funds are the same way. Once burned, institutional investors declare that they won't stand for such restrictive terms. Then, when the hedge funds become the best-performing investment firms, such concerns are easily discarded in the pursuit of returns.

There won't be a lawsuit by private equity groups. The weak ones will want it, but the stronger ones realize it serves no purpose to air this dirty laundry. And they will naturally regain the institutional customers once market conditions turn to their favor once more.

Still, it's an interesting circus to watch. Institutional investors looking to blame the recipients of their investments, rather than admit to their own mistakes, while the weaker private equity groups run for legal cover.

Monday, March 22, 2010

Leverage Doesn't Equal Risk, But It Seems To Account For Much Of It

I wrote this post a few weeks ago discussing the use of the Kelly Criterion for scaling allocations to uncertain investments.

By following links in that post, you can read my reviews and discussions of Scott Patterson's recent book, The Quants.

That book, and Poundstone's Fortune's Formula, were the subject of some discussions with a colleague on Saturday morning, as we drove to the Washington, D.C., "Kill the Bill!" rally on the Capitol lawn.

As my friend and I revisited the topic of risk, risk management, and the Volcker Rule, I realized that, despite there being many aspects of risk, Kelly's work demonstrates that, of all of them, leverage is by far the greatest source of risk.

First, our fractional banking system exposes us to constant leverage. The reason you have an FDIC is due to US experience during the Depression with failed banks which had lost their capital through leveraged mortgage lending, and no longer could pay depositors their money.

Fractional-reserve banking provides much of the multiplier effect in our economy.

But we have explicitly allowed leverage in other areas, as well. Margin lending for selling securities short, for example. And, in effect, credit derivatives.

By exchanging risk without the use of exchange-traded instruments, as in those swaps, we learned in recent years that there can be unknown leverage borne by a counterparty.

Many pundits immediately derided the Volcker Rule. It's also no surprise that any bank CEOs who commented on it did so negatively and dismissively.

That, I observed to my friend, ought to tell you how necessary and effective Volcker's recommendation actually is.

Of course, if you are Jamie Dimon, Vik Pandit or Lloyd Blankfein, you want people to believe that a US investment or commercial bank simply must be allowed to engaged in leveraged, proprietary trading. These CEOs easily confuse legislators and regulators by citing a need to provide complete client solutions.

But leveraged proprietary trading isn't customer service.

Like it or not, despite what Jamie & Co. assert, when a financial institutions is highly-levered, and federally insured, and it is allowed to engage in proprietary trading and/or investing, by definition, that proprietary trading or investment is levered.


Because any proprietary activities' losses hit the institution's equity. And since financial institution equity is often only 5-8% of total assets, it won't take much, as we saw in late 2008, to bring investment banks as large as Morgan Stanley and Goldman to the edge of solvency.

This is what Patterson exposed in his book. By failing to heed the Kelly Criterion, billionaire hedge fund owners levered up and sustained crippling losses.

Imagine if those had been part of insured banks.

Wait, they were! Morgan Stanley's PDT group.

That's why Volcker is right. So long as any institution is implicitly or explicitly federally insured, and operating with leverage, any proprietary losses are, in effect, guaranteed by taxpayers.

Heads, they win. Tails, the rest of us lose.

That is the most frequently observed risk in our financial system in the last 30 years.

But you must notice there are two characteristics which must be separated. And only two.

Leverage and federally-insured deposits or businesses.

For example, suppose Blackstone invests billions of borrowed money in various ventures, and loses it all?

As a private equity firm, its partners/owners lose a lot. Its lenders, presumed to have analyzed Blackstone's balance sheet and operations, will probably take painful writedowns.

Losses like these could come from bad private equity deals, or even bad startup venture funding.

Or, they could come from Blackstone's own proprietary trading operations.

So long as only private sector counterparties risked their capital, whether as a creditor via loans to fund the balance sheet, or a creditor via counterparty risk, the rest of us aren't directly hurt.

It's only when federally-insured entities lose in leveraged proprietary trading that we all suffer directly.

That's why the Volcker Rule is so simple and effective. He identified the only two practices which should never occur together, i.e., proprietary leveraged trading and government guarantees of deposit insurance.

We shouldn't care if an unlevered Chase lost on proprietary trading, because those loses are limited to its own capital. But as soon as the bank is allowed to lever, implicitly, its losses can outstrip its capital.

Risk management is challenging enough without adding leverage to increase it. All the squawking over Paul Volcker's recommendations indicate that they address a serious problem. One which should be solved along the lines of his Rule, while ignoring the bleating and complaints of those in the sector who know they will lose valuable access to federal bailouts if his idea is put into practice.