Friday, February 04, 2011

Odds & Ends From CNBC

I saw a couple of inane segments recently on CNBC that I felt merited comment.

This morning, former Fed member Randy Krozner appeared on the morning program to do damage control in the wake of Helicopter Ben's recent public remarks at a press club.

Unbelievably, Krozner denied that there's any inflation coming down the road in the US economy! No chance. None. Totally unfounded fears. This seems curiously at odds with a recent Wall Street Journal article (post about it here) and the comments of a guest on CNBC just this week.

Energy, in the form of oil prices, and food both seem empirically to be heading sharply upward. So why can't Krozner see that?

Oh, wait. The government uses an inflation measure that strips and energy!

Perfect. Our central bank has blinders on when it comes to inflation.

Then Krozner waved off concerns that any inflation would require rate increases that could choke off employment gains. Again, hardly reassuring or based in reality.

The other segment which left me somewhat incredulous earlier this week as yet another discussion between co-anchors spotlighting, ex post, one or two companies which have had huge total returns for the last 12 or 18 months. This seems to be a favorite CNBC pastime. Find a company with a single period of incredible market outperformance, preferably in triple digits, then laud it as an investment, and ask the perennial question,

'So, is it still a good investment, or is it too late to get in, and time to unload?'

My own proprietary equity research found that there are a fairly large number of such short-term outperforming companies. The problem is that few of them become long term outperformers. So investors are forced to time their exits. Never an easy task.

In effect, CNBC's continuing focus on recent one-hit wonders seems to me to be the epitome of irresponsible reporting on financial investing. I pity anyone who takes any investment advice from the network seriously.

Jon Corzine & MF Global

The Wall Street Journal ran a somewhat scathing article on Jon Corzine's plans for MF Global, the firm of which he became CEO last March, after losing his re-election for governor of New Jersey in late 2009.

You know the Journal isn't positive on Corzine's ambitions, because the headline, Corzine Builds MF In Goldman's Image, suggests a sort of vengeful lack of imagination on the part of the failed politician and former Goldman co-head. They also quote Corzine as arrogantly declaring,

"We had such a limited business plan the day I walked in the door."

The article alleges that Corzine denies he's trying to clone Goldman at MF Global, but his plans for expansion feature proprietary trading, government bond dealing, and the potential purchase of an asset management operation.

If that were all there were to the story, it would be pretty much open and shut that it's likely Corzine is attempting what the Journal article contends, bolstered by this passage,

"Mr. Corzine likely wants his job at MF Global to end differently than his 24-year career at Goldman. In 1999, after Mr. Corzine pushed for a Goldman initial public offering that would make him and other partners of the firm very wealthy even by Wall Street standards, he was pushed out in a power struggle with Goldman bankers led by former Treasury Secretary Henry Paulson, who went on to become CEO.

In terms of revenue, MF Global is about 2% of the size of Goldman."

But wait....there's more.

At the very end of the piece is this passage,

"After losing a re-election bid in 2009, Mr. Corzine was encouraged to take the top job at MF Global by J.C. Flowers & Co., which owns a stake in MF Global. The private equity firm's founder, J. Christopher Flowers, was a colleague of Mr. Corzine's at Goldman. Mr. Corzine is a partner at J.C. Flowers."

Now the picture becomes a bit different. It's not so hard to connect the dots.

Corzine loses re-election, but his friend and former colleague, Christopher Flowers, gives him a partnership in his firm. After all, despite his failed political career, Corzine has made many contacts while in the Senate, and at Goldman, so, like many former politicians or candidates (NJ's Bill Bradley and, before him, Pete Dawkins, come to mind), remains a potential rainmaker. Flowers has a significant stake in sleepy MF Global, for what reason we don't know. But he would like to transform it into something with selected aspects of the Goldman Sachs both he and Corzine helped run.

So Flowers, whose firm has a board seat at MF Global, held by partner David Schamis, convinces the rest of the board to hire Corzine, now a Flowers partner, too, as CEO.

At a stroke, Flowers has cleverly taken effective control of a public company by handpicking the CEO. His plan is evidently to transform the staid financial services firm into something more robust and profitable, albeit with more risk. But through his holdings, Flowers essentially gets other people's money to absorb risk and fund his plan to use MF Global to do things he probably can't accomplish with his own private equity firm.

So, now, the spotlight really shifts from Corzine to Flowers. We don't know if the business plan to which Corzine referred was limited in terms of timeframe or scope. But it really doesn't matter so much what Corzine thought of it. He's a high-priced, high-profile pawn in this affair, and the public face of Christopher Flowers at MF Global.

It's Christopher Flowers' views that really matter. Views which we will likely never know directly, because he's implementing them through two MF Global board members who are also Flowers partners.

And you wonder why retail investors and the public in general are concerned about webs of influence and suspect dealings in private equity and the non-commercial side of banking?

This is why.

Thursday, February 03, 2011

Scary Company Behavior In Anticipation of Inflation

Inflation has been a recent topic in my blog posts, such as here and here. Today's edition of the Wall Street Journal contains one of those quintessential articles on the topic that is destined to be cited in the future as a clear warning sign.

In the piece, several examples are given of companies scrambling to buy large amounts of inventory in advance of vendor price increases. From cotton t-shirts to spices to metal for mufflers, retailers and middlemen are noting the difference between interest rates on financing for inventory and expected price increases for that inventory, then buying the larger-than-normal amounts of the goods for future sale.

Sure enough, the article discussed how this distorts inventory-based measures for purposes of assessing economic cycles and trends. As well as noting that many companies were already trying to slim their inventories in order to manage risk amidst economic uncertainty.

However, this article provides some evidence that an economic conundrum may soon be at hand.

Just this week, we saw positive employment-related numbers suggesting a slowly-expanding economy with job growth finally appearing, albeit at modest monthly levels.

But if commodity input costs are rising, that will result in either lower margins and a curtailment of job growth, or higher prices which will cause lower quantity demand by consumers in the face of so much inflation.

Thus, the very inventory bloating behavior now underway by many companies might come back to haunt them when demand slows in reaction to the rising prices. Then we'll have overextended companies with unsalable inventories for which they are paying interest to fund. In retrospect, will they look foolish for having so aggressively bought real inventory, rather than used some type of financial hedging, to manage cost increases?

Or is it even possible that companies which simply accept the higher-cost inputs and raise prices with expectations of lower demand will avoid this entire mess?

One is somehow left feeling that there's considerably more economic turmoil ahead than many pundits would have us believe. We're seeing the first reactions by businesses to known inflation in input costs. How and where those costs, and the actions they have spurred, find their way into consumer prices, and how consumers react with their buying behavior, isn't being widely discussed.

However, with job growth still anemic, and US unemployment still uncomfortably high, will the Fed dare to raise rates? And would that not result in a stalled economy and job growth as higher rates choke demand?

Wednesday, February 02, 2011

Johnsonville Sausage's CEO On Food Inflation

Yesterday morning on CNBC, the CEO of Johnsonville Sausage, a Wisconsin-based company, spoke out clearly on the coming food inflation.

He indicated that his company's input costs are rising, so overall food inflation is on its way. Then he commented indirectly on the folly of 'using corn to make gasoline,' meaning the government's push for ethanol, about which I wrote here recently. His tone was dismissive as well as incredulous, as he described himself as 'just a guy who makes sausage.'

Funny, though, how he's in fairly-rural Wisconsin, or, at least, not back East, so you'd think, according to Newt Gingrich, that the CEO would be raving about ethanol.

He's not. Instead, as a food producer, he clearly sees the mistake in taking food and pointlessly wasting it in gasoline, where it doesn't even deliver sufficient power to maintain octane ratings.

But, unlike the Fed or other seemingly-blind pundits, the guy was crystal-clear in warning that major food inflation is coming down the pike, like it or not.

I believe him.

Scott Adams On Taxing The Rich

Scott Adams, a one-time Pacific Bell engineer, now famous semi-autobiographical cartoonist (Dilbert), wrote a hilarious piece in last weekend's edition of the Wall Street Journal. He's evidently entered into some sort of contributor relationship, because this is the second piece he's done in the last few months.

Adams begins by suggesting that by writing a 'bad version,' in Hollywood parlance, of how to tax the rich, millions of Americans can read it and invent better ideas for solving our fiscal mess. He then offers some ideas. Humorous, yes. But in the kernel of some of his wacky ones seem to me to be real opportunities.

For example, he wrote,

"Incentives. Another approach, also a bad idea, might be to treat the rich more like venture capitalists than sources of free money. Suppose the tax code is redesigned so that the rich only pay taxes to fund social services, such as health care and social security. This gives the rich an incentive to find ways to reduce the need for those services, which would in turn keep their taxes under control. Perhaps you'd see an explosion of private investment in technologies that make it less expensive to provide health care. You might see rapid advances in bringing down the cost of housing for seniors.

Meanwhile, the middle class would be in charge of funding the military. That feels right. The country generally doesn't go to war unless the middle-class majority is on board."

It strikes me that there's some rationale for dedicated spending of exorbitant tax rates. Such money has to go to a specific use, and no other. Adams' idea for the rich figuring out how to minimize the costs of what their (higher) taxes are spent on, so to reduce those taxes. But, generally, what if we simply designated some social services as being paid for by certain income classes or other source. When that source is exhausted, so is the spending.

It could be a backwards way of forcing Congress to cut spending by allocations. If they won't stop promising benefits, we'll just have them allocate tax sources, which are limited, so that the spending can't be unlimited anymore.

I also thought Adams was not too far off base in considering giving the rich, higher-taxed benefits such as preferred government service, a la concierge-level attention, use of HOV lanes, handicapped parking, or an extra political vote. There are, after all, some benefits that are better than the money that buys them.

Then there's his solution for cost cutting,

"Pull a random yet round number out of your ear, let's say a 10% cut, just for argument's sake, and apply it across the board. No exceptions. Everything from the military to welfare to federal pensions to government salaries would take the same hit. Managers in the private sector have been handling budget cuts this way for years. They know that their subordinates are all professional liars, so there is no reliable information for making cuts in a more reasoned way. They also know that any project can get by with 10% less money if there is no alternative."

Having just struggled through ex-IBM and RJRNabisco CEO Lou Gerstner's detailed steps for re-engineering government, I have to say, I'm actually more inclined toward Adams' jocular version.

Why? Because, although Gerstner wrote in the vein of classic, thorough process re-engineering, it's actually unlikely that such a process will occur as written. At least in the federal government.

Truth is, Adams is right. Anything can generally sustain a 10% cut in expenses. And doing so will, according to Gerstner, avoid allowing special dispensations.

Adams closes his piece with these astute observations,

"The way our political system is designed, politicians are not free to float bad ideas. Doing so is a sure way to lose an election. Politicians aren't even free to support good ideas if they are too far from the norm. But as citizens, we're free to speculate all we want. And if some new and better idea gains popularity at the grassroots level, our elected leaders would then be able to embrace it. In other words, it's literally your job to fix the budget problem because your government isn't equipped to handle it. The ideas I've mentioned here are bad by design. But if a few million people start brainstorming their own ideas for solving the debt problem, someone might come up with a winner. And if that idea gains popular support on the Internet, it frees politicians to consider it. I have no problem imagining that something along those lines can happen, and the thought feels delightful."

Sadly, I think he's right. Politicians are rarely able to speak the unspeakable. Consider Paul Ryan's Roadmap. He's taken incredible flack for that.

It probably is the case, for now, that our spineless politicians can't really fix our spending mess, or tax more intelligently, without being led from the rear, by ordinary citizens.

Tuesday, February 01, 2011

An Objective Forensic View of the Sources of the 2007-08 Financial Crisis

The Wall Street Journal has recently published a spate of editorials and columns regarding the official FCIC final report. One of those editorials was by the authors of a minority report- Messrs. Thomas, Hennessey and Holtz-Eakin. Mr. Thomas is a former Republican congressman from California. Mr. Hennessey served as director of the White House National Economic Council in 2008. Mr. Holtz-Eakin is a former director of the Congressional Budget Office.

Here are some key passages from their Journal editorial synopsizing their report,

"Today, six members of the Financial Crisis Inquiry Commission—created by the last Congress to investigate the causes of the financial crisis—are releasing their final report. Although the three of us served on the commission, we were unable to support the majority's conclusions and have issued a dissenting statement.

In a November 2009 article, Brookings Institution economists Martin Baily and Douglas Elliott describe the three common narratives about the financial crisis. The first argues that the primary cause was government intervention in the housing market. This intervention, principally through Fannie Mae and Freddie Mac, inflated a housing bubble that triggered the crisis. This is the view expressed by one of our co-commissioners in a separate dissent.

The second narrative blames Wall Street and its influence in Washington. According to this narrative, greedy bankers knowingly manipulated the financial system and politicians in Washington to take advantage of homeowners and mortgage investors alike, intentionally jeopardizing the financial system while enjoying huge personal gains. That's the view of the six majority commissioners.

We subscribe to a third narrative—a messier story that emphasizes both global economic forces and failures in U.S. policy and supervision. Though our explanation of the crisis doesn't fit conveniently into the political order of Washington, we believe that it is far superior to the other two.

We recognize that the other two narratives have popular appeal: They each blame a clear entity, and thus outline a clear set of reform proposals. Had the government not supported housing subsidies (the first narrative) or had policy makers implemented more restrictive financial regulations (the second) there would have been no calamity.

Both of these views are incomplete and misleading. The existence of housing bubbles in a number of large countries, each with vastly different systems of housing finance, severely undercuts the thesis that the housing bubble was a phenomenon driven solely by the U.S. government. Likewise, the multitude of financial-firm failures, spanning varied organizational forms and differing regulatory regimes across the U.S. and Europe, makes it implausible that the crisis was the product of a small coterie of Wall Street bankers and their Washington bedfellows.

We believe the crisis was the product of 10 factors. Only when taken together can they offer a sufficient explanation of what happened:

Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay.

Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed?

Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.

These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. Some firms had large counterparty credit risk exposures, and the sudden and disorderly failure of one firm risked triggering losses elsewhere. We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing, and thus unconnected firms failed for the same reason and at roughly the same time.

A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10).

We agree with our colleagues that individuals across the financial sector pursued their self-interest first, sometimes to the detriment of borrowers, investors, taxpayers and even their own firms. We also agree that the mountain of government programs supporting the housing market produced distorted investment incentives, and that the government's implicit support of Fannie Mae and Freddie Mac was a ticking time bomb.

But it is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers. Simple narratives like these ignore the global nature of this crisis, and promote a simplistic explanation of a complex problem. Though tempting politically, they will ultimately lead to mistaken policies."

The Journal's Holman Jenkins, Jr., a regular columnist, wrote his own piece commenting on the FCIC's various reports. He concurred with these three, and others, in decrying the commission's chairman's politically convenient tactic of simply blaming "Wall Street." But he also criticized Thomas, Hennessey and Holtz-Eakins for not concluding a simple, actionable source of the crisis.

To me, this minority explanation most closely approximates what is probably the truth. It addresses elements of the crisis that other explanations do not, i.e., its global nature, the different types of firms which failed, and the related, but not identical sources of mortgage-lending-sourced and -related factors which spread throughout the global financial system.

I think these authors stretched to arrive at the memorable round number of 10 factors. But, given a choice between competing explanations, I'd go for this one over all the others I've read.

Which leads to a conclusion I've expressed in prior posts on this topic. There were plenty of regulations and regulators already in existence to observe and act upon dangerous behaviors by various sector players. So rewriting regulations, adding more, or reshuffling regulators, won't likely change anything.

Moreover, consumer borrowers, investors, and various financial entities all behaved in ways which exacerbated the crisis, because that's human nature. Borrowers took sweet mortgage deals they couldn't likely afford under most scenarios. Lenders bet that they could pass their mortgage trash to investors before the stuff imploded. Too much greed and belief that creating and circulating mortgage-related assets of questionable value would not result in a systemic disaster.

In an earlier post, I likened it to too many people dumping toxic waste into a common sewer that drained into a drinking water supply. Like actually occurred in London before its modern sewer system, this will cause contagious diseases to spread.

So long as people are allowed to generate and circulate toxic waste with no regard for the systemic consequences, we'll see more of these crises in the future. If you don't believe regulators can effectively stop another crisis, then you should monitor the financial system for simple signs of building asset bubbles and make sure your assets are not in those instruments. Protection from broader equity market consequences and the progression of the shock to the real economy are more difficult effects from which to insulate or isolate oneself.

That appears to be an undiversifiable risk of modern financial systems and economies.

Monday, January 31, 2011

CNBC's Tyler Mathisen Exhibits His Naivete Of The Grocery Sector

CNBC seems to have developed a style of tossing co-anchors a bone in the form of their own subject-specific one-hour specials. They've done programs on airlines, McDonald's, Goldman Sachs, high-end prostitution, growing marijuana, the video porn industry, garbage and, now, Tyler Mathisen's piece on grocery stores.

I will admit at the outset that I have yet to see the entire hour-long program, but I did see most of the second half of it last night.
However, all last week, Mathisen related anecdotes from the program and introduced brief clips.

You don't really need to see the grocery documentary to grasp what struck me about it, or, more specifically, Mathisen. He seems to be incredulous about everything.

Over and over the guy keeps announcing into a camera, horrified, that these food chains are trying to make money! Oh, the shame! The danger! The horror!

He confides a secret- grocery managers place wine next to fish, hoping you'll buy both. Shocking!

Oh, the evils of this sector! Trying to make a profit by selling food to you. Knowing you must eat to live.

From the shape of mayonnaise bottles (svelte rather than bulbous) to the size of shopping carts (larger than in the past, so you won't think twice about buying more items), it's all just a trap to make money on your need to eat.

For all that, however, the average checkout ticket is remarkably small- under $20. Even in this era of food price inflation.

I have two marketing degrees, so I cut my business education teeth on reading marketing research articles about consumer buying behavior and was taught how attention to many details have a major effect on the profitability of grocery stores. They typically operate on sales margins of 1-2%. Not much room for mistakes. Turnover, of course, is, ideally, quite high, if a competitive ROI is to be earned.

What surprised me, though, was that Mathisen is either completely lacking in curiosity, or just really not at all intelligent. He looks to be at least in his 50s, yet it seems that he's gone his entire life unaware of how supermarkets use location and point-of-purchase displays to stimulate consumer buying. Since purchasing food is probably one of the two most basic recurring buying behaviors for most Americans that doesn't involve immediate total consumption- the other I'd guess being gasoline- grocery store marketing has been the subject of countless newspaper articles for decades.

How could Mathisen be so dense as to have learned nothing about the sector during his entire life? The look on his face as he apparently discovers for the first time that people respond to package design is over the top.

On the larger subject of the documentary, I'd have to say it was decidedly underwhelming. As I contended earlier in this piece, anyone who's middle-aged and remotely curious has, by now, learned some of the basics of supermarket marketing. Higher margin items around the outside of the store, frequently-purchased staples (milk, bread and juice) typically in the corner diagonally furthest from the main entrance, less-expensive, lower-margin items (processed foods) typically in the cluttered middle aisles. Shelf facings paradoxically reflect market share or fees paid to the grocer, and eye-level facings are choicest.

It's one thing to learn a lot about fairly hidden business sectors like growing marijuana, video pornography or ultra-high end prostitution/escort services. But you'd have to live under a rock to be surprised by much in Mathisen's supermarket piece.