Friday, June 17, 2011

Banks, Capital Requirements & The S&P500

CEOs of large US banks have raised an alarm recently due to the recommendations by several regulators, including members of the Fed and FDIC, for higher capital requirements. Some have suggested an extra 3%, bringing the large-bank level to around 10% of risk assets, while others have mentioned 14%.

Predictably, the CEO of at least one large bank, Chase, has warned that higher capital levels will result in higher lending rates and overall operating costs, as well as lower profit levels. These comments are meant to scare regulators away from imposing higher risk capital levels.

However, Chase' Jamie Dimon, aside from having an obvious interest in lower capital requirements, also lacks perspective. He spent the bulk of his career assisting his one-time mentor, Sandy Weill, in the brokerage industry. The sorts of retail brokers at which Dimon cut his teeth didn't engage in much risk-taking activity, so they were highly-levered.

But a more appropriate perspective on the current debate involving large US commercial bank capital levels should take us back to the 1920s. The events of the 1930s, in which then-integrated commercial and investment banks, such as the forerunners of today's Citi and Chase, improperly sold questionable investments from one side of their bank to customers on the commercial side of the bank, resulted in the Glass-Steagal Act. The Act broke up banking into its investment and commercial pieces.

Up until the 1970s, commercial banks, the retail deposits of which were FDIC-insured, didn't typically engage in much risky activity outside of conventional lending. Even that resulted in the occasional large regional bank failure, such as First Pennsylvania, Seattle First and the like.

However, with the complete removal of Glass-Steagal, commercial banks were allowed to function as investment banks, but retained federal deposit insurance. This oversight effectively resulted in the federal government subsidizing, via deposit insurance, the risky activities of trading and underwriting in the investment banking side of these newly-integrated large US banks.

Earlier this week, I saw an analysis on Bloomberg predicting that as commercial banks divested or closed newly-prohibited trading businesses, their profits would fall, bringing down equity indices of which they comprise something in the neighborhood of 20%. This sort of statistic, combined with the specter of higher capital levels and resulting lower profits, is being trumpeted as the reason to reject such calls for more bank capital.

However, I believe this is incorrect reasoning. What I believe is correct is to ask why equity indices such as the S&P500 allocate so much weight to financials. As integrated, risky companies, financials may well have merited such weight.

But now, the large US commercial banks are more properly viewed as financial utilities. As such, they don't merit a large presence in the S&P, nor should they be expected to be engines of high and consistent total return delivery for their shareholders.

This may not be to the liking of Jamie Dimon and the CEOs of Citi, Wells Fargo or BofA. But it's reality.

After the tremendous cost to taxpayers of the financial crisis of 2007-08, in which large US commercial banks with insured deposits played a corresponding major part, even if they didn't initiate the crisis, it's understandable that capital requirements would be increased and risky activities prohibited.

As I have written in prior posts, the basic business of lending and safekeeping money, plus some ancillary trust and processing businesses, are the core of what large US financial utilities, a/k/a large commercial banks, perform. Those aren't a huge part of the American economy, nor should they be. Such businesses aren't high growth businesses, either.

Regarding interest rate levels, who's to say they should not be higher? Large bank profits rise with interest rates- why didn't Dimon mention that? Further, we didn't have a crisis three years ago because rates were too high- it was because they were too low. And still are.

Cries of 'foul' by large bank CEOs and analysts stem from a refusal to acknowledge reality- both recent past, current and future. The days in which banks such as Citi, Chase, Wells Fargo and BofA may be expected to rival Google or Apple as consistently high total return performers are over. They are now meant to be fairly safe, unexciting basic financial services firms which don't engage in overly-risky activities.

That's the reality of the new financial landscape. And it's consistent with such an environment that those large banks should carry more capital, the better to avoid needing taxpayer funds to rescue them from insolvency in the future.

Thursday, June 16, 2011

Regarding The Recent Equity Market Turmoil

There's little doubt that the mechanics and dynamics of the US equity markets changed as of late April and early May. The latter timeframe saw volatility begin to rise, while the S&P peaked on May 2nd, falling nearly 9% since then.

At times like these, I consider how different equity portfolio management styles react and perform under such conditions.

As I've written in prior posts, the framework and structure of a quantitative approach to equity portfolio management gives me confidence in relying on my tools, signals and consistent management methods. I can't fathom how a qualitative manager responds to such rises in volatility and a plunging index.

For example, my signaling tools for long/short allocation are still, despite the recent market decline, displaying values associated with long positions. Thus far, June's S&P total return is nearly -7%. A few more months like this and the signal will turn to short allocations. But it's quite likely that the next few months will see the indicator remain long. It's September and after that appears to be the worrisome period. However, while I simulate its behavior, I don't forecast the indicator- I use its contemporaneous output. That's one of the benefits of having time-tested, non-forecasted, quantitative components of a quantitative equity management system.

Thus, I was mildly surprised by the reaction I recently received from someone presented to me as a formerly-successful hedge fund manager. This recent post concerning a networking situation gone wrong due to a friend's inept and lying contact. The same contact made much of connecting me with the alleged hedge fund manager whom I'll call L.

The initial feedback was that L was seriously interested in learning more about my portfolio management approach and performance. But after a few days had passed, I grew sceptical. I requested L's email and sent him my one-page description, along with an invitation to discuss my approach at our mutual convenience. Several days passed with no reply. Not knowing L, nor having spoken with him, and seeing his non-response as possibly a change of mind, or, more likely, wrong information in the first place regarding his interest level, I forwarded my initial email with another suggestion that we talk or meet. Later that holiday weekend, L sent me a reply which read, in part,

"I personally have no need for a black box. I had a partner that left me 20 years ago to work on his algorithmic program. I am aware of all the success stories and I'm sure your is as prudent as the rest. I've seen some very sophisticated programs but in the end nothing that has held up to the tests."

I had to laugh when I read L's response, as it contained such a mix of naivete, bad thinking and errors of logic.

First, why would someone being approached to invest in or back an equity management process believe he will remain 'in the dark' regarding said process? While I've never relinquished control or shared possession of my software code, I've explained how my quantitative process works in detail to former partners. Only an idiot would believe that the process would remain a 'black box' to him.

By the way, even a fundamentals-based analytical type of manager who pores over 10Ks is a quantitative manager. Quantitative means numeric, and probably algorithmic, but not necessarily advanced physics or calculus.

Second, it seems that a long-ago slight by L's former partner has left him biased against all quantitative equity management processes.

Finally, the assertion that "nothing...has held up to the tests" suggests some pretty faulty logic circuits in L's brain. For example, just that week, one of the world's larger hedge funds announced that it was creating a new quantitatively-managed fund.

Several of the best-known and -performing hedge funds, including Jim Simons' Renaissance, are quantitative. So I guess they have passed "the tests."

Precisely which "tests" L is referring to is a mystery to me, and I've been involved in equity management since 1997.

Then, again, considering the wild goose chase on which I was led with the contact's first allegedly valuable network connection, I have my doubts that L had, in fact, developed, built and sold a successful equity management business. Or that he even has substantial funds to invest in one now, either.

There are varying preferences for returns, consistency, etc., over varying periods of time by individual investors or backers of hedge funds and equity management ventures. But, to my knowledge, there is no single set of "tests."

What I wondered, in contrast, was, if L doesn't like quantitative, disciplined, rigorous approaches to equity management which at least have the advantage of being able to be backtested, what does he prefer- totally subjective managers with no ability to retroactively model their selections and performance? If he's worried about "black boxes," does it get any blacker and more impenetrable than an individual manager's undocumented mental meanderings?

Equity markets like those of the past few months and, probably, the next several, always lead me to wonder why anyone would risk their investments on pure, inexplicable subjective hunches without any sort of objective guidelines or rules.

Wednesday, June 15, 2011

Anatomy of a State's Ill-Considered Tax Policy

Last week the Wall Street Journal featured Illinois' recent tax hikes in its lead staff editorial. Normally, a topic like this would be more appropriate on my companion political blog. But I think this merits treatment here, instead.

For several years now, as I've written in prior posts, more of my business blog writing has been devoted to government actions, primarily because, since 2008, so much of the so-called private sector has been either infringed upon, taken over by or otherwise heavily influenced and affected by government activity to overwhelming extents.

In the case of this topic, the situation was set up by years of profligate state spending and giveaways to unions in the form of pensions and compensation for government employees. As an attempt to fill state budget gaps, Illinois' Democratically-controlled legislature and its Democratic governor enacted tax increases which effectively raised personal rates 67% and corporate rates to a 9.5% level, which the Journal reports as "fourth highest in the nation."

Predictably, many large Illinois corporations promptly let it be publicly known that they were considering relocating out of the state, due to the sudden rise in tax bills.

Caterpillar, Motorola Mobility, Sears, Navistar Continental Tire, U.S. Cellular, Chrysler and even Groupon all used the ploy to extract tax givebacks of varying sizes from the state. The governor, Pat Quinn, used these occasions to claim he was working hard to keep business in the state.

The irony, of course, is priceless. The state raises tax rates, then trumpets its efforts to offset the loss of economic activity as businesses respond to the higher rates. But the underlying process of funding the state government has been corrupted, as the Journal editorial describes,

"The victims are the thousands of businesses that don't get the favors, and an overall state economy that is less attractive for employers. That's one reason Illinois has ranked 47th of the 50 states in job creation in the last decade, and has lost more private jobs (360,000) than the entire private work force of Delaware...

Illinois is proving what bookshelves full of studies have found: Handing out special favors one business at a time is politically corrupting and an ineffective economic development strategy. A sounder way to create jobs is to provide a welcome tax and regulatory climate for all businesses. Some states, such as Arizona, constitutionally prohibit politicians from granting special favors to a business or citizen."

Today's Journal has a second part to the editorial, reporting that financial market giant CME Group is now threatening to leave the state if it, too, does not receive some special tax relief.

According to the Journal, Illinois' increased tax rate is expected to capture around $6B, of which something like a quarter of a billion dollars is now being forgiven as political favors from the governor.

Is this any way to run a state? Or a country? Because we all know that Congress does exactly the same thing with the federal tax code. Special exemptions are created by Senators and Representatives for businesses which fit suspiciously complicated descriptions which- surprise surprise- result in a company in their state or district enjoying some tax break.

When are citizens, at taxpayers and voters, going to catch on to this bi-partisan scam which saps national economic activity while fostering tens of millions of dollars in economically unproductive lobbying for tax relief?

The net result is to transform what could be simpler, lower-rate tax systems for state and federal governments alike into complicated traps, partial escapes from which are granted by elected politicians in return for various favors- campaign donations, jobs for friends, or public relations events showcasing how the official 'saved' jobs by giving a company a special tax break.

If the tax break was a good economic move, why was the tax rate raised in the first place?

By the way, since it's topical in a political sense this week, Rick Perry's Texas has created more jobs in the past decade than any other state.

It has no state income tax- and, thus, no tax rates from which companies need to spend money to escape. And less political corruption.

Tuesday, June 14, 2011

Bob Lutz- Savior of the Car Making World!

To read Bob Lutz' version of Detroit's decline, he personally knew better than everyone else at Chrysler, Ford and GM how to run a car company.

So how is it two went into bankruptcy and he's not running the third which is doing better?

Lutz recently had his book published, so he's on the talk show tour as the Wall Street Journal released two excerpts of the book in recent editions.

Let's just say I'm completely underwhelmed with Lutz' tale. Where to start?

Well, my first reaction, after only about half of the first Journal excerpt, was that I believe objective auto sector journalist, Pulitzer Prize winner and former Journal executive and one-time squash partner Paul Ingrassia did this all better and earlier. You can still see Paul periodically on CNBC and read his pieces in the Journal. I think he was easily two decades ahead of Lutz in recognizing the same defects at the Big Three.

My second reaction is to distrust anyone who was a senior executive with real power at failed companies who claims he knew better, but it was the culture and everyone around him who were the problems.

Lutz clearly has no shortage of ego. He constantly describes himself as a 'car guy' who knew better than everyone else at Chrysler and GM. He portrays himself as patiently teaching design teams how to do their jobs. Ruminating on whether he was really able to impart enough of his personal values about cars to the teams. Did any of it take? Was it really just Bob doing all the work after all?

Frankly, most of what Lutz revealed was, as I noted above, either already disclosed by Ingrassia years ago, or are things which most business observers with a brain had already figured out.

For example, back in the 1970s, my late father, a senior engineer and marketing executive at an American mining equipment company, remarked on how badly designed and made the expensive Chrysler New Yorker was. How you could run your finger along the hood and cut it on the raw, unfinished edge of the sheet metal.

As I'm writing this, Lutz is hamming it up on CNBC, enjoying the adulation and on-air time as he goes on and on about no-longer shocking practices at the failed US auto makers. His remarks about debates at GM regarding incentives and margins is, again, old news.

For a retired senior executive at not one, but two failed companies and a nearly-failed third one, Lutz seems to feel compelled to tell 'his' story, regardless of the fact that it's no longer newsworthy.

From what I read in the Journal pieces, it's not enough of a personal career story to be unique in that way. All Lutz' comments on air and published passages attempt to paint himself as the one enlightened guy in a car company full of 'bean counters.'

In one passage in the first Journal excerpt, Lutz dated his epiphany on some issue to fairly late in his career, which leads one to conclude that much of what Lutz claims as insight was actually, well, hindsight.

His story just doesn't ring true. Either he was an early seer who failed to lead and manage, or came late to these realizations, and, therefore, like most of those three companies' managements, was naive and dull-witted during their declines.

Which was Bob Lutz' true path? We'll probably never know. But we know which path it wasn't- enlightened and talented manager rises through embracing the truth and leads company to success.

Given that, I can't imagine spending any money to read Lutz' self-inflating stories of his days at Chrysler, GM and Ford, or his views about them now.

Monday, June 13, 2011

Update On Bricks vs. Clicks 2011 Style

Last week I found myself in a discussion with another member of my fitness club after I finished my morning's mile swim. We had apparently spoken before, perhaps last summer, so he felt sufficiently uninhibited to inquire about my use of a heart rate monitor.

We had a lengthy conversation about training regimens, diet, the protein reduction to cut fat, and related topics.

He asked me several times which current model of Polar HRM I would recommend, and I reiterated what I last recall seeing as their lowest-level product with calorie burn estimation capabilities, noting that his local Sports Authority was sure to have them.

Being older than me, he astonished me by dismissively snorting,

'Oh, forget that. I'll just find it on Amazon and buy it there.'

Pretty interesting. He clearly already uses Amazon as his go-to general store, but doesn't believe he's paying much for the privilege.

On one hand, that's good for Amazon. On the other, though, the online retailing giant is one of those Schumpeterian forces that prospers by slitting the economic throat and gutting the profit model of existing 'bricks' retailers.

Growth has been and remains the key for Amazon. It took some time for the company to get its model right and profitable. Since then, it's latched onto some key growth categories- ebooks, DVD rentals, and, now cloud computing.

But a bit over ten years on from the first great internet binge, it's clear that online shopping has taken hold in a lasting manner. Thus, for many product categories, finally answering the 'clicks vs. bricks' argument decidedly in favor of the former.