Friday, July 01, 2011

BofA's CountryWide Tab Explodes

Back in January of this year, I wrote this post concerning the escalating tab for Ken Lewis' purchase of CountryWide in 2008 for BankAmerica, of which he was CEO. I wrote then,

"So that makes the running tab for Countrywide $9B, when you include the $18/share purchase of Countrywide equity in August of 2007 for a total of about $2B. By the way, when Lewis made the January purchase, Countrywide's stock was less than half its August price, or $8/share.

According to the Journal article, a Sanford Bernstein analyst assesses the additional put back risk to BofA at as much as $4B."

On Wednesday, current BofA CEO Brian Moynihan settled outstanding claims on Countrywide bonds and 'defective' mortgages for $8.5B and $5.5B, respectively, plus an additional $6.6B prospectively for future costs and losses against old Countrywide business.

Adding this $20.6B in losses to the prior $9B cost,  and you get the Wall Street Journal's subheadline $30B cost of Countrywide to BofA. They printed this comment regarding the deal Lewis so extolled at the time he made it in mid-2008,

" 'It turned out to be the worst decision we ever made,' said one Bank of America director who voted for the Countrywide deal. "

According to the Journal piece, this may not be the end of BofA's losses on the deal.

My old mentor at Chase Manhattan Bank, Gerry Weiss, made sure several of us who worked for him got plenty of contact with the bank's EVPs, Vice-Chairman, CEO and Chairman. He used to say that many of them woke up in the morning saying, as they looked into the mirror to shave,

'God, don't let them realize today how incompetent I really am and how little I actually know about what I'm doing.'

Next time you read or hear about some large US bank CEO making an incredible acquisition, think carefully about whether you believe him or her.

Citigroup should have been bankrupt by now, and is still headed by an inexperienced, over-matched former middle-office manager of an investment bank. Wells Fargo is choking on its own acquisition of Wachovia's problems from Golden West, the former California S&L, as well as its own real estate portfolio. Chase remains simply slower and stodgier than the other large commercial banks, thus having accidentally avoided the worst of the last financial crisis.

Ken Lewis' type of self-inflicted fiasco at BofA could easily happen again.

Thursday, June 30, 2011

US Money Market Funds & Euro Bank Debt

Perhaps, like you, I was horrified to read the Wall Street Journal's lead staff editorial on Monday and, that same day, to see clips of Ben Bernanke's testimony played on business cable channels confirming that their is concern at the Fed regarding substantial US money market fund holdings of European paper. No doubt bought and held for the higher yield on said paper, reflecting its greater risk. Duh.

To connect the dots, European banks hold lots of Greek debt. Greek debt has fallen in value due to that country's ongoing fiscal crisis. It's generally believed that European banks have not chosen, nor been forced by European financial regulators, to write down their Greek debt to market price levels.

Thus, it's highly likely that many European banks have overstated asset values. Their short-term paper, held by US money market funds, are thus vulnerable to default, in the event that something sets off a chain-reaction of Greek debt default and subsequent further devaluation of Greek debt held by the European banks.

How in the hell can this have happened in the wake of the US financial crisis of 2008? Between the multi-billion dollar bailouts, radical new regulatory law, and Federal guarantees of money market fund assets, you'd think our financial regulators would be on top of this one.

What's the difference between allowing banks with FDIC-insured deposits to engage in risky trading and underwriting, and allowing federally-insured money market funds to buy the short-term, unsecured debt of European banks holding Greek debt?

Only the matter of the specific risky activities, not the probably outcomes, nor the inherent risks.

As the Journal editorial expressed, our "regulators miss the systemic risk right in front of them."

This is neither trivial, nor a joke. Our vaunted Congress and federal regulatory agencies have already failed to head off yet another risky activity by private financial sector players.

Wednesday, June 29, 2011

Jobs, Growth & The US Economy 1939-2011

Michael Spence's recent Wall Street Journal editorial discussing types of jobs, and "Why the Old Jobs Aren't Coming Back," got me to thinking about a much longer cycle of employment and growth in the US economy.

Some pieces become watersheds for me, and, like the occasional piece by Brian Wesbury, Alan Reynolds or Robert Barro, Spence's recent piece is for me right now. It is the catalyst that has allowed me to reshape a number of ideas and observations into a more coherent fabric than I was previously able to do.

Nobel Laureate Spence distinguished "nontradable" jobs which produce goods and services which "must be consumed where they are produced," from "tradable" jobs which can produce exports. He wrote,

"Nontradable job growth can't mask the declines in the tradable sector any more. The structural problem demands a structural answer."

Well, what if there is no long term answer? At least, an answer that everyone's going to find acceptable over the long term.

Spence mentions Germany, which has heavily-unionized labor, limiting

"wage and salary growth as part of a restructuring in the period 2000-05, allowing it to compete more effectively in exports and the tradable sector than other advanced countries."

That's a fairly serious admission of a very undesirable solution, i.e., deliberately slashing standards of living in an advanced economy in order to try to compete with lower-wage nations in tradable goods and services. Frankly, it doesn't strike me as a sustainable approach in any advanced economy where citizens' aspirations and expectations have been raised by decades of cossetted, unrealistic long term economic conditions.

Why would that be necessary if an economy like Germany or the US could train its least-productive workers to be more productive, thus offsetting their higher wages and maintaining their higher standards of living?

I think the answer lies in trade, evolution of various geographic parts of the globe, and the natural refusal of humans to see bountiful periods as fleeting and a lucky combination of factors which won't be occurring again, at least not foreseeably.

Consider this view of the US economy from the mid-1930s to the present.

Having futilely borrowed and spent like crazy, FDR's federal government found itself, by late in the decade, as Roosevelt's Treasury Secretary put it, to paraphrase,

'billions in debt and the unemployment rate no lower.'

But, luckily for the US, economically, at least, a world war came its way. By the late 1930s, FDR and Congress were re-arming America. This was yet another example of an aphorism popular in my youth, i.e.,

"Elect a Democrat president and go to war."

Digging holes, then filling them in, or doing other non-economic work with federal borrowing, didn't do the trick in the 1930s or, for that matter, in 2008-11, either. But spending on defense to prepare for war with a German madman, well, that's different.

Never mind that munitions were expended, tanks, planes and ships destroyed. Men and women killed in the millions. In the short term, people went back to work and, after the Allied victory in 1945, peacetime economies could pick up where they left off.

Oops....not all of them. Europe and Japan were in ruins. South America and Asia remained relatively undeveloped economically, certainly no challenge to the one remaining economic superpower with a now-trained workforce and plenty of invested capital plant and equipment- the US.

From 1945 until roughly the mid-1970s, America was luckier than smart. Many of the jobs available in the burgeoning US economy which supplied the world were blue collar, middle-class building jobs which were within the reach of high school-educated workers, e.g., auto assembly, steel making, heat-beat-and-bend manufacture, transportation, and construction, to name a few.

Without serious global competition to provide downward pressure on goods and services prices, labor costs and benefits soared, with no difficulty in sight to funding lavish defined benefits for private and public sector workers alike.

The good times had arrived and would roll forever! After all, it was America, the mightiest economic and military power on Earth.

However, thirty years on, by the mid-1970s, the ruined Allies and losers of WWII, Germany, Italy and Japan, had rebuilt their economies and infrastructures to the point that they began to be serious global competitors. US auto and steel industries were the first to feel the impact, being among the lowest value-added sectors with the lowest-skilled labor. As such, they were most easily priced out of the market, as the unionized US work forces in those industries refused to absorb pay and benefit cuts, choosing instead to penalize new workers entering those industries as US capacity shrank amidst crippling, bankrupting losses.

Look at the recent union contract settlements in the airline, auto and public sectors. It's still the solution of choice for unionized workers in vulnerable sectors,

'I'm in the union, I have my time in, and I've got mine. Pull up the ladder and screw the younger workers coming in behind us.'

That's almost an exact quote from my New Jersey teachers' union friend concerning the current situation affecting his union, job, pension and health care benefits.

Meanwhile, by the end of the Reagan era of lessened regulation, lower taxes and renewed US economic growth, the nature of job growth was already changing. White-collar jobs requiring more education and an ability to use technology such as computers began to move the US to a more service-based economy. Truth is, after Reagan, we've never had robust economic expansions following recessions in which overall employment growth across education and skill levels participated equally.

Recently, say, since 2000, the internet and rapid global transportation of components, combined with a maturing Europe and a growing, better-educated India, China and Southeast Asia, have rendered even many of the formerly-unassailable high-paying US service sector jobs tradable and vulnerable to price competition.

While your local grocer and dry cleaner remain relatively unaffected in terms of competition, but not necessarily in terms of demand, jobs in legal services, banking, equity research, chemical research and the like have begun to move abroad as transnational firms locate those functions where productivity is highest. Indian financial analysts are sufficiently good to offer reasonable quality, yet be much less expensive and, thus, more productive analytical product than their US counterparts.

While growth in revenues and profits for America's S&P500 firms continues apace, thanks to the global coverage of many of the firms in terms of both facilities and demand, the domestic employment picture in the home economy of the index, the US, is much bleaker.

Every nation has some bottom quartile of adults in terms of intellect, skills and education. In fortunate times, the nation can employ those people in lower-value-added jobs like construction, basic materials extraction or simple fabrication of materials and goods.

But the days of America being competitive at producing commodities is long gone. And, with it, I believe, a brief, probably unreproducible period from 1945-1970, in which lesser-educated and -intelligent Americans could make middle-class wages and enjoy "30-and-out" careers with bountiful pensions and healthcare.

My late father's cohort, he being born in 1927, enjoyed this golden era. Those before did not, nor those who followed.

It seems to me that Americans have become used to two generations, my father's and the early baby-boomers, of economically-lucky circumstances and have cemented their financial life expectations at an unsustainable level.

Today, the only long term sustainably-competitive businesses and jobs are those which can continue to innovate, create value and move forward technologically and in terms of meeting consumer needs. Static professions and jobs are all seeing declining wages and benefits.

I've been fond of saying for several decades, upon hearing or reading pleas from unemployed Americans in sectors such as footwear production, logging, steel, mining, or auto assembly,

"Do you really want a job in those industries anymore? Do you really want to take a competitive wage to make shoes when Asians are doing the same job for a fraction of what you hope to be paid? But can't be paid anymore because the shoes you make will be too expensive for other Americans to buy?"

Thus, it was disappointing to hear the president claim just yesterday, in Iowa, that America needs more manufacturing jobs, and to 'make more things.'

First, economic resource allocation is best done by market forces, not government mandate. Second, last I read, within the past two years, the value of American manufacturing output has remained fairly steady at about 20% of GDP for decades. However, due to the forces I've mentioned in this post, lower value-added products requiring less-skilled manufacturing have not survived competition with overseas sources. Further, again, due to the technologies and capital involved in on-shore manufacturing,increased productivity in such advanced products which are more difficult to manufacture have resulted in fewer workers producing the same, or more, value-added. This is a very conventional economic model- applying more capital to the production of higher-value products which require more advanced technology and fewer workers per dollar of output.

For better and for worse, we've evolved a global trading system in which all economies are now easily linked. David Ricardo would be quite at home with the economic rules of our world. But there are challenges.

Today, I can visit a local grocer and buy soft fruit from South America, fresh fish from the coast of another country, and the like. But the same global trading economics which allow that have closed US fisheries and led American fruit growers to hire migrant laborers at low wages and no benefits to compete with overseas goods.

While I'm not happy to acknowledge this, I must admit that today's interlinked global economy can no longer inexpensively shield and support the lowest quartile, decile, or whatever economically-determined least-productive, -skilled and -employable portion of any nation's workforce.

Nobody's worried about the workforce at Google, Amazon or Facebook. But the marginal banker, auto assembler or generic factory worker is a real problem for all of us. If they can't be re-employed at anywhere near their historic standards of living, how does that affect and change the US?

Spence wrote, in closing,

"Can business, government, educators and labor come together to tackle the structural employment challenge head-on? Some will say that in the present political and fiscal climate, this is highly unlikely. They may be right. But it is a choice, a collective choice. We can invest in future growth and employment of an inclusive kind, or not. If we do, it will take significant shared sacrifice."

His identification of the challenge seems correct to me, but not his vision of a solution. I really don't think it's about better education or some grand government-business entity "investing in future growth" anymore.

Here's what the modern interlinked global economy has done. It's forced economically-mature, once-vibrant advanced economies to decide, with their antiquated mix of unions, defined benefit pensions and health care systems and raised expectations, how to deal with the costs of supporting the now-unemployable citizens who have been taught for one or two generations to expect lavish standards of living by historic comparison.

A well-educated, bright, risk-taking young person who is comfortable with a long, changing, working life will probably get a reasonabl facsimile of "the American Dream." Others will not.

I think it's time we acknowledged that, in America, a high-school graduate with an average intellect and skill set has a near-zero chance of achieving "the American dream" of a good-paying, secure job leading to a comfortable, decent home, spouse and family, health care, pension, vacations and a pleasant retirement after age 70.

Thanks to the global ubiquity of better education, I would guess that even an average US college graduate can't count on that dream anymore, either.

But it's not just because of the US government's 80-year binge of deficit spending. Rather, it's this global economic linkage, combined with profoundly bone-headed, behavioral- and expectations- altering, fraudulent promises of defined-benefit schemes. A topic about which I'll write in an imminent post.

Spence correctly fingered the necessary economic accommodation in his German example, but I doubt it went far enough. Economic evolution is making more and more formerly-nontradable goods, services and jobs tradable. So economic growth and employment are likely to exist not among the most productive nations, but the most productive people in most nations which fully-participate in the global economic system.

America won't, as a nation, I believe, be able to protect and employ it's least-productive citizens without paying unaffordable social costs. The time for that has long since passed, and, absent another devastating, global-economy-wrecking war, natural disaster or crisis, I don't see it ever returning.

This isn't a pleasant scenario. However, my background as a strategist, especially under my mentor, Gerry Weiss of GE and Chase Manhattan Bank, taught me that strategic options and realities are periodically unpleasant. But that doesn't make them untrue or unlikely.

Those who delude themselves into believing there is some undefinable, indescribable better, rosier scenario than the plausible, describable, even existing and self-evident ones facing them, are destined to learn the hard way they were wrong. At great pain and expense.

Tuesday, June 28, 2011

Pepsi Under CEO Indra Nooyi

This morning's Wall Street Journal featured a Marketplace section lead article on PepsiCo's performance under CEO Indra Nooyi.

Specifically, the article detailed the slide of the company's premier brand, Pepsi, to number 3 among US sodas, trailing not only Coke but, now, Diet Coke, too. Still, it was relatively reserved in criticizing the Indian-born CEO.

Nooyi has been CEO of Pepsico since 2007. Googling her yields a series of results which echo the theme of the Journal's article, i.e., that she took pains to herald her change of focus of the firm to healthier drinks like Gatorade, the company's Quaker Oats unit, and, generally, avoid 'selling flavored colored sugar water' charges.

Now, it appears she went too far in ignoring Pepsi's own health, leading to a disappointing performance.

The nearby chart displays the past five years of share price changes for Pepsico, CocaCola and the S&P500 Index. Pepsi has outperformed the S&P by less than 20 percentage points over the five years, but trails Coke by some 40 percentage points.

I don't typically analyze either company, since neither usually survive my equity portfolio selection process. Thus, I've mostly seen Nooyi's appearances on CNBC, which loves to showcase a foreign-born female as CEO of a large, iconic US firm.

Too bad it looks like she's messed up. According to the Journal piece, she starved the flagship brand of attention and ad dollars, resulting in its slipping relative to the two Coke brands.

Further, she more or less prominently dedicated Pepsi to 'healthy' products, resulting in the very profitable and popular snacks and sugary drinks being either mis-positioned or left less-well-attended. Meanwhile, the article reports that the healthy, "good for you" product portfolio at Pepsico accounts for only 20% of revenues.

Perhaps the fundamental question is whether shareholders of the company are well-served when the larger flagship Pepsi and Frito-Lay brands that are salty, sugary, less "good for you" but very much in demand by US consumers, are shunted aside in favor of Nooyi's focus on changing Pepsico's image to that of a healthy food purveyor.

As recently as this late this winter, Pepsi had only matched the S&P in performance over the period since 2007, suggesting that Nooyi isn't doing much for her shareholders. Certainly not compared to CocaCola, the price series for which broke cleanly above and away from Pepsi and the S&P in mid-2007. Coke's share price premium shrunk last year, but never evaporated, and it has enlarged its premium over Pepsico and the Index since then.

It's interesting to me that the Journal piece is the first really negative one about Nooyi since she became Pepsico CEO. It makes one wonder whether the business media have been reluctant to criticize a politically correct CEO, requiring more time and evidence of slack performance for even a relatively weak article like today's to be published.

Given all the adulation Nooyi receives for being an Indian-born woman who is now running Pepsico, one might wonder, given her performance thus far, which is somewhat erratic and far from stellar, just what she can mentor and teach all the women for whom she is apparently now a shining beacon of hope?

Monday, June 27, 2011

Private Equity Goes Public

A recent Wall Street Journal article spotlighted the growing trend for private equity firms to go public. Included in the group were Apollo Global Management, Blackstone, Och-Ziff, Fortress and, soon, Carlyle Group.

Here's the passage that purports to explain the trend,

"Many of the firms speak of talent they can recruit and retain using shares. Some have said their primary duty remains to investors in their funds, not public shareholders."

Face it' those are lies. The only reason private equity firms go public is, as I wrote in posts regarding Blackstone's transition to having public owners four years ago, is to sell at the top of their valuations, relative to where the private equity firm owners see their firms' near-future valuations.

The real allure of working for a private equity firm is to have one's sizable compensation participate, at least partially, in the firm's own deal funds. To work for a firm unemcumbered by so much of the regulation of publicly-held financial sector firms. And to be part of a shadowy elite in the financial services world. None of that remains when the firm goes public.

In my last Blackstone-related post, I wrote,

"Which goes to prove my contention that you never, ever want to be on the other side of an IPO of any equity-oriented investment bank.

First, they don't sell at a trough. They are smarter than that. If they are selling, why on earth do you want to buy. Their very sale means they think the asset- their firm- is overvalued. In each case here, the founders were correct. If anything, you should consider buying puts on the shares, rather than buying the equities.

Second, these firms are not managed the same way when so much cash is off of the table. Either the founding owners can now take excessive risks with outsiders' money, or they might just take it easier, having realized billions in cash returns. Either way, the prior track records of prudent, steady returns is probably over."

I don't believe any of that has changed.

Despite the Journal's piece suggesting that private equity firms which go public may become more "professionally-managed" and invest more in running their firms, as well as build brand value, I think something else is afoot.
All you have to do is look at the long, 40-year experience of former Wall Street partnerships gone public. Generally, owners cashed in at the top, took excessive risks with new shareholders' money, and took formerly-nimble, lean firms, turned them into slower, overly-manned and -regulated public entities, and diluted their performance.

The public isn't buying into or getting what the former private owners enjoyed.

Further, if private equity firms go public to attract more capital, that means the barriers to entry of the sector are falling, more capital will chase the same amount of deals, and profit margins will fall as risk rises.

Which is pretty much happened with the old Wall Street partnerships. Many went out of business or were acquired. In short, this phase is suggestive of a move of the sector to maturity, not a more profitable era.

Perhaps larger in scale and gross profit dollars, but on lower margins and with higher risks.

As always, investor/buyer beware.