About Creating "Bad" Banks

There is much ado this week about a putative 'bad bank' asset disposition plan from Treasury.

Well, sort of. Despite having months to conceive his plans for the financial sector and the economy at large, Treasury Secretary Tim Geithner apparently still needs a few more months to figure all that out. Heavens knows what he was doing since November.

Regardless, let's take a step back and consider just what it means to create a 'bad bank.'

First, it's basically Bill Seidman's RTC redux. Back in the late 1980s, in the aftermath of the S&L crisis in which those institutions borrowed short, lent long and low, and largely went insolvent. The thrifts were closed, loans collected into the Resolution Trust Corporation, and sold off to investors at deep discounts, providing many of the latter healthy returns. The 1980s S&L/RTC crisis was more about stupid funding strategies than bad loans.

Now, however, the nature of the 'bad bank' is different. This time, our largest commercial banks, as well as smaller ones and specialized lenders, e.g., Golden West and Countrywide, with Federal and state regulatory tacit approval, lent mortgages on only 5%, or less, down.

Consider two banks with different approaches to loan or securities value loss recognition.

Bank A, like Merrill Lynch, promptly begins to clean up its books by writing down questionable asset values. It rapidly erodes its capital, becoming nearly insolvent. It is taken over and merged with another institution, its shareholders losing everything. There may, or may not, be Federal loss-limiting guarantees on some of the loan portfolio.

If there are such guarantees, then not only investors, but all taxpayers, have just shared the losses of the badly-managed bank.

Bank B, however, holds out and avoids writing down its losses for months. Eventually, Treasury creates a 'bad bank' to buy bad loans from commercial banks. The theory is that, once freed of the bad loans they chose to make, these ailing commercial banks are now healthy and able to make new loans.

But before we know that, we need to know at what general price level the assets were transferred to the Treasury's 'bad bank.' I wrote about this dilemma back in late September of last year, in this post, when Bernanke and Paulson first unveiled their TARP plans. Specifically,

"Further, if Treasury bids such high, close-to-maximum-economic value prices for these securities, then there is virtually no chance of the US taxpayer realizing any gain on subsequent sales. At best, they may breakeven.

At the other extreme, though, also described by Bernanke, if Treasury's bid is a little above the fire sale price, but well short of the economic, or 'hold to maturity' value, then the selling bank receives little extra capital, and not much more in the form of marking similarly-held securities up to the bid, either.

What is it that I am missing? This isn't going to work!"

In fact, it didn't work that way, and was never actually implemented as stated. Now, Geithner's Treasury faces the same dilemma in creating a 'bad bank.'

If Treasury pays face value for the loans, fully recapitalizing the banks, then Bank B's management was smart in playing for time. In effect, by gaming the regulatory system, Bank B lives to make more bad loans, while Bank A was closed for the same offenses.

If, however, Treasury buys the bad loans at economic, or lower, value, which might be as low as the 37%-or-so value Merrill accepted in its funding deal last year, then the banks aren't sufficiently recapitalized to survive. Bank B is determined to be insolvent and, like Bank A, closed and/or merged with another institution.

In the latter case, taxpayers end up owning the bad loans at distress prices, so they don't share in the losses of the inept lending institutions.

From this little mind experiment, we've learned something valuable.

If Treasury pays at or near face values for the bad loans that will fill the 'bad bank,' then taxpayers, who individually may have chosen not to own equity in the ailing lending institutions, effectively find our government buying the losses from those banks anyway. And society is penalized for the sins of a few inept lenders, while the lenders get to remain in business and, in fact, are encouraged to lend again.

If Treasury pays economic, or lower, values for the bad loans to fill the 'bad bank,' then incompetent lenders and their institutions pay a price for their mistakes, and taxpayers don't subsidize them.

Either way, however, there is a net loss of recognized value to society, in the sense that the merry-go-round of overvalued assets stops and those values are forcibly reduced.

In the case of the RTC, the private, publicly-owned financial sector was not recapitalized by the government. Instead, weak and failing thrifts were eliminated, capacity removed, and a healthier, if temporarily smaller financial sector remained.

If Treasury creates the 'bad bank' by compensating existing publicly-held, private financial institutions at or near face value for recognized 'bad loans,' this will not be at all like the 1980s RTC solution.

Instead, Treasury will, in effect, be recapitalizing shareholder-owned institutions with public money, making taxpayers effectively own the mistakes, while rewarding the incompetent management that managed to hold on long enough to get this ultra-sweet deal.

Talk about moral hazard!

This would be among the worst things to happen to capitalism that ever occurred in the US.

Private financial companies are relieved of their mistakes and given money to err again. Taxpayers are socked for the losses, despite their perhaps not having chosen to ever buy equity in the incompetent financial institutions.

And to pay for all of this, Treasury prints or borrows money, thus either devaluing the dollar or saddling the entire society with the interest and principle costs associated with the stupid lending decisions of some publicly-held, privately-owned banks.

That scenario makes no sense. The only defensible course of action is the creation of a 'bad bank' through loan purchases at lower, economic prices, resulting in bank closures, a reduction in lending capacity, and stronger resulting institutions. Which is what Anna Schwartz advocated last fall.

Private Equity's Perfect Timing On Going Public

The Wall Street Journal ran an interesting article last week in their Heard on the Street column concerning private equity. Entitled, "Private Equity's Ultimate Buyout," the piece discussed the plunging prices of various formerly-private equity shops like Blackstone and Fortress.

Back in October of last year, I wrote this post on a similar topic. My point in that post was that Blackstone sold out to the public at a market top. I wrote, in closing,

"So, amazingly, I was correct in my cynical view that the best of the private equity shops either called, or defined the market top with its IPO."

The Journal piece goes further, noting how many billions of dollars of cash was taken out of these private equity firms by their founders, upon their initial sale of minor stakes to the public.

According to the article, Blackstone netted $2.6B, Fortress $1.3B, and even Apollo group took in $1.2B, after a cash dividend of nearly $1B paid to owners.

Of course, since their IPOs, all three firms' valuations have declined precipitously. Sure, the founders still had equity stakes in their firms, but with billions taken off the table, does that really matter now?

The Journal notes that the three firms' equity prices have declined between 85% and 95% since the respective IPO dates.

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'm happy to say I never even considered buying an investment bank IPO. Goldman Sachs made us some nice returns in the past few years, prior to 2008. And we were out before its severe decline last year.

But, just on principle, you would never catch me buying when a private equity firm is selling a share of itself.

What Ken Chenault Isn't Telling You About AmEx's Performance

This morning's Wall Street Journal's front page of the Money & Investing section carries a headline at midpage screaming, "AmEx Net Sinks 79% as Customer Spending Falls."

Buried in the article is the passage,

"In addition to cutbacks in spending, the financial firms that issue credit cards are being hit hard by strapped consumers, who are falling behind on the bills with increasing frequency."

Maybe so, but that first element is circular, and Ken Chenault isn't telling you why AmEx is experiencing such a drop in charge volume.

The truth is, AmEx encouraged it. How?

Beginning several months ago, the firm began cutting the credit lines of even its best customers by 50%!

For example, a colleague of mine was told, while on a business trip, that his AmEx card had reached its limit. In a scene reminiscent of that old AmEx ad showing a young man being embarrassed when his Visa card can't handle the charge for his fiancee's ring, or a business dinner, this colleague was told to come up with another way to pay his hotel bill.

Upon contacting AmEx, he was told that, to use his card again that month, he'd have to immediately send them a check. Mind you, this customer has been with AmEx for decades.

Going back some twenty years, it was common knowledge at Chase Manhattan Bank that credit card users charged more in proportion to their credit lines. The key to the process of profitably growing credit card businesses is to sensibly extend more credit to capable, creditworthy customers, who will then, as a group, on average, obligingly carry higher balances.

AmEx has stood this principle on its head now, cutting credit lines, and, thus, balances and spending with their cards.

It should come as no surprise that the firm is now seeing a plunging net income.

The colleague in question was so furious that he closed every AmEx relationship he had, including business loans, and transferred all of them to a local bank's competing credit card.

AmEx has been a sinking ship ever since their naturally-hedged businesses, travelers checks and credit cards, unlinked. Without the free source of funding, their credit cards became less competitive just as credit card volumes soared.

This is yet another financial services company which, pursuant to today's first post, should have been allowed to die, merge, or be acquired, rather than become a commercial bank and suck up public funds to survive.

Carl Icahn On Corporate Governance

Carl Icahn wrote a piece in Friday's Wall Street Journal on corporate governance. Coming from a guy who regularly invests in equities of companies he feels are poorly run, it's worth reading his thoughts.

He wrote,

"Private enterprise forms the basis for our economy. It provides most of the jobs we enjoy and creates the wealth that raises living standards. New government spending can only do so much to repair the economy. Reshaping corporate management can do much more.

The problem with doing nothing is obvious. Faltering companies are now soaking up hundreds of billions of tax dollars, and they are not substantially changing their management structures as a price for taking this money.

How does it serve the economy when we subsidize managements that got their companies into trouble? Where is the accountability? More importantly, where are the results?"

On this point, I am in total agreement with Mr. Icahn. We are currently wasting money by subsidizing badly-managed companies, e.g., GM, Chrysler/Cerebrus, Citigroup, BofA, and AIG.

Icahn suggests Congressionally-mandated reforms,

"Changes are needed and can come if Congress insists on reforms that make corporate boards and managers more accountable to stakeholders.

First, Congress needs to pass legislation giving shareholders enhanced rights to elect new boards, submit resolutions for stockholder votes, and have far more input on executive compensation and other issues. As companion to these reforms, Congress needs to pass legislation that prevents managers from making it more difficult for shareholders to exercise their ownership rights.

Managers often come up with creative ways to perpetuate their reigns of error. These include myriad takeover obstacles like poison pills, bylaw provisions, and others devices that thwart shareholder efforts to hold managers accountable.

If Congress is reluctant to make wholesale changes at the federal level, it can enact one simple provision that would allow many of the needed changes to take place on the state level: It can give shareholders the right to vote to move a company's legal jurisdiction to a more shareholder-friendly state such as North Dakota. Currently that decision is in the hands of company boards."

While I continue to disagree with investors', including Icahn's obsession with the pay of senior management, I don't disagree it's worth having Congress pass Icahn's proposals, one way or the other. The state's rights option is very appealing by creating 50 competing corporate domiciles.

Mr. Icahn closes with these sentiments,

"What we need are measures that let the capitalist system produce jobs and economic activity, with minimal but effective government oversight. Government spending is an important catalyst to economic gains, but we need to focus on improving the way private companies are managed so private capital can flow into them.

Lax and ineffective boards, self-serving managements, and failed short-term strategies all contributed to the entirely preventable financial meltdown. It is time for battered shareholders to fight back.

It is time for change and the place to start is in the corporate boardrooms of America."

It all sounds good, and very patriotic. But, really, just how do thousands of individual shareholders mount an attack upon a few members of the board of a large corporation?

Why isn't plain old share price the best investor weapon? Sell shares of companies you don't want. If enough shareholders do this, and other investors short the stock, the price will fall to a level that makes current management vulnerable; to creditors, predators, or simple liquidation, at which point some better management team swoops in to recover any salvageable value.

What's wrong with this scenario? Isn't it the ultimate in capitalist retribution? A poorly-run company simply loses value, until it no longer has capital with which to operate?

The Problem Facing Chase & Wells Fargo

There's an interesting problem now facing Chase and Wells Fargo banks.

How do they price and take risks when their two largest competitors, BofA and Citigroup, are effectively nationalized banks?

Citigroup's net market value is now less than Federal infusions.

So if BofA's, if my arithmetic is correct. The bank's current market value is roughly $31B, but it has been given two $20B TARP infusions, plus an open-ended $115B loan loss line for the Merrill purchase.

And we've seen that Vik Pandit sold off his brokerage unit to a joint venture with Morgan Stanley under pressure from the Feds. Ken Lewis was forced to consummate a bad merger with Merrill Lynch because of Federal coercion.

How do John Stumpf and Jamie Dimon compete against a force even larger and prospectively more coercive than the organized crime?

Specifically, while Citi and BofA might actually take fewer new market risks now, they alsom might be coerced into accepting losses on consumer loans or mortgages as part of a Congressionally-mandated 'forgiveness.'

Further, as Bill Siedeman noted on CNBC a few weeks ago, as soon as a bank is seen as being backed fully by the Federal government, its capital costs decrease, its need for capital disappears, and, thus, a key cost component is subsidized.

When competing for loan business, will Chase and Wells Fargo use higher internal capital costs, thus making them less competitive?

Chase and Well Fargo, though performing better over the past six months than Citigroup and BofA, per the nearby price chart, have each still lost roughly 40% of their equity price.

How long before investors abandon the latter two banks, fearing pre-emption by the Federal government, to which Ken Lewis acquiesced at BofA?

It's a very interesting and unusual situation never before seen in US financial services. One can't help but think that heavy governmental intervention, to the point of essentially owning two of the nation's largest banks, by assets, will have to have a damaging impact on competition in the sector going forward.

Thain Ousted From Merrill-BofA By Lewis

John Thain's recent firing as head of the Merrill Lynch units of BofA seems to reinforce the sentiments I expressed only last month, in this post. I wrote,

"Now, Thain is also remembered for gulling investors in December and the first quarter of 2008 to put money into the disintegrating brokerage firm, then claiming they didn't need to raise any more capital. To me, Thain is tarnished by some of what he did early on at Merrill, and for even leaping into the mess. I think it smacks of too much ego and too little perspective on the unfolding disaster that was in process a year ago.

Maybe I'm alone in this view, but I think Thain's time at Merrill has diminished his reputation and raises questions about his judgment."

My view hasn't changed. And I've held it since back in late 2007, when, in this post, I wrote,

"Merrill represents the last of an otherwise dead model, the retail wire house. Sure, Merrill bought and grafted on investment banking in the past decade. But it hasn't internalized the risk management skills which seem to have prevented Goldman Sachs, Morgan Stanley, and Blackstone from suffering the same losses during this year's financial crises.

For an experienced, capable outsider, though, the job might ultimately hold more risk than opportunity."

To me, this whole affair continues to be an embarrassment and the downfall, in time, of both CEOs- Thain and Lewis.

Sure, this week's revelations of Thain's expensive renovation of his office at Merrill amidst its hemorrhaging losses is quite a statement to his lack of judgment, even at micro-levels. That sort of arrogance and waste looks really bad in retrospect. It's hard to believe the stories are only surfacing now.

But, judging from the recent editions of the Wall Street Journal, and comments on CNBC, others are finally seeing what I did over a year ago. Thain didn't perform proper due diligence on Merrill, in so great a rush was he to prove himself one more time. His ego got the better of him.

But Lewis looks bad for throwing over his own common shareholders, under government pressure. Not to mention his first mistake, which was even offering to buy Merrill.

I thought he should have simply hired their brokers, if he really had to have them, rather than buy the whole mess. Merrill never had a particularly stellar investment banking team, nor trading function, for that matter. And Lewis wouldn't know how to manage those anyway.

But, given that he mistakenly wants a full service, full cost brokerage force, simply luring them from Merrill, or, better, picking them off from a bankrupt Merrill, or one taken over by another firm, would have been cheaper and simpler.

But, for now, Thain is the goat. And I agree that it might be a long time before he is well-regarded again in financial services. For now, it's probably time for him to open that small hedge fund and take money from a few friends, so he can hang out a shingle and expense some of his business activities for the coming few years.

Our Resilient Economy: Remembering Nixon's Wage and Price Controls

Last year's ineffective tax rebate checks for how many hundreds of billions of dollars? I can't even recall.

The badly-managed, ill-conceived and ineffective TARP for $350B, with another like sum to follow this year.

Now, a $1T+ 'stimulus' plan to allegedly fix an economic recession. Except the larger part of the economic shrinkage is due to deleveraging, more than recession. And spending doesn't fix recessions, it only adds to government debt.

Still, we've endured worse. Perhaps the very worst, the nadir of America's free-market economy, was the 1971 imposition of wage and price controls by Republican President Richard M. Nixon.

Having defeated the hapless socialist Senator from Minnesota, and sitting VP, Hubert Humphrey, Nixon was viewed as a cold-hearted, paranoid conservative. If any Republican in then-recent memory embodied corporate politics, it was Nixon.

Yet, in what was to become a new paradigm for US Presidents, the ardent cold warrior opened China. And, as conservative, business-supporting President, he crossed over to commandeer the economy though cumbersome wage and price controls. All because inflation rose to the then-scary range of 2-3%. Union demands drove wage increases beyond prior experience.

Just about two years later, on January 11, 1973, Nixon called the whole thing off, ending the two-year travesty.

Later, in the late 1970s, Jimmy Carter almost instituted gasoline rationing. My girlfriend in the early 1980s had worked on the program for Energy Secretary James Schlessinger as a consultant at one of the beltway firms.

Yet, some thirty-five years later, in the mid-2000s, our economy had risen to unbelievable size and prosperity.

Ronald Reagan's tax cuts, Paul Volcker's steady hand at the Fed, and American enterprise combined to usher in the most productive, wealth-producing era in modern American history.

If our economy could withstand the body blows of Nixon's wage and price controls, Carter's energy policy, and even, before both of them, LBJ's inflationary financing of the Vietnam War as he raised taxes, it can also probably survive the current tough times, and those to come.

There's still hope for the US economy not because of, but despite, the planned programs of Congress and the administration.

GE's Weakness & Immelt's Defense

Well, it's GE earnings time again. And time for its inept CEO, Jeff Immelt, to bluster with excuses about his weak leadership of the ailing conglomerate.

I caught some of King Jeffrey I's interview with his own minions on GE-owned CNBC this morning. Salient among Jeff's various excuses was this gem, as closely paraphrased as I can recall,

'We made $4 billion last quarter. I'm not apologizing for that.'

My old boss at Chase Manhattan Bank, Gerry Weiss, then SVP of Corporate Planning, and a longtime GE senior planning officer, used to comment on the inertial earnings power of large companies.

At Chase, he noted, we made enormous profits just by being one of the three largest US commercial banks. In fact, he would frequently say,

"We make money in spite of ourselves."

But that line of reasoning, as Gerry also noted, is inherently flawed. It ignores returns on equity, market value, or even assets. It's a desperate play for the shock and awe of big numbers.

As the nearby 1- and 5-year price charts for GE and the S&P500Index indicate, shareholders have voted, via price, that Immelt's profit numbers are not acceptable. Over the past five years, GE's price has fallen at a faster rate than the S&P. In the past twelve months, GE's earnings have apparently continued to disappoint investors. Just this year, the company's stock price has declined faster than the price of the S&P.

GE had, as of last quarter's report, assets of $829B. On that basis, $4B of quarterly earnings doesn't seem all that awesome, does it?

For Immelt to resort to that is an indicator of just how desperate he is to somehow explain GE's sudden collapse under his mismanagement.

Microsoft Cuts Workforce, Ends Growth Era

Yesterday's pre-market open announcement by Microsoft that it is cutting 5,000 of its 91,000 employees marks the first time the company has trimmed its workforce.

For some, this is a sign that the firm is no longer a high-growth technology company. For me, though, charts like the one nearby have said it for years, as my prior posts on the company have stated.

For the past five years, Microsoft has been unable to outperform the S&P500Index. Say what you will about employee or revenue growth, the total return simply hasn't provided sufficient, risk-adjusted reasons for holding the equity, versus the index.

One fund manager on CNBC today complained bitterly of the firm's pre-open announcement, and swore never to hold any of Microsoft's equity ever again.

The layoffs were blamed, in part, for the major selloff of the equity market from the opening bell.

I haven't seen Microsoft in my equity portfolios for over a decade. Looks like market perceptions are finally catching up with mine.

Another Blunder At Citigroup

Just when you thought Citigroup couldn't make another blunder, it managed to do just that by naming failed Time Warner ex-CEO Dick Parsons as Chairman.

Talk about going from the frying pan into the fire. As bad as Bob Rubin was for the firm, Parsons may well be worse.

True, Parsons probably won't actively and knowingly mislead the board and the rest of the bank into risky CDOs and other ill-advised business decisions, as Rubin did.

Parsons might, I suppose, simply do nothing. Which, in a way, would be an improvement over Rubin.

But Parsons has no track record of succeeding at anything at Time Warner, where he replaced Gerald 'let's buy AOL' Levin. Nor at Citigroup, either, as a board member.

Citigroup has now managed to shuffle executives over the past year or so in such a way as to have no experienced commercial banker as either chairman or CEO.

Nice job, guys.

The nearby price chart for Citigroup and the S&P500Index shows that the bank's equity has declined by some 60-70% in the past year, while the S&P declined 'only' about 40%.

Does anyone really believe Parsons can do anything to help the situation?

State Street Bank's Troubles

State Street Bank has now joined the ranks of US commercial banks experiencing problems from asset value declines.

I provided consulting to the bank's then-CEO, Marsh Carter, some years ago, in the company of my mentor and one-time boss, Gerald Weiss. The three of us knew each other well from our days at Chase Manhattan Bank, and Gerry was a more or less permanent, personal consultant to Carter when he ran State Street.

From the work I did for the company in 1997-98, I recall that the bank's primary competitive advantage was, and probably still is, its immense custody function. As a result of bidding a low price to service pension fund custody needs, the company knew where to locate quite a few securities, as well as became the institutional broker for trades from those customer accounts.

With this huge front end asset servicing business, State Street's other, downstream businesses could make money as a result of information about these securities. All perfectly legal.

Among the bank's least-related businesses was its own asset management group. The current CEO, Ron Logue, headed that group back when I consulted with the firm. So it's rather ironic that, now, the Wall Street Journal reported yesterday that Logue cited the asset management business as the source of the bank's current losses.

On Friday, it disclosed- unexpectedly- that it had some $9.1B of unrealized portfolio losses.

I haven't followed State Street very closely since Carter departed. He went on to become chairman of the NYSE in the wake of John Reed's departure. His successor, David Spina, was a somewhat myopic, cost-conscious operations executive who never understood that the key to State Street's long term ability to earn consistently superior returns was the investment in its ability to process more diverse and foreign-sourced assets, in support of its main customer base, US pension and other large asset funds.

I have no idea how it came to pass that Logue, an outsider to the bank's core functions, has eventually become CEO. But to read that State Street now has problems involving off-balance sheet conduits and other asset quality issues makes it sound like it began to operate more like Citigroup, and less like the less-risky, fee-based custody and processing bank it has historically been.

As the nearby price chart for State Street and the S&P500 Index shows, the company enjoyed a period of fairly consistent outperformance of the index from 1991 through about 1998. It was at that point that my consulting findings predicted that, if management failed to change some operational parameters, it would see a corresponding decline in its future total returns, relative to the S&P. Only a few days after my final presentation, the bank reported results which triggered a 10% drop in the price of the firm's equity in a single day.

Since that time, State Street's performance has been about the same as the index's. As I expected, Spina's cost focus eventually ended the firm's ability to continue benefiting from its massive market share. I would venture to guess, not having access to internal financial information, that State Street's market shares in key custody segments either eroded, or became less profitable.

Thus, it is understandable that they began to look to unrelated asset management units to make up the shortfall. But, in this area, the bank had no particular competitive advantage.

But in the last decade, it would have been fairly easy for even mediocre asset management by those units to offset the falling custody profitability and provide Logue with his ticket to the top job.

It is, in my opinion, yet another example of how failure to understand and manage a company's core businesses can result in a serious failure due to the attempt to maintain performance in the face of changing business realities. Either State Street's main business began to grow much more slowly, signaling an end to its natural period of consistent market outperformance, or they attempted to harvest the business prematurely. In either case, by using ever-riskier asset management to offset this decline, the once-conservatively managed bank has now joined so many other US commercial banks in requiring Federal money to stave off the effects of serious losses due to badly chosen business actions in the past few years.

Fiat Proves My Point On Detroit Bankruptcies

Yesterday's Wall Street Journal reported Fiat's interest in taking a controlling interest in Chrysler.

According to the article, Fiat would begin by taking a 35% position, with the option of increasing to a controlling 55% ownership. Incredibly, Chrysler has fallen so far that all Fiat must do for this position is to cover

"the cost of retooling a Chrysler plant to produce one or more Fiat models to be sold in the U.S."

Thus, my claim, along with others, expressed in this November post, is being shown to be true. Given the opportunity, other auto makers will step in to buy parts of the troubled Detroit-based US auto makers, when they prove attractive for those buyers' own strategies.

Fiat is essentially getting a US base on the cheap. They don't even want to build Chrysler cars, just use the existing plant infrastructure. Then they'll escape foreign-import laws and sell their cars as US-made.

If Congress and the prior administration had simply let GM file Chapter 11, the same sort of market self-cleansing would have occurred. Maybe it still will, but the odds grow longer as Wagoner feels he's successfully elbowed his way to the Federal cash trough.

It's really a shame, because now, during the very week of US political power transfer, Schumpeter's theory of creative destruction is being proven true for the zillionth time.

Chrysler's millstone becomes Fiat's new beginning in the US market. Problem solved!

When, if ever, will politicians, collectively, ever learn that markets do right themselves, and, short of that, forced, arbitrary intrusions by government, and false price-setting always distorts or delays eventual market self-healing?

Another GE-Welch Alum Goes Down: "Rusty" Mike Zafirovsky

Last Thursday's Wall Street Journal reported that the former "Iron" Mike Zafirovsky has put his company, Nortel, in to Chapter 11. Thus becoming, I guess, "Rusty" Mike, and the latest of Jack Welch's spawn to fail in running a company.

Of course, Welch's replacement, Jeff Immelt, has been a complete disaster. Jim McNerney had little to negative effect at 3M, before moving to Boeing and assisting in the Dreamliner snafu.

Bob Nardelli managed to help ruin Home Depot, then jumped out of the frying pan, tens of millions of dollars wealthier for his 'work,' and landed in the fires of Chrysler. No sign yet that Bob has turned that one around, either. I suppose asking for a Federal bailout would qualify as failure, don't you think?

Now we have Mike Zafirovsky. As CEO of Nortel since 2005, he certainly owns the company's current situation. As the nearby price chart for Nortel and the S&P500 Index for the past five years shows, Nortel has been in decline for the bulk of Iron Mike's tenure.

It's now lost nearly all of the value it had when Zafirovsky took over the company.

Like Lucent, it seems the business of developing, manufacturing and selling telephone-based digital processing switching systems just seems to have been the wrong business to be in since the digital revolution.

At least Lucent managed to fall into the arms of Alcatel. No such luck for Nortel, the once-vibrant competitor of Lucent's businesses when they were under the AT&T umbrella so many years ago.

It doesn't seem like any of these companies managed to survive the onslaught of wireless and the digitization of information streams. They might claim to have gone digital with their communications systems, but, somehow, that didn't seem to matter.

As a GE-trained success story, I'd have expected Iron Mike to have either merged or reshaped Nortel before this end befell the company.

Then again, looking at the records of Nardelli and McNerney post-GE, and GE post-Welch, under Immelt, it really doesn't look like any of these guys learned much in their alma mater's famed training program, does it?

Regarding The New Revelations About BofA's Purchase of Merrill Lynch

Yesterday's post discussed Citigroup's recent debacle in some detail. Thanks to long mismanagement and the choice of a novice as its latest CEO, the financial giant has become, essentially, a government-owned banking utility.

Now we come to the other, most recent ward of the government, Bank of America.

Back in December, when Merrill Lynch's shareholders voted to sell their firm to BofA, it seemed rather straightforward. True, BofA's Ken Lewis seemed to be missing the chance to step back and drive a harder bargain, with Merrill's continued weakening condition offering him that opportunity.

But, as I noted in this post from late 2007, commercial bank CEOs are notoriously less capable and effective than their (former) investment bank counterparts. Thus, Lewis' forbearance seemed to be just business as usual.

Now, however, from a spate of Wall Street Journal articles last week, we learn that surprise, surprise- Lewis refrained from backing out of the Merrill purchase due to coercion from Federal government officials.

So, once again, we see that the allegedly passive interest which the Federal government bought last year in our large banks is anything but. In BofA's case, Bernanke and Paulson dictated to Lewis that he must penalize his common shareholders in order to satisfy their demands, and conclude the purchase of Merrill Lynch.

But there's plenty of blame and shame to go all around the table of senior officials, government and private sector, in this travesty.

Lewis claimed that Merrill was a feasible purchase, stating even last Friday, according to the Journal,

"We did not expect the significant deteriorate in mid to late December that we saw."

Gosh, Ken. Isn't that what you are paid to do? Correctly anticipate evolving credit and market risks to your assets?

Apparently Lewis and his team either failed to conduct a proper, updated due diligence on Merrill, didn't insert sufficient clauses to provide for Merrill's asset value shrinkage, or simply did not know what they were seeing when they conducted their analysis of Merrill's books and positions.

Regardless of the reason, this blunder certainly must cost Ken Lewis what little credibility he still has with anyone- analysts, employees, investors.

Oh, and, to close the deal, Lewis then required a further $138B of US taxpayer money, from Treasury, to both provide adequate capital so that the resulting combined firm would pass muster on regulatory bases, as well as provide guarantees for losses on suspect Merrill assets.

It looks like we, the taxpayers, pretty much own another large commercial bank. Nationalization continues apace.

Then we come to John Thain. Reading this morning's Wall Street Journal article about his actions, it is nearly impossible to escape the conclusion that Thain knew very well he had misled Lewis into consummating the deal, while all along knowing of the serious, significant deterioration of Merrill's positions.

Thain disingenuously removed himself from New York during a critical week in December to ski in Vail, Colorado. His spokesperson claims Thain was 'working and available,' while others see him as having deliberately distanced himself from the gathering cloud over the transaction.

It's much more understandable why Thain chose not to revisit the transaction's desirability with his own board or shareholders. Per my prior, linked post, once again, an investment banker managed to out negotiate a commercial banker.

Seen from a distance, once again, we see the needless, expensive and private property rights-trampling behavior of government. Rather than have the excess, incompetent capacity represented by Citigroup, Merrill Lynch and BofA removed, their assets sold at market prices, and only healthy institutions left to compete, instead we have them all being propped up, polluting and delaying the process of the markets to cleanse the financial system.

As I noted in my post from October of last year, reviewing the Journal's interview with Anna Kagan Schwartz,

"Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years." Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake. "

I think this past week has more than validated Ms. Schwartz' judgment. We're in for either a very long return to a market-oriented financial system of credit provision, or a very short journey to a fully-nationalized system of core credit provision.

CitiGroup Becomes Our First (or Third?) US National(ized) Bank

Last week's events concerning Citigroup and Bank of America are surely historic and momentous.


Let's consider Citigroup's situation first. Citi was the first of the large banks to be given the sweetheart deal of US government investment beyond the initial TARP funds, with the government taking losses above some maximum level.

Friday's Wall Street Journal reported that,

"The rescue didn't shake Mr. Pandit's confidence in his strategy. He framed the chaotic week as a reflection of the overall financial industry, not Citigroup. "He had a spring in his step," said a Wall Street veteran who met with Mr. Pandit on Nov. 25. "You could not tell that he is a CEO that's under pressure." "

Maybe he wasn't. Pandit never seemed to really, seriously embrace the reality of the crippled institution he had been allowed to lead.


Yet, only a few months later, we see Citi dismantling itself with a rapidity only those like me and other observers of the long-ailing bank for years, have previously advocated.


Pandit, the bank's CEO of only a little more than a year, has suddenly reversed course on the subject of preserving Sandy Weill's treasured financial supermarket, both by shedding the brokerage unit via a joint venture with Morgan Stanley, and the creation of a 'bad bank,' to free what's left to become, again, Citibank.


What caused the sudden change of mind? Vik's newest, large governmental shareholder used some muscle, indicating that the cookie jar of bailout money was closed until and unless Citi finally did something to resolve its mess of an operating structure and business mix.


According to the Journal article,


"By mid-December, Mr. Pandit and his team realized the company was heading for a big fourth-quarter loss, according to people familiar with the matter. Over the course of a week of meetings, it dawned on them that they needed to at least symbolically break with Mr. Pandit's past insistence on preserving Citigroup's business model, these people said."


Indeed.


But let's be clear about what has transpired. After years of flattened returns under Rubin, Weill and Prince, nobody thought to actually fix Citigroup by undoing Weill's tangled business conglomeration.

No, instead of letting market forces, via its mediocre total return performance, push it into either divestiture, or a merger with a healthier bank, the federal government first bought preferred equity in it. Then gave it even more money, and backstopped some of its potential losses.

Then the Feds began to exert the sort of influence that they promised only last fall that they would not, in fact, use.

If you had any doubts about Citigroup, or the other large commercial banks effectively being nationalized, this should dismiss them. Taxpayers, via the Treasury, now own the real market value of Citigroup. It's basically our bank.

So our government is now calling the shots. How long before my various posts on the evolving nationalization of our commercial banking sector are realized?


The Journal article ends with the incredible observation,


"As word of the looming fourth-quarter loss surfaced earlier this month, Citigroup's shares tumbled to their November lows. Colleagues said Mr. Pandit remained in high spirits, pressing his lieutenants to remain focused on their work."


Maybe Vik should change his name to Chance Gardener, the equally-clueless and improbable protagonist of Jerry Kozinski's "Being There."

Carol Bartz Assumes Command at Yahoo

Yesterday's Wall Street Journal carried a very flattering, supportive article describing a more favorable reaction by most interested parties to Carol Bartz' elevation to CEO of Yahoo than prior pieces had been.

The Journal piece noted,



"In a call with analysts Tuesday, Ms. Bartz said, "I don't expect it's going to take an extraordinary amount of time" to examine Yahoo's strategic options, but she indicated she is unwilling to cave in to outside pressure to act. "More than anything, let's give this company some frickin' breathing room. It's been too crazy -- everybody on the outside deciding what Yahoo should do, shouldn't do, what's best for them. That's going to stop." "

You have to love Bartz' attitude. Somehow, you just envision dozens of investment bankers, analysts and related onlookers collectively shutting up and watching while Bartz sorts out the ailing company's fortunes in the next month.

For what it's worth, per my earlier Bartz-focused post, I found my 2006 Yahoo chart comparing GE and Autodesk. Then updated it to the present.

Bartz served as CEO of the cad/cam company from 1192-2006.

As mediocre as GE looked back in 2006 compared to Autodesk, it's even worse now, not even outperforming the S&P.

By viewing the slopes of the price curves, even allowing for GE's dividend, you can see that Bartz outperformed Immelt and, over her tenure, significantly outperformed the S&P. To a degree, I believe, that would work out to a higher rate per annum than Welch's, but I'll have to go to my Compustat data to confirm that.

In any case, Bartz is already taking charge and making it clear she'll be the one running Yahoo and doing the talking. And more than likely, her counterparts elsewhere realize the days of pushing the hapless internet company around are over.

BYD As Auto "Manufacturer"

Amidst the hue and cry over whether and how GM, Chrysler and, in time, Ford might survive and perhaps even prosper again, a mention was made in a recent Wall Street Journal article of battery manufacturer BYD.

This Chinese firm specializes in lithium ion batteries, but is showing its plug-in hybrid at the upcoming Detroit Auto Show.

What I find remarkable is the implication for the three remaining US auto makers which is going largely unheralded.

Part of the recent and, so they hope, upcoming bailout of GM and Chrysler by the US Treasury is an expectation that the companies' new minority partners, Uncle Sam, will mandate 'green' car technology- hybrids, electric cars, and that sort of thing.

But it would seem to be a troubling omen that a Chinese battery-maker is already showing a complete and functioning electric hybrid vehicle. Specifically, given that so much automotive technology is provided by suppliers to the 'manufacturers,' i.e., assemblers, even a simple batter maker can toss a hybrid car together.

This would seem to spell serious doom for the UAW and its employers in America. Not even having marketed production quantities of hybrids yet, these firms and the union depending on them will have to contend with a vehicle built by non-union Chinese workers. Something so simple, evidently, that it would presumably be tough for US auto makers to add sufficient value to make their cars more salable. Yet, the vehicle doesn't emanate from a vehicle manufacturer.

Does this not suggest that hybrids are going to be so easy to make that Detroit producers, with their high legacy costs and union employees, have basically zero chance of making the hoped-for bonanza on this type of vehicle?

So much for throwing tens of billions of taxpayer money into GM and Chrysler so they can make it all back, and then some, with so-called world beating hybrids and other non-gasoline cars and trucks. It's looking like they'll once more be late to market and competing with much more nimble, imaginative and dangerous competitors.

Yahoo Gets An Adult CEO: Carol Bartz

Finally, after years of mistakes, the board of Yahoo did something right. They've attracted veteran technology CEO Carol Bartz to replace hapless Jerry Wang as the CEO of Yahoo.

I have written two posts involving Bartz, here and here. The second linked post, from October of 2006, lauded Bartz as an unheralded, effective CEO. I wrote,

"In my opinion, however, Carol Bartz is the class of the class. She has created value consistently at Autodesk for 14 years, with the exception of some rough years in the late '90s. Even then, however, the company tended to tread water, and not lose substantial value for long time periods.

I think it does seem unfair that Bartz is not accorded the type of press that GE's Jack Welch received for his long-term performance. Blogger is not cooperating with the uploading of a price chart comparing GE and Autodesk over many years, but suffice to say, Bartz looks as good as Welch, when the two companies' performances are compared for the years in which they both were CEOs of their respective companies.

If Bartz is being ignored because of her gender, then that's even more bad news to add to Alan Murray's contentions. Not only do poorly performing female CEOs, like Jill Barad, get spotlighted, but the rare excellent performers, like Bartz, are conveniently forgotten."

The nearby price chart of Yahoo for today indicates that there was initial disappointment by Yahoo investors at the news, even allowing for the S&P500's down opening.

Additionally, the Wall Street Journal ran at least one piece critical or questioning of Bartz' ability to sort the Yahoo mess out.

I disagree. Emphatically.

I don't know what Carol Bartz will decide to do to create or extract maximum value from Yahoo for its shareholders. But I am confident that, whatever it is, it will be as good as, or better than others would have done.

To her credit, Bartz was quoted as saying she had,"a lot of ideas " regarding what to do at Yahoo, but "It would be very presumptuous for me to do so on my first day on the job and I am not going to do so."

How very adult and professional! Yahoo shareholders must be shocked at the new quality of management at the firm. If I were one, I'd feel very comfortable with the image of Bartz across a table from the hulking Steve Ballmer in any upcoming discussions regarding search businesses, joint ventures, et. al.

At the same time, the firm is finally rid of Susan Decker. It didn't seem that she ever made a significant difference at Yahoo. Of the two, there's no question Bartz is the better choice to salvage whatever value can be at Yahoo at this very, very late date.

Deleveraging vs. Recession: Recognizing The Effects

I have noted with increasing concern a confusion in the general business media regarding what are the sources of our current economic difficulties. They are not just a bad recession. In fact, the recession, on its own, is probably simply of average depth and duration.


However, mixed in with the recession is a heretofore unseen deleveraging of the global economy. I first called attention to this phenomenon in this post in late November of last year. In it, I wrote,


"Since leverage, a function of debt, implies confidence in the future returns of loans placed with various enterprises, its unwinding corresponds to a loss of such confidence. The forced reduction in this leverage began, understandably, with the short-term borrowing instruments of both financial and non-financial instruments- commercial paper, most notably.


As this massive de-leveraging of fixed income instruments occurred, the simultaneous drop in real estate values and equity market values caused several consequences.


First, large-scale losses in US, and other nation's market, i.e., societal capital stocks, valued notionally, plunged. Those who previously owned the capital suffered large losses.


The second major consequence of the calamitous drop in price of many stores of value- real property, equity, debt- coupled with the deleveraging, was the cessation of bank lending. Thus, a financial crisis, partially unleashed by a narrowly-defined 'mark to market' rule in a single US law, Sarbanes-Oxley, led to the real effects on non-financial sectors of the US economy. As banks struggled to deleverage their assets in order to both conserve remaining equity from further losses, and abide by regulatory capital requirements, lending suffered. This became a self-fulfilling act, as, starved of normal, short-term operating liquidity, more and more businesses began to reduce operations and cut staff.


The third unforeseen consequence, then, to complete the circle, was the rising joblessness as the economy was already softening, of its own accord, by early 2008.


This last link in the circle of economic causes and effects has now driven a dramatic drop in consumer spending, due to: rising unemployment, lower home values as a source of personal household net worths, and lower financial asset portfolios as a source of personal household net worths."

Probably not since the 1950s have we seen such a secular deleveraging of American capital. I vividly recall, while in graduate school, reading articles on the Treasury's attempts to tax gains of foreign bond holders in the 1960s, which led to the creation of the Eurobond market.

I discussed with my business partner recently the evolution of capital formation, beginning with our early ancestors storing extra wood or food in caves. Early barter systems represented market-clearing mechanisms for surplus food or other primitive goods, allowing specialization to develop. With specialization came production for others, rather than mere personal survival consumption. In time, one person's surplus became another's borrowed capital for further expansion of production.

Somehow, through the centuries, capital creation became increasingly dependent not upon hard assets or saved money, but some analyst's or banker's estimation of the forward earnings power of an entity issuing debt or offering equity subscriptions.

Culminating in events including the famed technology equity 'bubble' of the late 1990s and the recent real estate bubble of the late 2000s, the financial community's allowance of increased leverage, via lending on ever-smaller equity bases, resulted in economic expansion which has to have been secularly due to that higher leverage.

This is important right now, because many people, businessmen and politicians alike, are running around declaring the coming of a second Great Depression any moment.

The President-elect has been engaging in economic scare tactics and fear mongering since this past summer's election campaign. Thus his reason for requesting- no, demanding- a $1T stimulus package.

But, in reality, the economic difficulties we currently face are a combination of two very different phenomenon.

On one hand, there is, based upon the NBER's December statement based upon job losses, a US recession which began in late 2007.

However, within this recession is a secular trend of economic shrinkage that will not be reversed by anything but a return to higher leverage. Thus, no amount of unleveraged economic 'help' will reverse these losses and the accompanying fall in GDP growth.

Seen from this perspective, the only way in which a new, massive Federal stimulus package can provide 'recovery' is to substitute government-issued obligations to return US societal economic leverage back to the dangerous, unsustainable levels at which it was before the current crisis.

How is it that leverage undertaken by the private sector, and judged imprudent, can now be replaced with government-sourced leverage, in the form of either: 1) more printed money, or 2) increased sale of government debt, without creating even more risk by spending the money in less accountable, measurable ways through political channels?

The simple fact is that, for the US economy to lower its capital leverage, and adjust to that lower leverage level, some jobs and business activity will have to simply vanish and not return. Whatever economic level we enjoyed, from which our current recession guideposts are measured, it logically follows that we cannot return there anytime soon unless we collectively decide, as a society, to try to raise financial leverage back to what it was.

If we decide this is unwise, then we have to accept that unemployment will be higher, and business activity levels lower, as the marginal, leveraged activities have been eliminated with the fall in financial leverage.

There is no other way around this fact.

Thus, the component of the current US economic weakness which represents simple, normal cyclicality is smaller than the overall, measured recession which includes the results of this deleveraging process. Any Federal programs which seek to, in a carefully identified and measured way, "fix" the economy beyond this normal cyclical impact, will be a disguised attempt to reflate our economy with added leverage through public debt and spending, rather than private resources and channels.

Citigroup Finally Considers Largescale Change

Today's business news is all a-twitter over the Citigroup-Morgan Stanley brokerage joint venture.

Forgive me if I yawn.

What, exactly, is all the excitement about? Two has-been financial giants with huge long term viability issues toss both their mundane, yesteryear personal retail, full-service brokerage businesses into a common pot?

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.

Yes, there's also talk of selling Citigroup's Banamex unit. But with Citigroup effectively owned by the Federal government, dismantling it any further is probably academic.

With both Morgan Stanley and Citigroup having significant Federal government ownership stakes, I have trouble understanding how the brokerage joint venture is much different than two related businesses reorganizing units serving similar markets. This is one of the effects of Treasury's actions.

If anything, it probably argues that such combinations and consolidations should continue, until wholesale banking, retail banking, etc., are centrally managed, but dispensed to Americans via different old, familiar brands, e.g., Morgan Stanley, Goldman Sachs, BofA, Wells Fargo, Citigroup and Chase.

The names might differ, but the credit allocation policies, interest rates and such will be unvaried.

It's simply hard for me to take seriously the notion that two government-dependent commercial banks, each unable to prosper, let alone survive on its own, can effect much exciting, useful change for their shareholders anymore.

Let's be honest, even if the Wall Street Journal and CNBC won't. This is a government-owned sector now. It's no longer truly private enterprise.

Citigroup's actions are, at least, explained as being coerced by government officials who are now more owners than regulators.

How do you report that and still believe there's any private enterprise angle to these stories anymore?

Bob Rubin Finally Leaves CitiGroup- In Ruins

Finally, after assisting in wrecking the firm to which he was recruited as non-executive Chairman not quite ten years ago, with unusual powers, Bob Rubin has resigned.

The nearby chart shows the effects of Rubin's last major act at Citigroup, the hiring of CEO Vikram Pandit. Compared to the S&P500 Index, which suffered its worst year ever, the large money-center bank performed even worse under its novice CEO.

In the Wall Street Journal article this weekend discussing Rubin's gift to his erstwhile shareholders, he is reported as having excused the damage he caused at Citigroup by citing the fact that Alan Greenspan, among others, had failed to forsee the totality of the financial sector crisis which crippled the bank this past year.

Where was the Citigroup board all these years? Didn't they ever consider the losses to shareholders brought on by following Rubin's 'counsel?'

Allegedly, Rubin's letter of resignation expressed his desire to "intensify my engagement with public policy."

Seeing as how Rubin presided over a loss of some 70% in Citigroup's share price over the time he served as chairman, one wonders just what benefits Rubin imagines he now can add to public policy debates.

Instead, one wishes he would have written,

'Because my leadership at Citigroup was so disastrous, my counsel on risk-taking and entering the mortgage finance business so wrong, I have decided to retire permanently from any work, private or public, involving finance. I have clearly caused far more damage than could ever be corrected by my further involvement in this sector, and it is debatable that my future decisions or advice would be any better than that of the last decade.'

But we all know Rubin wrote, nor will express, anything of the kind. Sadly, he may, in fact, go on to badly advise the incoming administration in Washington.