Deere's Surprising Quarterly Results & Forecast

Deere & Co.'s pre-opening earnings announcement sent S&P futures up by about 3 points. The online Wall Street Journal article concerning Deere's results contained these passages,

"Chairman and Chief Executive Samuel Allen said economic conditions "remain stubbornly weak." However, "We are clearly seeing benefit from efforts to win customers with advanced new products while taking cost and asset discipline to an even higher level."

Deere, often viewed as a bellwether of U.S. agriculture, had seen earnings socked as farm-equipment sales dropped by double digits in the U.S. and Canada segment and elsewhere. But the declines mitigated in the latest period, falling 8% in the U.S. and Canada and 6% in the rest of the world. International results were boosted by 12 percentage points from currency changes.

For the quarter ended Jan. 31, the world's biggest farm-equipment producer by sales reported a profit of $243 million, or 57 cents a share, up from $204 million, or 48 cents, a year earlier.

Revenue dropped 6% to $4.84 billion, with net sales down 7.1% to $4.24 billion. Sales were boosted by five percentage points from currency fluctuations.

Analysts polled by Thomson Reuters had most recently forecast earnings of 19 cents on $4.18 billion of net sales."

Essentially, Deere's stunning earnings results were the result of cost-cutting and, to some extent, overseas demand. Not US sales growth.

For some perspective, here's a price chart for the past five years for Deere, Caterpillar and the S&P500 Index.

Both companies, based not far from each other in central Illinois, track the index fairly closely, having crested somewhat higher during the beginning of the recent financial sector troubles in late 2007-08.

Is Deere the bellwether for US economic recovery that so many investors apparently hoped, as today's equity markets opened, retaining the pre-open gain?

Well, Cat, a more diversified earth-moving equipment manufacturer than Deere, despite talk of its order book, remains flat. Deere, primarily an agricultural equipment producer, is benefiting from the constant need of people to eat, and global population growth.

If its recent results are based on overseas demand and internal cost management, that doesn't really seem to bode well for US recovery, does it?

And, in fairness, today's S&P gains are relatively small. Yesterday, the index rose nearly 20 points on, well, who knows exactly what?

In contrast, Deere's unexpected earnings surprise isn't really igniting the broader market.

More Curious Omissions From Elizabeth Warren's Rants

Last week I wrote this piece concerning Congressional TARP Oversight Panel chair Elizabeth Warren's flawed editorial in the Wall Street Journal. In a related appearance on CNBC the next day, Warren continued her rant along similar lines.



Back in November of 2007, I wrote this piece discussing what was really occurring as investment committees of various endowments, pension funds, et.al. bought debt obligations of a then-hot topic, bank-originated SIVs, or Special Interest Vehicles.



In my fictitious example, I suggest that investment committee members of various entities, with their fiduciary obligations, do a poor job investigating and/or understanding some of the prospective investments they ultimately purchase for the funds of which they are trustees.



Warren goes on rants about allegedly-predatory bankers, but seems to conveniently overlook the members of the investment committees for union pension funds, corporate pension funds, non-profit endowments, municipal funds, and other entities.



How about those buyers of CDOs and other ultimately over-engineered paper? Did anyone put guns to their heads? Hold their children hostage against buying the instruments?



No, not so far as I've been able to discover.



The dirty little secret of the investing world is that these so-called "sophisticated" investors, a technical term of legal consequence in the investing world, are frequently ill-prepared, unqualified people put on investment committees as a sort of plum assignment or favor.



They engage in practices which are supposed to be beneath sophisticated investors. Practices such as: using only S&P, Moodys or Fitch ratings to guide their investment choices, rather than do their own due diligence; succumb to overtures from investment bank sales people without doing objective analysis and asking tough questions; failing to consider, and ask about, the motivations of the selling institutions of various exotic, financially-engineered instruments; believing outsized yields on complex financial instruments can occur without accompanying outsized risks.



Years ago, a colleague introduced me to a middleman for several union pension funds. The person in question was a retired, rather beefy ex-working guy himself. Now wearing a white shirt, tie and suit, he never the less behaved pretty much as he probably did back in the day when he worked beside his fellow union members on a line or dock, etc.



When I met him, however, he was essentially peddling his connections to now-aged union chiefs whose investment committees he could deliver to deserving fund managers. He wasn't too shy about claiming that, either.



At no time did he ever suggest that the investment committee members of the union funds to which he could provide access and to which he would provide endorsement of selected fund managers would ask tough questions, were well-trained in analyzing various fund strategies or instruments, or that there would even be any serious analysis of a manager's approach.



It was pretty much a case of passing muster with the middleman, in order to gain access to relatively easily-provided union pension funds to manage.



I don't recall the person's name, nor the sectors in which he had union connections. But at the time, it was quite clear to me that this was SOP for marketing to some pension funds. Investment committee members were just not very responsible.



I'm sure this was not a rare exception. In fact, in CNBC's 2009 production, House of Cards, David Faber interviews the mayor of, I believe, Narvik, Norway. Unbelievably, the woman seemed aghast that the investment bank vendors of complex financial instruments had apparently hoodwinked her concerning the risks of the CDOs they offered to her municipality. She seemed incredibly naive, never engaging in independent information gathering or analysis of the instruments.



Why doesn't Elizabeth Warren go on a rant- and crusade- to find, identify and punish inept members of investment committees? Why isn't she advocating using existing laws to charge and punish such persons for failing in their fiduciary duty as trustees of the funds on the investment committees of which they sit?



For every flawed, risky asset sold by an investment or commercial bank during the period of financial excess, there was a willing institutional buyer.



Why do we only hear about the sellers, and never the culpable, guilty buyers, as well?

Comedy on CNBC This Morning

Nouriel Roubini was a guest/host on today's CNBC morning program. Among the topics were, of course, in what phase of recession/expansion the US economy currently is.

Roubini is pretty clear about his belief that unemployment will persist for a year or so, with a weakening economic picture next year.

The comedic moment came when Roubini reiterated his view that there isn't any real private sector growth, and most companies have figured out how to do more with fewer employees. In particular, he emphatically declared,

"Those jobs aren't coming back."

CNBC's senior economic idiot, Steve Liesman, then retorted that Roubini ignored the recent data showing a minor downtick in continuing jobless claims.

As Roubini attempted to explain his contention that a few thousand people, more or less, employed, was a mere drop in the bucket compared to the tens of millions of jobs needed to restore employment to pre-recession levels, Liesman began to shout over the Columbia economics professor.

As well as being funny, it was sort of a pathetic moment. Here's a so-called journalist and wannabe-economist, Liesman, who's dumber than paint, yet fancies himself the equal of genuinely-trained, degreed economists, yelling at a well-respected economist's legitimate and substantiated positions.

Roubini sort of scowled at the treatment from CNBC's resident economic buffoon, and finally waited until Liesman finally shut up.

How many more episodes like this will it take before CNBC finally fires Liesman and hires an actual economist for the network's economics coverage?

More On Scott Patterson's "The Quants"

I last wrote about Wall Street Journal reporter Scott Patterson's new book, The Quants, here on Monday of this week. At the time, I'd read less than a third of the book.

Yesterday morning I finished it. I'd still recommend it as a very useful read. However, as I made my way through more and more of the book, it began to feel not only like a cross between Tom Wolfe and Michael Lewis, but Ayn Rand began to appear, as well.

By that I mean the following. When I read Atlas Shrugged, it took very little time to realize that Rand was a poor writer when it came to doing much more than espousing her philosophies. Character development and, in particular, romantic scenes in her book were so poorly written that I learned to just optically scan over those passages and return to full reading comprehension when they had ended.

Another major annoyance, and what I would call a glaring defect, is Patterson's apparent need to label certain phenomena with cute names. Perhaps it stems from post-The Right Stuff style requirements. When Tom Wolfe coined that term, it was a relatively new idea. And, anyway, Wolfe made somewhat of a career, as a leading writer of the new school of the late '60s, labeling phenomena.

Patterson calls the interconnected financial markets of the modern era The Money Grid, while the much-sought after inefficiencies in financial markets, when found and implemented to create wealth for the quants, becomes The Truth.

By the book's end, I'd become sickened by the word "truth," he'd employed it in so many predictable, silly passages.

I like Patterson's WSJ columns, and even his book. But he's no Tom Wolfe. Not yet, anyway.

Patterson does, however, a truly wonderful job cataloging the roots of modern quantitative trading in financial markets. That's why the first third of the book is so captivating.

When he turns his focus to the books four main contemporary characters- Peter Muller (Morgan Stanley's PDT) , Boaz Weinstein (Deutsche Bank) , Cliff Asness (AQR) and Ken Griffin (Citadel)- he becomes infatuated with their personal lives, idiosyncrasies and immense wealth.

As a result, the last third of the book can be read quite quickly, because so much of it cites all manner of numbers of total fund assets, losses, equity, and personal fortunes of the protagonists. Plus their various romantic couplings, births of children, latest expensive mansion purchase, etc.

To put Patterson's book in perspective, let me express it thus. He provides deep and numerous empirical confirmations that several things which I have long contended, and expressed in prior posts on various related topics, are, according to Patterson, true of this class of quantitative traders:

1. They all exhibit a shallower comprehension for the human behavioral aspects of financial markets than their mentors.

2. With each succeeding generation of acolytes, the belief that pure mathematical and statistical methods can apply, sans contextual understanding, to financial markets grows stronger, and the awareness of key underlying, limiting assumptions grows weaker.

3. Crucial dimensions of risk management for both the hedge funds, and the instruments they often trade, e.g., leverage, collateral, and ability to meet an instrument's, such as a credit derivative swap's obligations, are profoundly separated from the actual trading activities.

4. As such, both senior managers of the firms engaging in these activities, as well as counterparties, bear significant responsibility for having little understanding of the pragmatic aspects of risks which were undertaken by these quantitative traders.

5. Perhaps most ironically, all of the current generation of quantitative traders believed in exceptions to Eugene Fama's general EMH model, yet, in a fallacy of composition, when, together, they exploit commonly-observed inefficiencies, they become the very agents of EMH, obliterating the profitable inefficiencies they so recently observed and on which they traded.

At the book's end, Patterson brings back several historical figures from the earlier part, including Ed Thorp, Nassim Taleb and Benoit Mandelbrot. He has them voicing knowing sentiments concerning the eventual meltdown of the quants' funds from over-leveraged, commonly-held positions which were all simultaneously undone by the behavior of other investors which had not been modeled by the quants' research.

However, my fourth point is distressingly not explicitly driven home by Patterson. He succeeds marvelously in providing all the supporting evidence. He has the salient characters, including Fama and his ilk, in the book. The stage is magnificently set for Patterson to coyly spring the ultimate irony.

But he never delivers on it.

You have to figure that one out for yourself. Which is a pity.

Because if there is any one, over-arching, ultimate Truth (my bad- I can't resist mocking his label) to the book, it is the totality of the book's contemporary content in proving that, even when quantitative mavens find and exploit market inefficiencies, to the contradiction of the Chicago School's contention, they are, in reality, simply becoming players in that school's EMH world, pushing values back in line and eliminating the profitable inefficiencies.

That so few of these quants expected this is somewhat shocking. That they persisted, and persist, still, in believing they can escape this self-fulfilling prophecy is perhaps more shocking.

After a bit more reflection, I'm going to write a post discussing, from the viewpoint of Patterson's book, the folly of the TARP, government intervention, and implicit saving of the quant funds by the federal government.

Holman Jenkins On Apple

Holman Jenkins, Jr., wrote a very interesting column in yesterday's Wall Street Journal concerning Apple's recent product extensions, entitled "The Microsofting of Apple?"



In a nutshell, Jenkins contends that Apple is beginning to behave like Microsoft

"Rumors abound that Apple is considering a deal with Microsoft's search engine Bing to displace Google on the iPhone. Rumors abound that Apple will get into the advertising business, that it will expand its cloud services to compete with Google's. Who is this beginning to sound like?"

As the nearby price chart for Apple and Microsoft illustrates, the latter's price plateaued shortly after it won the 'browser war' with Netscape.

It can be argued, as Jenkins does, that Microsoft's spread into internet browser, its online business unit, and even gaming, gradually eroded and unfocused the company's software strengths.

The details of Jenkins' piece involve Apple's refusal to support Flash software on its iPhone and iPad, making them suspiciously built to only download material from the iTunes store.

In an era of interoperability, Jenkins notes, Apple seems content to and intent on restricting its products' owners to content available only from Apple. He also relates stories of Steve Jobs lately becoming obsessed with Google and its infringement on Apple turf, e.g., the Android cell phone operating system.

I think Jenkins makes good points. Generally speaking, when companies expand beyond their original areas of competitive advantage, their profit margins fall. Growth is purchased at the expense of margin, and, in time, the key unique elements which originally defined the firm become blurred.

In a word, well, two, really, Schumpeterian dynamics at work.

Sad to say, the areas into which Apple is rumored to be looking to grow, and, with the iPad, is growing, aren't quite so unique as its recent sources of growth. That alone should give one pause concerning Apple's future prospects.

Elizabeth Warren's Flawed WSJ Editorial

Yesterday's Wall Street Journal contained a very flawed and misleading editorial by Elizabeth Warren, the Harvard law professor selected by the Senate's Democratic leadership to head the TARP Oversight Panel. Here's how she begins her piece,

"Banking is based on trust. The banks get our paychecks and hold our savings; they know where we spend our money and they keep it private. If we don't trust them, the whole system breaks down. Yet for years, Wall Street CEOs have thrown away customer trust like so much worthless trash.

Banks and brokers have sold deceptive mortgages for more than a decade. Financial wizards made billions by packaging and repackaging those loans into securities. And federal regulators played the role of lookout at a bank robbery, holding back anyone who tried to stop the massive looting from middle-class families. When they weren't selling deceptive mortgages, Wall Street invented new credit card tricks and clever overdraft fees.

In October 2008, when all the risks accumulated and the economy went into a tailspin, Wall Street CEOs squandered what little trust was left when they accepted taxpayer bailouts. As the economy stabilized and it seemed like we would change the rules that got us into this crisis—including the rules that let big banks trick their customers for so many years—it looked like things might come out all right.

Now, a year later, President Obama's proposals for reform are bottled up in the Senate. The same Wall Street CEOs who brought the economy to its knees have spent more than a year and hundreds of millions of dollars furiously lobbying Washington to kill the president's proposal for a Consumer Financial Protection Agency (CFPA). "

It's obvious that Warren confuses commercial banking with investment banking and securities brokerages. Thus, she paints the entire financial sector with a brush that is largely meant for a few investment banks and the securities units of perhaps one commercial bank, Citigroup.

Warren then goes on, in her second paragraph, to conveniently omit the actions of various government actors, including Barney Frank, Chris Dodd, Kent Conrad, and former HUD Secretary Andrew Cuomo, all of whom mandated GSEs Fannie Mae and Freddie Mac to buy and securitize questionable, risky mortgages.

Private sector, publicly-held investment and commercial banks were only following the lead of Washington. But Warren doesn't choose to acknowledge this fact.

Warren then characterizes all banks which received TARP funds as needing a bailout, which is very far from the truth. Anyone alive two years ago and watching the scene unfold knows that, in order to be able to unwisely inject federal funds into a few ailing financial institutions, specifically Morgan Stanley and Citigroup, then-Treasury Secretary Paulson forced a larger number of financial institutions to accept federal money. The reason given was to not stigmatize, in the eyes of the investing public, those institutions clearly about to fail without the infusion.

What you, as a reader of this blog, ought to understand from Warren's statements in her editorial is that the appointed leader of the Congressional witch hunt that is the TARP Oversight Panel can't even get the facts straight regarding the history of events which led to the creation of the TARP.

Later in Warren's editorial, she writes,

"So far, Wall Street CEOs seem determined to stop any kind of watchdog. They seem to think that they can run their businesses forever without our trust. This is a bad calculation.

It's a bad calculation because shareholders suffer enormously from the long-term cost of the boom-and- bust cycles that accompany a poorly regulated market. J.P. Morgan CEO Jamie Dimon recently explained this brave new world, saying that crises should be expected "every five to seven years."

He is wrong. New laws that came out of the Great Depression ended 150 years of boom-and-bust cycles and gave us 50 years with virtually no financial meltdowns. The stability ended as we dismantled those laws and failed to replace them with new laws that reflected modern business practices. "

As Ronald Reagan might say, were he alive,

"There she goes again!"

First, Warren continues to use the phrase "Wall Street," to refer to large financial institutions. But that term was originally meant to apply to investment banks and brokerages. None of which now exist as large institutions. Only boutique investment banks remain.

The remaining former investment banks- Goldman Sachs and Morgan Stanley- rushed to take bank charters. Merrill was sold to BofA, while Lehman and Bear Stearns collapsed.

Leaving that topic of Warren's misinformation, it's probably unfair of her to contend that the CEOs of the nation's remaining large financial institutions, all of which are now commercial banks, don't want any regulation or the trust of their customers.

As stupid as some of these CEOs are, they're not that stupid.

Warren is correct to note that Jamie Dimon's statement should be wrong. It's not really correct to say it "is" wrong, but it should be a wrong statement.

That said, Dimon is hardly the person you'd look to for a sense of history in financial markets. He spent his formative years carrying Sandy Weill's bags. It's notable, then, to observe that Dimon's mentor created what has probably been the single worst-run integrated financial services company, Citigroup. What, exactly, did Dimon learn from that which is so valuable?

However, Warren is wrong. And in a way that Dimon wasn't in his statement.

To write that we have had "50 years with virtually no financial meltdowns" is "virtually" meaningless.

Either there were meltdowns, Elizabeth, or there weren't. Which is it?

By the way, it is "were."

Since Warren is referring to "Wall Street" in her piece, let's start with the go-go Nifty Fifty Era in the late 1960s. And it's contemporary scandal, the mutual fund collapse of Bernie Cornfeld.

Then we had the S&L crisis of the late 1980s, during which era the first CMOs were spawned.

Let's not forget the internet stock bubble of the late 1990s. Which followed the near-meltdown arising from LTCM's collapse.

Read enough?

Evidently Elizabeth Warren doesn't know any history of the sector of which she now writes with so much apparent authority.

Warren continues to the end of her article savaging "Wall Street CEOs" as being against new regulation. Which regulation, of course, is all pure good and truth. She paints the aforementioned CEOs as evil, greedy and only desirous of slipping the regulatory noose and caring not a wit for the trust of their customers.

As I've written in prior posts, these constant appeals for just one more perfect regulatory scheme to prevent the next financial crisis reflect serious misunderstandings, or total lack of understanding, of the behavior of those involved in trading and underwriting businesses.

Old-fashioned, conventional commercial lending businesses, be they consumer or business, are fairly predictable and cyclic in their mistakes. We have sufficient regulations in place to oversee those activities. What we haven't had is effective implementation of existing regulations.

As to the underwriting and trading businesses, it's a different ballgame. Volcker is correct in calling for a complete separation of these activities from federally-insured deposit-taking institutions.

What Warren, and others, fail to understand is that there is only one motive for people in those businesses: profit. It's up to their counterparties and customers, and, in fact, anyone who deals with them, to beware. No amount of regulation will ever make them "safe" with which to do business.

Best they be sequestered in their own shark tank.

Think of the worst, most risky and rapacious behavior possible in underwriting and trading securities, and you are near right in guessing the extremes to which the best professionals in these businesses will go to make money.

This will never change. Believing it can be made to be otherwise is perhaps Elizabeth Warren's editorial's most significant flaw.

Pfizer's Bad Example: CEO Jeff Kindler

It was with great interest that I read Kim Strassel's piece in Friday's Wall Street Journal concerning Pfizer's CEO, Jeff Kindler's bargain with the devil over health care legislation last year.

I've written in earlier posts concerning the auto company bailouts that both government and corporate executives have unwisely failed to observe a separation that ought to remain.

Specifically, corporations ought not seek government aid, and government ought not give it.

Yet, from reading Strassel's editorial, it appears that Kindler did exactly that by pandering to the administration's and Congress' coercive threats, to be embodied in last year's failed health care bill.

Strassel details how Kindler, upon arriving at Pfizer, suddenly oversaw the retirement of free-market oriented governmenat affairs personnel, and magically hired people with ties to various Democratic powers, current and out of office.

In a variant of requesting aid for his firm, Kindler caved in to Congress on opposing the socialization of medicine, in exchange for protection from threats like drug reimportation, guarantees of purchase of branded drugs by the government, and no price controls.

Then, as Strassel carefully notes, Congress reversed itself as the going got tough. Now, reimportation is back on the table, as are Medicare drug price controls and new limits on certain pharma patents.

This just goes to show how dangerous it is for the private sector to succumb to Congressional coercion and, worse, try to jump into bed with that branch in order to trade favors.

It's always far better for industry to aggressively defend and express its own views contrary to government's. The risk to business is that, having given in on some key aspects of a business model, the impression is that the firm was either lying in the past about its business processes, or didn't really need some practice it vociferously defended.

Now, thanks largely to Kindler, Big Pharma is left looking like they agreed with Congress on many issues which are, in fact, key to their current business models.

Perhaps Pfizer's board should have been more careful in choosing its new CEO and so radically changing its pro-free market orientation.

Scott Patterson's "The Quants"

I recently purchased Scott Patterson's new book, "The Quants," about the excerpt of which I wrote here.

So far, about 1/5th of the way through Patterson's work, I would give it a huge, unequivocal "buy and hold" rating.

The excerpt was a very representative sample of his writing. But the book is much, much better than the excerpt could possibly convey.

Patterson writes in a style reminiscent of Michael Lewis crossed with Tom Wolfe. He digs deeply into the roots of quantitative trading, providing very interesting stories of Ed Thorp and his own mathematical predecessors.

Having worked at AT&T, and knowing of Claude Shannon's impact on information theory and computing, I was delighted to read of his chance involvement with Thorpe's own early work.

In any case, my early verdict is that the book is well worth buying/reading.

Cuomo, Lewis, Paulson & Bernanke...and the Martin Act

New York gubernatorial candidate and, oh, yes, current AG Andrew Cuomo has finally brought suit against former BofA CEO Ken Lewis, and his CFO, under the Martin Act, for Lewis' alleged wrongs in the BofA-Merrill Lynch affair. My initial thoughts about this go back to last March, when I wrote this post, as Cuomo began bellowing his threats to file this case.

I had a very spirited debate about this case with my business partner yesterday morning.

My partner's opinion is that what is done, is done. Let's not waste time and money picking through the wreckage of a done deal that has, by the way, actually turned out profitably for BofA. Government if full of thugs who wield too much power, usually coercively, and this case won't change that.

In fact, he noted, even Ken Lewis doesn't want his day of reckoning in court.

I have a different perspective. I welcome the opportunity for a trial in which Lewis, probably John Thain, Ben Bernanke and Hank Paulson can all be made to tell the truth, under oath, about their actions in this mess.

The motives of everyone are quite transparent:

Andrew Cuomo- currently thuggish AG of NY, badly wanting to follow Eliot Spitzer to the governorship on the back of this sensational case.

Ken Lewis- hapless, gutless former CEO of BofA who folded like a house of cards under pressure from Bernanke and Paulson, probably violating a slew of SEC regulations involving his fiduciary duty to his shareholders.

Hank Paulson & Ben Bernanke- probably engaged in illegal, improper and coercive behavior to force Lewis, against his wishes, to complete the Merrill Lynch purchase and deceive his shareholders regarding the total cost of the deal and Merrill's losses.

John Thain- recently-hired CEO of failed CIT, wants desperately to publicly clear his name in the Merrill Lynch affair.

Ideally, this trial will illuminate just who did what. From the various media accounts, someone is lying.

Bernanke and Paulson deny strong-arming Lewis. Lewis claims he didn't want to consummate the deal, but was forced to do so by Bernanke and Paulson. Thain claims he told Lewis about the losses and bonuses at Merrill. They can't all be telling the truth.

Ironically, as today's lead Journal staff editorial notes, Cuomo is personally responsible for having touched off the financial meltdown by setting higher percentages of low-income mortgages to securitize at Fannie and Freddie, while lowering downpayments.

In the recent Journal editorial, however, they made a rare mistake, claiming that because Merrill made some money for BofA last year, the deal was thus a good one. Really?

Doesn't it matter what the final purchase price was, and how much money was made? It's not clear yet whether Lewis' final string of acquisitions, including Countrywide and Merrill, will actually prove to be accretive. Maybe, with the fungibility of federal loans, we'll never know.

What better day of reckoning for the lot of them than a public courtroom and sworn testimony?

If everything goes well, there should be some perjury charges coming against someone or ones.

As I said to my business partner, I believe it's important for the public to see, if true, how federal officials Paulson and Bernanke improperly used their positions to coerce private company executives. If they abused their power, it should be made public, and they should be charged and convicted of said offenses.

We'll never curb abuses of power by high-level federal officials without making examples of those who misbehave. No matter if the events are now in the past.

Were someone with omniscience to inform us all, here's what I believe we'd learn:

-Ken Lewis abdicated his fiduciary duties to his shareholders, in order to keep his job.
-Bernanke and Paulson illegally coerced Lewis to behave improperly, keeping his shareholders ignorant of important new risks in the Merrill Lynch transaction
-John Thain informed Lewis and his BofA team of the losses Merrill was incurring, and the bonuses planned to be paid to Merrill personnel.

I may be wrong. But those are my contentions.

If I'm right, Lewis, Bernanke, Paulson and maybe Lewis' CFO should all, ideally, be wearing orange suits and raking sand traps at Allenwood.

On Risk & Capital Allocation In Commercial Banking

Most people have little notion of how capital is treated inside a commercial bank. While regulators and those concerned with systemic risk want banks to hold as much capital as possible, those inside the bank want to operate on as little capital, especially equity, as possible.

Like every other business, banks are sensitive to the costs of capital, and, following basic economics, which is about rationing scarce resources, their managements want to use the absolute minimum to do their business.

Back in the late 1980s, RAROC (Risk Adjusted Return On Capital) was developed at Bankers Trust's. It is, or was, the original risk management tool for bank capital allocation. From it, and its design team, flowed many of the modern variants of VAR-style risk metric systems in financial services firms.


While working on resource allocation and productivity at Chase Manhattan, it was necessary to address risk capital. Thus, I retained the developer of Bankers Trust's famous RAROC model, Philippe Geneste, as a consultant to assist us in introducing the concepts into resource allocation at Chase, as well as to better understand its likely ramifications on business unit operating decisions and overall bank profitability.


There were, and are, fundamentally two methods to internally adjust for risk. One is to raise required rates of return for businesses, on notionally-allocated capital. The other is to use some variance-based approach to allocate more capital to riskier businesses, where risk is defined by greater variances in returns, or losses, of the business.


When dealing with risk, internal capital and allocation, one rapidly runs into a conundrum. It was on display yesterday morning on CNBC, where a guest, no less than Bill Gross of PIMCO, was opining on the need to make banks carry as much capital as possible to mitigate risk.


Here's the problem.


Internally, business units decline to accept capital allocations. They will claim to not need as much as is allocated. But, from a corporate viewpoint, the regulatory-mandated capital has to be allocated. Otherwise, one is in the position of having unallocated, in effect fallow capital. Capital that has been raised and is being paid for, whether through interest or implied total return to shareholders.


In the normal course of business, probably 95% of the time, that added regulatory capital buffer is unnecessary. It constitutes a drag on bank earnings and returns to shareholders.


Of course, in rare circumstances, like those of late 2008, losses in various units of a bank can skyrocket. But, when those so-called black swans appear, even the excess regulatorily-mandated capital levels are unlikely to be sufficient to absorb the losses.

If you look closely at a commercial bank, such as Chase, you'll see that even today, it's common equity/total assets ratio is only about 8%. An incredibly thin wedge of pure equity is in that ratio, as preferred equity outweighs common by about 10:1.

It doesn't take a genius to see how fast a commercial bank can lose substantial equity and become insolvent from a particularly big valuation hit in one or two businesses.

Yet, if regulators force a commercial bank to carry more equity, they inevitably depress profitability and returns. Bank CEOs want to believe their institutions can offer total returns which are competitive with industrial firms. But, if regulators have their way, this can't and won't be true.

Like it or not, fractional reserve banking systems and commercial banks' participation in modern capital markets as publicly-owned entities virtually guarantees that big risk mistakes on their part will quickly lead to insolvency. The banks won't carry more capital than they are forced to, yet, given the risks they take, they are occasionally going to burn through that thin wedge of equity.

Debating about a few percentage points of capital won't really change that.

The False Hope of a New Financial Resolution Authority

As I listened to Paul Volcker's testimony before a Senate committee earlier this week, I found myself rather incredulous that he believed some special, additional 'resolution authority' would be able to prevent sudden failures of financial service companies.

I saw this again yesterday morning, as Senator Bob Corker, R-Tenn, reiterated Volcker's belief that, no matter what else the Senate does, they'll create some new entity to put 'banks which are near failing' into some sort of regulatory limbo, to avoid systemic repercussions.

As I discussed this topic yesterday with a colleague, I asked whether he saw things as I did.

To wit, consider Bear Stearns. When Bear went out of business, its financial condition deteriorated in a matter of only days. And the worse the rumors became, the more counterparties began pulling their business. Add to this the fact that modern investment banks are primarily funded with short-term borrowed money from broker dealer desks at commercial banks, and you have situations in which a company can become insolvent literally overnight.

Forget, for a moment, for argument's sake, the fact that Morgan Stanley and Goldman Sachs are now, technically, commercial banks with access to the Fed window.

In markets as far back as 1998, when Long Term Capital Management failed, here is how non-commercial banks become insolvent.

A broker or investment bank takes positions in securities. The positions may be on a trading desk, or they may be, as was the case with First Boston some 20 years ago, underwritten debt from a funding transaction on behalf of a client, e.g., Ohio Mattress.

Suddenly, the securities begin to lose value. A lot of value. Marked-to-market values plummet, destroying the firm's equity deployed to the desk at breakneck speed. Since the firm is highly-leveraged, its counterparties react by either requiring more collateral on losing positions funded with their money, or, if a general lender, perhaps cutting credit lines.

As word begins to circulate, within hours, of the firms' losses and emerging credit pressures, counterparties shun the firm, and clients remove money from accounts with them, so as to not risk its being tied up in a bankruptcy.

Perhaps only a day later, as assets drain from the firm's balance sheet, and trading volumes shrink, the firm's positions, after the 4PM market close, show that it cannot settle all of its trades, because it has lost credit lines, has too little cash to honor its commitments, and cannot quickly borrow enough to fund them.

For any 'resolution authority' to be credible and effective, it would have to have a representative on site, at the firm, observing the insolvency as of the 4PM markets close.

Seeing the inability of the firm to settle its trades and, with resulting trading and other asset values, post a positive equity value by the market open on the following morning, the authority would have to call a halt to all financial flows from the firm, and declare it failed.

That's effectively what happened to Bear, and Lehman. When the end comes, it can be a matter of hours. But notice that only 24 hours earlier, the firm wasn't insolvent. So shutting it would have probably been an illegal government taking of private property.

If what is being suggested is having regulators on site at each major, and perhaps even minor/boutique financial service firm, that can already be done with Fed, FDIC and OTC regulators. It's not a matter of requiring a new resolution authority, but, rather, acknowledging the context in which such closures would have to occur.

Regulators would have to be viewing the firm's books, current financial and trading positions in near-real time.

As I listened to Volcker and Corker, I heard, instead, a sort of semi-languid tone suggesting that someone from Washington would board a plane to visit the troubled firm and see what was going on.

In the real world, there's just not that much time. The unremarked upon reactions of trading counterparties to ailing and failing institutions is what seems to be unacknowledged by legislators and regulators.

There's a fine line between government seizure, without basis, of an about-to-fail institution, and the closure of an insolvent one. But if the government sends clear signals that no financial institutions that fails will, beyond deposit insurance, be assisted in any way, you can rest assured that counterparties will look after their own risks.

The Constitution specifies bankruptcy for failed firms. For some reason, regulators no longer wish to use that option.

As my colleague and I discussed this topic, we wondered why so many people believe that Lehman's failure could have destroyed the US and, possibly, global financial system.

What if, instead of everyone's worst fears, Lehman's regulator simply stepped in and declared it bankrupt, froze its assets, appointed a trustee, and, like Drexel Burnham Lambert years ago, went about the long and complex task of sorting it all out under court protection?

Or Bear Stearns? Rather than let Chase steal the firm, first for about $2/share, then, grudgingly, about $11/share, how about simply letting a bankruptcy trustee and court freeze the firm's assets and begin to settle its liabilities? If there were value remaining at the end, it could be auctioned to the highest bidder.

Not some large bank which extracted a government loss-protection guarantee as it paid a lowest-possible bid to 'rescue' the firm.

It all boils down to expectations. If market participants believe that a failing financial services firm will be allowed to do so, and enter bankruptcy proceedings, then they will take appropriate steps to limit their exposure.

If, however, government officials run around wringing their hands and declaring each possible failure to put the nation's financial system at risk, then market participants will behave differently.

The most effective, disciplined, and efficient method of removing systemic risk from individual financial service firm failures, regardless of their size and nature, is for government to warn market participants that conventional bankruptcy will be the only option, and action, for failed companies.

No government intervention prior to that event. No quick sweetheart sales to large competitors. No stripping off and selling of choice business units. No emergency loans from the Fed.

Nothing.

Do that, and watch how the system's players move to protect themselves from any systemic catastrophes in the future.

James Lockhart's Disingenuous Claims

James Lockhart, former regulator of Fannie Mae and Freddie Mac, appeared on CNBC yesterday to respond to questions raised by passages from former Bush Treasury Secretary Hank Paulsen's newly-released book.

Lockhart's comments provided an ideal example of how federal regulators, Congressmen and administration officials, both former and current, twist and misrepresent history in their quest to appear blameless, heroic and successful.

In Lockhart's case, he contrasted his office's takeover of Fannie and Freddie, whose oversight he bungled in the first place, with Lehman's demise.

Crowing proudly, Lockhart claimed that there was no systemic shock from his handling of the two GSEs as his regulatory office placed them into "conservatorship," while Lehman's poorly-handled bankruptcy had a catastrophic impact on financial markets.

Of course, Lockhart conveniently glossed over the fact that his and Paulsen's actions meant that the Federal government guaranteed Fannie's and Freddie's obligations, thus removing any need for financial markets to panic.

But there was Lockhart, grinning and taking credit for what was actually caused by your and my role as taxpayers.

Lockhart also failed to mention the continuing losses stemming from the GSEs' operations, and the recent action by Geithner to uncap taxpayer exposure to their losses going forward.

That's success, Jim? I'd hate to see the cost of a failure in handling Fannie and Freddie.

Following Lockhart's dissembling on the matter of Fannie and Freddie, a CNBC anchor asked him if, in his new capacity as Vice-Chairman of one of Wilbur Ross' companies, his advocacy of principal forgiveness for mortgage loans wasn't convenient for his new employer, who happens to own substantial mortgage servicing companies that will benefit from being allowed to charge for implementing these revisions to the mortgages?

Lockhart again danced around the question, claiming to have been in favor of this tactic last year, and assuring the questioner that his and Ross' stances were beyond reproach.

Throughout the interview, Lockhart exhibited a nervous, anxious visage and manner which contradicted his words.

So much for truth about the past, or present, from our regulators. Especially when they are in that revolving door between their government posts and new, related private sector positions.

Volcker vs. Dodd Yesterday On Capitol Hill

If you happened to watch former Fed Chairman Paul Volcker's testimony on Capitol Hill yesterday, you were treated to some subtle comedy and tactful snubbing.

Volcker was testifying before retiring Senator Dodd's committee on his so-called "Volcker Rule."

After reading a lengthy, clear and comprehensive prepared statement, Volcker entertained questions.

The first one was from the witless Connecticut Senator, himself. Dodd began by presumptuously asking "Paul" to elaborate on how the matter of detecting proprietary trading would be handled. Dodd continued by pontificating on the subject of how difficult this would be, and generally exposed, despite years on the committee, his near-total lack of understanding of modern commercial and investment banking activities.

Volcker responded in an icy tone, fairly dripping with disdain, beginning with a pointedly formal, non-personal "Mr. Chairman."

He then went on to implicitly spank Dodd by casually noting that the answers to Dodd's questions were contained in the text which Volcker had just finished reading.

It was a priceless moment. I think Dodd was probably the only person either in the room or watching via cable coverage who didn't grasp how he'd been humiliated by Volcker in a single sentence.

There's a reason Paul Volcker is iconic, and it was clearly on display yesterday.

Gerald Weiss, SVP Corporate Planning & Development, Chase Manhattan Bank, N.A., RIP

It was with great sadness that I learned over the weekend of the death of Gerald Weiss, retired SVP of Corporate Planning & Development, and Chief Planning Officer at Chase Manhattan Bank, NA, for some twenty years, and prior to that, senior strategist at the General Electric Corporation, where he had worked for over twenty years prior to joining Chase Manhattan.

Gerry was 83 when he passed away last Friday from pneumonia in Cincinnati, Ohio.

It's a challenge to convey succinctly the unique talents of someone who, over time, was my boss, mentor, informal business adviser, career guide, co-consultant and close friend.

I believe the best way to provide some measure of Gerry Weiss' brilliance, importance and impact is to provide some anecdotes representing, during the years I knew him, those qualities.

When I joined Gerry's Strategic Planning group in 1983, I was one of five VPs in a group that had two other smallish units, comprising no more than perhaps 20 professionals. Gerry had originally been recruited to Chase by David Rockefeller, where he inherited a much larger staff, including a bevy of individuals responsible for business unit strategy development. These latter he rapidly transferred back to their respective businesses, preferring, instead, to run a smaller, more objective and creative group focused on advising the Chairman and CEO on how to manage the bank to increase shareholder value. Few SVPs would willingly give up staff and budget, but Gerry knew what he wanted, and didn't care to be an empire builder.

For the next decade, while larger, more cumbersome and less-focused corporate planning and strategy units vanished from America's large corporations amidst leveraged buyouts, layoffs, restructurings and corporate raids, Gerry maintained his small but influential group of strategists, management scientists and M&A specialists.

Over the next few years, by working closely with Gerry and two of his former GE colleagues, Jack Grossman and Don Heany, I learned that Gerry had reconstituted the vaunted GE Corporate Planning unit, in design and style, of his own mentor, Jack McKittrick. McKittrick, for whom a Google search will return this reference, was the strategic mind behind Fred Borch's management at GE. Gerry explained to me on several occasions how McKittrick, due to his personal wealth, enjoyed an objectivity at GE that few others could have managed. In his own way, Gerry duplicated McKittrick's philosophy, style and aggressive attitude.

Few others at Chase Manhattan realized how much of GE's legendary strategic planning function, attitude and skill had been grafted into Chase with Gerry's arrival.

To those of us fortunate to have worked for and with him, Gerry provided a very rare ability, constantly on display through example, to remain objective and honest on matters of corporate strategy, amidst heavy pressure to simply go along with what was either popular or desired by the Chairman or CEO.

To wit, when I informed a close friend, contemporary and one-time colleague in Gerry's shop over 20 years ago, he replied,

"I will always fondly remember Gerry as the smartest corporate strategy guy I ever came across and as one who had the confidence and principles to say no even when his bosses wanted to hear yes (Ohio thrift acquisitions for instance). He set a great example for all of us."

I can't really express that aspect of Gerry better than my friend and his onetime staffer did.

Another former Chase Manhattan colleague, with whom I spoke on Sunday about Gerry's passing, mused,

'You just never imagine some with Gerry's brilliance and intellect ever not being there anymore.'

During the era in which Chase Manhattan foolishly rushed into acquisitions of failed S&Ls in Ohio, Maryland and Florida, and unwisely overpaid in a bidding war for a real estate development financier, masquerading as a bank, in Arizona, Gerry steadfastly warned against such expensive squandering of bank capital. Only a few years later, one of the expansion's staff, a friend of mine, calculated the deadweight loss of capital invested and losses incurred in the various purchases throughout these states at a then-staggering amount nearing $100MM, at a time when that kind of money was material to Chase's bottom line.

Most Chase employees never knew of the creative initiatives developed by Gerry Weiss, which would have vaulted the bank into the forefront of US finance. Among his ideas were a combination with Norwest Bank, then a leading regional power, to allow Chase shareholders the benefits of Norwest's younger, better management team's prowess with our larger bank's asset base and business mix. Others included moving the regulatory charter to the UK, in order to have the freedom to buy or start businesses in areas prohibited in the US.

Yet, at the same time, over a quarter-century ahead of his time, Gerry prophesied catastrophe from a removal of Glass-Steagall. To paraphrase him back in the mid-1980s on the topic,

'All that will happen is the addition of too much underwriting capacity, managed by mediocre commercial bankers, driving down profits for everyone. This will require ever-riskier behavior from all the investment banks, brokers, and commercial banks, leading to bigger systemic losses, as new, poorly-understood, risky asset classes are invented to drive higher profit margins.'

That's exactly what we saw in the last few years, as Wall Street responded to Congressionally-mandated expansion of marginal quality residential finance lending.

Gerry had the unique ability to both pragmatically understand when a project or idea had hit a brick wall, while also retaining a tireless optimism that, eventually, good strategic ideas and common sense would triumph.

He never shirked from giving his blunt, honest opinions to the chairmen he served, David Rockefeller, Bill Butcher, and Tom Labrecque. The first two valued Gerry's objectivity and wisdom, so that they were never so threatened by his candor that they resorted to asking him to leave.

Having worked closely with Gerry and my then-partner in Corporate Planning, Debbie Smith, in his latter years with Chase, I saw how the bank began to lose momentum and languish, as the CEO ignored Gerry's recommendations on resource allocation and prioritization among businesses, to regain growth and improve income.

The unfortunate result of ignoring Gerry's advice came home to roost after Gerry's retirement, when mutual fund manager Michael Price forced then-Chairman Labrecque to seek a merger with Chemical bank.

Even in so-called retirement, Gerry Weiss had influence well beyond what would normally be expected of a Chief Planning Officer. He continued to guide the Boston-based Strategic Planning Institute, a long-ago spinoff of GE's own planning group from the 1960s.

When Chase EVP Marshall Carter was recruited by competitor State Street Bank to become its next CEO, Carter, upon arrival, retained Gerry as his personal strategy consultant. That relationship continued for roughly a decade, until Carter's own retirement from the well-regarded trust bank.

During the years after Gerry's formal retirement from Chase Manhattan, I saw measures of his continuing influence and the high regard in which well-known business leaders held him. Gerry introduced my own corporate performance work to Carter, whom I also knew from Chase, at State Street Bank.

When Gerry found some related work on productivity and economics which I had developed to be of interest, he contacted David Rockefeller. Within a few months, we had a meeting with the former Chase Manhattan chairman discussing my work.

Similarly, my evolving work on corporate performance, productivity and resource allocation found its way to a meeting between Gerry, Jack Welch, then CEO of GE, and me.

It only took a letter from Gerry to these business leaders suggesting they take a look at some interesting new business research, for their actions to indicate the credibility they attached to Gerry's opinions.

Throughout my own career, I have never worked for, nor even met, any senior executive who was as intelligent, curious, and secure, as Gerry Weiss. At his own formal Chase Manhattan Bank retirement dinner, he explained his longevity, influence and success as resulting from hiring the best people he could find, then facilitating their efforts, not trying to take credit for their work.

People on Gerry's staff routinely presented to and worked closely with the bank's chairman, CEO, and Vice-Chairmen. Thanks to him, a fortunate group of younger managers gained valuable insights into, experience with, and real understanding of the often messy, inefficient and highly political nature of actual business management and decision-making at senior levels in a modern US corporation.

As I reflect on my relationship with Gerry Weiss over more than 25 years, one anecdote remains with me which I believe depicts his unique mix of talent and style.

My partner, Deb Smith, and I had labored on several drafts of a key presentation that we would be giving to Chase's then-chairman, Bill Butcher. By then, both Debbie and I were in our 30s, and had had years of of working for senior managers who would micro-manage such presentations, then take them to a more senior executive for presentation.

Gerry was different. Sessions spent working on a presentation like this one were highly interactive, with Gerry taking on a role as equal team member, not our boss. Ideas bounced back and forth, with a lot of laughter and sarcastic remarks about the managers and culture through which we typically had to work to effect results.

On a Monday morning, after several iterations of the presentation, he assembled the heavily-marked up pages, stacked them together, and looked at us.

'Well, I think you've done all you two can. I know how I want to tweak some of the points, and there's no point wasting your time making you try to read my mind.'

Where most executives would have had us doing another two or three iterations to precisely machine the presentation to his requirements, Gerry retired to his old IBM Selectric typewriter for the morning. Between his edits and his secretary's finishing touches, he produced the final presentation. Which Deb and I gave, while Gerry observed, largely silently.

Nobody else for whom I ever worked, before or since, possessed such intellectual security and confidence. Nor was so effective.

As my one-time colleague noted in his email, Gerry set a great example for those of us fortunate enough to have worked for and with him.

Yet Another Excuse From Geithner For AIG's Rough Treatment

Thursday's Wall Street Journal's staff editorial reminded us of yet another excuse being offered by then-NY Fed president, now Treasury Secretary, for directing AIG to pay 100% on its credit default swap obligations. Prior posts, here, here and here, have addressed this puzzling aspect of the AIG affair, and earlier Geithner attempts to evade criticism for this action.

First, we were told it was to prevent a systemic meltdown of the US financial sector due to swaps failing to settle.

Then, it was explained that all counterparties had to be treated equally, and some French executives would be imprisoned if forced to accept less than a 100% payout on their swaps. So Geithner blinked and agreed to the full payments.

Somewhere in the confusion since last fall, Geithner suggested that AIG was "too big to fail."

Now, the Journal reports Geithner's latest excuse. He was concerned about AIG's credit rating!

The Treasury Secretary testified that the state-supervised insurance businesses of AIG were, in fact, subject to failure from the effects of the financial products unit's swaps troubles. Further, Geithner said,

"the people responsible" for AIG's insurance unit regulation "had no idea" of the risks the company was facing.

The Journal editorial correctly notes that this is essentially the complete opposite of what state regulators, including Eric Dinallo, former NY state insurance regulator, believed. And that it's a very different story to explain the AIG swap payments as necessary to maintain AIG's credit rating, for the benefit of its many insurance businesses.

This latest excuse rings false. As the editorial observes, when the US government owns 80% of you, nobody will worry about your credit lines.

The real concern arising from Geithner's ever-shifting reasons for the AIG full swaps payments is that each one portends different problems in the US financial services sector, different regulatory issues and potential solutions.

If Geithner can't keep his excuses straight, how can Congress possibly author a responsible, effective reform of regulation for the sector?

It's neither an academic question, nor a funny one. This is serious. We can't even learn what the primary actors in the sad story of AIG's takeover truly thought was the major risk, and why.

The editorial points out the very major question Geithner's latest excuse implies. That is, is our entire state-based regulatory approach to insurance flawed? Or is Geithner simply grasping at excuses in order to evade responsibility for a bone-headed, expensive, unnecessary and ill-advised action?

How can there be productive forward movement for the financial sector from the recent financial crisis if we can't even pin down simple things, like why the Fed behaved toward and with AIG as it did?