Apple v. Microsoft- Lessons On Value Creation

Today's Wall Street Journal happens to contain two separate articles involving Apple and Microsoft.

The headline piece in the Marketplace section is "Microsoft CEO Takes Over Gadget Unit," while Holman Jenkins, Jr.'s editorial is titled, "Apple's Second Date with History."

In the Marketplace article, Nick Wingfield discusses the troubles Microsoft has had since its initial splash with XBox. Two key senior managers are retiring, and Ballmer is now taking over the entertainment and communications devices units. He writes,

"Microsoft's problem hasn't been that it was late to the consumer-device market. Michael Garternberg, an analyst at advisory firm Altimeter Group, said Microsoft missed important consumer trends by focusing on its core business markets.

The shifting fortunes could be underscored in the coming weeks by a changing-of-the-guard in market capitalization. While Microsoft has long been the tech industry's most highly valued company, a little more than $6 billion now separates its $229 billion stock market value from Apple's."

Wingfield quotes an academic attributing the difference to higher consumer spending growth versus that for business IT products and services.

Personally, I think that academic got the cart before the horse, in the sense that the real difference between the firms has to do with pursuing commodity markets instead of product/markets which reward better design and functionality.

Holman Jenkins begins his editorial noting how Apple had a near-death experience many years ago, only to be rescued by the internet. Jenkins, too, discusses how Microsoft competed in operating systems, which became commoditized, while Apple went off in a different direction, specializing in digital devices for specific applications.

Jenkins believes Apple, through its closed systems for the iPod and iPhone, risks another brush with death, as Google's Android cell phone operating system challenges it for supremacy. He ends his piece contending,

"Apple this time understands (we hope) that it isn't playing for all the marbles, but can build a very nice business on just those customers who crave a premium service tightly controlled by the wonderful Mr. Jobs, even if it means paying a bit more and forgoing access to a lot of Web goodies that might not work so well in favor of a smaller number that work really well.

Still, we'd rather be Google. Why? Because Google can fail at everything but as long as it keeps its search box at the center of our digital lives, the ad gusher will continue to flow."

Jenkins' parting comment led me to construct the nearby Yahoo-sourced price chart for Apple, Google, Microsoft and the S&P500 Index for the past five years.

Sorry, Holman, but I'd bet on Apple. And actually have, as it's been a frequent member of my recent equity strategy portfolio selections, whereas Microsoft has not for a decade, and Google has not, if at all, for quite some time.

The price chart confirms what I suspected. That is, Apple's highly-focused, niche strategies have given its shareholders better returns over time, with Google already falling back to earth, and the now-hapless, gargantuan Microsoft lumbering along near the S&P's return.

I think quite highly of Mr. Jenkins, but on this topic, I have to respectfully part company with him.

In my humble opinion, as a trained marketing professional, both Messrs. Wingfield and Jenkins miss the key point about Apple's strategy versus Microsoft and Google.

Jenkins actually mentions that Apple chose to forsake the open operating systems world, and focus on niche digital devices. But he fails to understand the key benefit of that choice.

I believe it is this. Both Microsoft and Google became dominant in large markets, which, though providing for rapid early growth, have made it difficult to sustain such growth. Whether it's operating systems and basic office productivity software or online ad revenue from free search, both companies have saturated those markets and must look to higher-cost, more challenging new businesses for growth.

Apple, by contrast, chose to pursue specific consumer need satisfaction with a family of specialized digital devices. Steve Jobs has a flair for design, packaging and promotion of these devices.

Truth be told, over time, the product/market segment Jobs chose provides for better product margins and higher barriers to entry. Note how Microsoft has become loathed for its poorly-designed, patch-heavy operating systems. It's an open secret that many users still run XP and older Office packages. Including me.

Google has even forced Microsoft to include net-based Office applications in their recent product version. Meanwhile, Bing competes with Google's search, and everybody is looking at proprietary online or cell-based ad systems.

The lesson here seems, at least to me, to be obvious. Mr. Jenkins' appetite for market size notwithstanding, I'll take consistently superior total returns every time. And as long as Steve Jobs continues to run Apple, that's probably what you'll get.

The nearby price chart for the same entities, from 1985, clearly shows Microsoft flattening by the dawn of this decade. Apple declined after the dot-com bust, then rocketed forward on the i-series products and services. Google, from its inception, only matched Apple's returns.

After Jobs, le deluge. No argument there. But Microsoft crested while Gates was still there, and Google's very wide-open business model, while initially capturing huge profits as the first-mover, is now having some difficulty continuing that early growth.

I see Schumpeter's theory at work in this picture. Apple re-invents itself in a technological space far faster and more successfully, profitably, than either of its putative rivals.

With large markets tends to come commoditization and earlier end to superior growth and returns. The case of Apple, Microsoft and Google bears that out once again.

TARP Oversight Chief Scold Elizabeth Warren On CNBC (Yet Again) This Morning

TARP Oversight panel chief scold Elizabeth Warren was on CNBC, yet again, this morning.

For the very first time, she actually had something positive to say, and came really close to fingering two culprits responsible for some of the financial problems of 2008 and their aftermath.

Self-identifying as a bankruptcy law professor, Warren asserted that there are two fundamental principles in that discipline- equity owners take losses first, to exhaustion, if necessary, followed by creditors taking a haircut on their claims.

She noted that in AIG's case, neither occurred.

I found this to be atypically lucid and useful, for which Warren should be commended.

Then she proceeded to drop the ball. For the next few minutes, she nattered on about how the New York Fed had claimed that they either had to let AIG fail, and, thus, the US economy, or pay creditors in full. No other option existed. This would speak to Warren's second bankruptcy principle.

To anyone familiar with the publicly reported facts, there is one person, and one person alone, to whom Warren and her TARP oversight colleagues can turn to probe this curious situation- current Treasury Secretary Tim Geithner. (For more on the tax-cheat-in-chief's role in the AIG affair, search my posts with the label 'Geithner.')

But instead of stating this, and either castigating Geithner for his actions, or promising to (re?)call him to testify for the panel, she immediately began pulling other names out of the air, like Bob Willumstad.

Could Warren be skipping over Geithner because she was appointed by a Democratic Congress and, thus, knows better than to implicate one of their own, the administration's Treasury Secretary? That's certainly how it looks.

Warren also stated that AIG shareowners are still trading their equity, which should not have occurred under bankruptcy law.

Well, for that, we have Congress to thank, do we not? Because Congress authorized the TARP, and then-Treasury Secretary Paulson to do whatever he thought necessary. And I believe he was responsible for choosing to rescue AIG in the fashion that left it largely government-owned.

Why doesn't Warren probe the reasons why Paulson and Congress chose to simply disregard bankruptcy law and arrange bespoke bailouts?

In the one area in which Warren would seem to have applicable expertise, bankruptcy, all she seems to be doing is warning that it's a bad idea to let financial firms know they may get rescued.

She spent considerable time at the end of her CNBC appearance warning that it is dangerous to let firms believe they will be, once again, rescued by the federal government. She also offered that the just-passed financial regulatory bill should be continued to be modified as time goes by.

Aren't you glad Liz thought of those two ideas? Because nobody else has.

Seriously, we don't need Warren to lecture us on what a bad idea the entire TARP/bailout idea was, nor that regulatory law shouldn't be passed as a work in progress. Being naive about financial services, Warren completely missed the obvious, i.e., capital flows will be affected by current legislation, not some unknown, hoped-for future fixes in a bad law about to be passed and signed.

Well, thank God for small favors. At least, for once, Warren actually used her legal background to come close to identifying the guilty parties in the TARP fiasco.

Wither The Euro?

I heard a quote attributed to Milton Friedman last week regarding the Euro.

Friedman allegedly predicted that the currency would collapse with its first financial crisis. After considerable reading, reflection and discussions with well-informed, learned colleagues, I find myself in agreement.

I wrote here recently that Doug Dachille crystallized for me some misgivings I've had since the beginning of the Euro. Dachille's viewpoint was echoed as I spoke with a very experienced retired CEO this past weekend.

With some added days' perspective since last week's continued turmoil over the Euro, and the prior week's ECB actions, it continues to be difficult to see how the Eurozone countries can grow their way out of this fiscal mess.

And it is a fiscal mess. Recall that the origin was a rather quiet disclosure months ago that the prior Greek government simply lied about its budgets and deficits.

I won't reiterate my and others' comments on the quasi-socialist, slow-growth economies of the EU, the transfer of wealth from Northern European nations to Southern ones, and the inevitable stress on fiscal policies, savings, taxes and long term Eurozone growth. It's enough to note that, once the immediate bailout/crisis mode has passed, the EU will continue to live with economic problems associated with funding the Greek and other national rescues.

The trouble may well bring down Angela Merkel's government in time. At that point, you have an opening for the previously unthinkable- German withdrawal from the Euro and its return to the DeutschMark.

Just because this won't all happen this next month or this summer doesn't mean pressure isn't building for a radical, discontinuous resolution of the simmering Euro problem. It's ultimately a cultural clash- robust, harder-working Northern European economies rescuing more spendthrift Southern European economies.

These nations have hundreds of years of experience as independent nations with independent fiscal policies. It's hard to believe they will move closer to surrendering those differing fiscal policies to a single, more powerful Brussels-based EU government. Thus, with the status quo probably untenable, the other extreme becomes more believable- the end of the Euro.

How Governments Brought Uncertainty and Risk Back Into Capital Markets

Several pieces of information or opinion I received over the weekend leave me with the clear sense that the recent, sudden slide in US equity market prices is very clearly attributable to actions of governments around the world. As such, what governments, including Germany, the Euro community, and the US Congress and Fed have done is effectively inject fear and uncertainty into investors in global capital markets.

For example, PIMCO executive Mohamed El-Erian penned an opinion piece in the weekend Wall Street Journal discussing the return of the "nervous weekend."

Referring, originally, to US government weekend triage actions in the fall of 2008, now it's European governmental entities providing the stream of market-roiling actions.

Among El-Erian's observations were,

"I fear that markets may not get sufficiently reassuring answers any time soon to these questions.

There is still a deep hesitancy among European policy makers to acknowledge that the approach to rescuing Greece is incomplete. But few outside observers are fooled by a strategy that results in a further increase of the country's already excessive debt-to-GDP ratio, relies too heavily on a blunt and draconian fiscal policy instrument, and sustains a debt overhang that will deter new investments and amplify an already painful drop in GDP.

The bottom line is simple yet consequential: The disruption in financial markets is not a garden-variety market fluctuation. Instead, it's an over-due recognition that the global economy faces an uncertain future that involves slower growth and greater government regulation."

In another Journal editorial, columnist Jason Zweig focused on professional investor Seth Klarman's recent comments in an interview he gave to Zweig at the CFA Institute's annual meeting. Among the remarks attributed to Karman were,

"The government is now in the business of giving bad advice. By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone to speculate.

All we got out of this crisis was a Really Bad Couple of Weeks mentality.

I am more worried about the world, more broadly, than I ever have been in my career.

Will money be worth anything if governments keep intervening anytime there's a crisis to prop things up?"

And, finally,

"Sometimes, when you can't figure out a good defense, the best thing to do is to go on offense."

Finally, the US Senate passed a dysfunctional, horrible financial regulatory so-called 'reform' bill authored chiefly by a retiring Chris Dodd, who is beating a hasty path home to Connecticut ahead of corruption charges over his sweetheart mortgage deals from now-defunct Countrywide.

New Hampshire GOP Senator Judd Gregg, also retiring, but for different reasons, contended this morning on CNBC that this bill is a knee-jerk reaction to show voters that Senators will punish "Wall Street."

He ticked off a number of serious flaws in the bill, and noted that, surprisingly, House financial committee chairman Barney Frank actually has a Senate bill further to his left than to his right.

Take all of the actions these three people have noted, together, and you have a heretofore rising, low-volatility US equity market turned upside down in just a little over three weeks.

When governments lie about their finances, e.g., Greece, and then attempt to duck responsibility and consequences, followed by uncoordinated fiscal policies among the Euro's members, and the US Congress adds to fears with bad legislation, global investors are rightly concerned.

In fact, my volatility measure, which is calculated differently from, but tends to track the VIX, has hit recent highs in the past week.

Count me among those who believe this equity market swoon is by no means over, nor is fear out of the equity markets by a long shot.

Congress' New Clearinghouses

A Wall Street Journal editorial earlier this week exposed some inconvenient truths regarding proposed Congressional so-called 'reform' of derivatives trading. The topic is clearinghouses.

Personally, I find the notion of establishing clearinghouses for derivatives to be progress, if it prevents the valuation panics attendant upon derivatives due to counterparty risk, and the consequent panic over the valuation of the holders of said derivatives.

If, rather than having daisy chains of derivatives existing among various institutions, the bulk of the instruments are traded via an exchange, perhaps counterparty risk will be reduced, thus improving confidence in the risks of potential losses to the various parties.

However, the evolving, awful Dodd bill doesn't seem to have so much confidence in the proposed exchanges for derivatives.

The Journal editorial notes that the fine print of Dodd's effort gives said clearinghouses Fed discount window borrowing privleges.

Pretty scary, eh?

Because that blows the argument about 'no more bailouts' out of the water.

In fact, this provision makes clear that Dodd & Co. fear precisely that even a derivative exchange can't be sufficiently well-capitalized to cover losses, and, thus, needs access to...you guessed it....our taxpayer money.

The editorial points out,

"Also most clearinghouses that operate today set margins based on historic volatility. Everything works well as long as patterns continue as they have in the past, but as we have so painfully learned the worst crises involve assets long considered very safe that turn out to be risky. We now know that regulators at the Treasury's Office of Thrift Supervision signed off on AIG's credit-default swaps because they backed AAA-rated mortgage assets. And everyone knew housing had been rock-solid for decades."

Once again, we are reminded that regulators who are, frankly, less smart than industry practitioners will cause taxpayers losses every time. In the last crisis, our federal regulators proved unable or unwilling to challenge rating agency opinions and/or think for themselves about high ratings on securities backed by whole new mortgage instruments (subprime and Alt-A).

So any Congressional creation that depends upon regulators to get the basics right, such as, oh, say, the derivatives exchange collateral levels, is bound to be wrong.

And that means, as the Journal piece concludes, that this legislation won't do much more for derivatives risk than, first, concentrate it into an exchange, then pass any uncovered risk/losses to taxpayers, via the Fed window.

Makes you want to cry, doesn't it?

The "Flash Crash" & Market Liquidity

Tuesday's Wall Street Journal featured an article comparing the recent "flash crash" to what it termed "a real one in 1987."

Surprise, we're flirting with another such day today.

A key paragraph in the long piece read,

"Selling pressure became on both days became so intense that any remaining buyers were overwhelmed, creating an "air pocket" in stocks and other securities that led to vertiginous declines.

Many market makers on Black Monday had exhausted their funds, while others were overwhelmed by the volatility. The NYSE later took steps to boost traders' capital."

Here's my question.

It's been 33 years since the 1987 crash. We knew then that small market makers on the NYSE were incapable of withstanding the avalanche of sell orders that what was then advanced technology allowed to occur. Technology has moved on and now dwarfed the volume of that crash.

One of the significant results of that crash was the acquisition of many market makers by larger brokers, as so many of the former had shown themselves either unable or unwilling to fulfill the role, in exchange for which they were given monopolies on trading selected issues.

Why have we not yet decided, once and for all, to either let the chips fall where they may in the rare, but inevitable market free-falls, or to halt trading entirely?

It's not like we haven't had three decades and change to reflect on this important question, is it?

Markets need to be continuous, liquid and able to prevent any one buyer or seller from having pricing power over an issue. If any one of these conditions is violated, it's no longer a market.

Period.

Maybe the problem is that the industry hasn't given Congress a sensible, practical approach to what are well-known conditions.

In 1987, there were 2-3 similar 'gapped pricing' upward spirals earlier in the year. But, because fills resulted in higher prices, nobody complained. It was a different story in October of that year, when equity sell orders got filled at prices far lower than the quotes at the time of the market order placement.

We know how equity markets behave in these situations. Simply put, market makers won't step in to catch the "falling knife" of plummeting prices on equities. They will not answer phones, and will institute "speed bumps," in hopes that a pause of 1-2 minutes will fix everything. So, in that situation, it's an implicit closure of markets.

If, instead, as over on the NASDAQ, market sell orders continue to flood a market with no buyers, prices will plummet. If anyone still wishes to enter market orders in that situation, it's buyer beware.

Which do we want to exist in observable situations of market panic, as characterized by trading volumes and index price declines/unit of time?

We need our sector executives, especially on the exchanges, to formulate workable solutions and insist that Congress enact them so that all investors know, a priori, how markets will, or will not, function at times in which pre-defined crisis parameters apply.

The Shadow Banking Safety Net?

A few days ago, on CNBC, guest Steve Crawford, late of Morgan Stanley, advanced the notion that current Senate regulatory efforts to shove risky trading out of regulated banks and into a "shadow banking system" won't keep the federal government from bailing out that sector, too.

This seemed to be an unsubstantiated claim.

Crawford didn't name names, but alleged that "shadow banks" had already been bailed out in the recent crisis, so there was no real discrimination, new legislation, or not.

I wonder which companies he considered to be shadow banks which were saved?

To me, any publicly-held, private sector entity which has material regulation of some sort is not a "shadow bank."

For example, I'd say that hedge funds and private equity groups are "shadow banks." Private equity lends, does leveraged buyouts and, at the upper end, can engage in significant proprietary trading.

Hedge funds clearly meet the trading units of heavily-regulated banks in the marketplace. But the hedge funds enjoy notoriously lighter regulatory burdens than their publicly-held competitors.

I'm not aware of any private equity or hedge fund groups being rescued in late 2008, are you? In fact, a few hedge funds went under, though I can't recall specific names. Other than LTCM, in 1998, no hedge fund, to my knowledge, has been the subject of a coordinated, government-led action to preserve markets.

Even in the case of LTCM, the firm wasn't saved. Rather, there was concern for counterparty losses due to the lack of bids for assets held by the firm, causing financial markets to crater as a by-product.

Counterparties and other large institutions contributed to the orderly unwinding of LTCM positions, but the firm's owners lost everything.

So I confess to not really understanding why Crawford is so worried about shadow banks. Existing hedge funds and private equity firms would pose risks due to unwise levels of leverage. But surely their lenders are capable of judging for themselves what those balance sheets can handle. At least better than an army of civil servants who have yet to forestall a financial crisis due to their exercise of their lawful supervisory powers.

Doug Dachille on CNBC This Morning

I caught a fair amount of Doug Dachille's appearance for, I think, an hour this morning on CNBC.

As always, his comments were lucid, powerful and candid.

Dachille crystallized something which has always bothered me about the creation of the Euro.

In effect, Dachille, more clearly than anyone else whom I've heard on the subject, noted that the EU chose to create a currency, but no centralized taxing authority. Thus, unlike the US, the countries share a currency, and some loose federation policies, but have no effective means to back the Euro as a currency.

It really brings to mind something I said just yesterday to a colleague about Alexander Hamilton. Our first Treasury Secretary was truly brilliant. He had the federal government assume the debts of the states and created the dollar, thus seamlessly unifying the nation fiscally and monetarily.

Pity the Eurozone. As Dachille so succinctly put it, they can't take unified measures to support the Euro because there is no federal taxing power. Everything has to be a country-by-country vote to fund actions in support of their shared currency.

This addresses what I had misgivings about so many years ago, i.e., that the Euro countries weren't sufficiently unified in both fiscal and monetary policies. As such, at some point, their lack of federal authority to coordinate the monetary and fiscal aspects of the Euro would come back to bite them. In effect, Germany, with the most stable currency and strongest economy of the EU, had not ceded its fiscal authority to the EU.

You might not be able to clearly define how the monetary and fiscal aspects of a nation's currency interact, but you know it's an important phenomenon. In the Eurozone, it's now clear they just don't have that linkage in a manner that global investors trust or believe.

Taxes & GDP

David Ranson, the head of research for H.C. Wainright & Co. Economics, wrote in Monday's Wall Street Journal on the relationship between US GDP and tax revenues.

The graph from his article appears nearby. It shows real US tax receipts (Y axis) plotted against US GDP (X axis), with the dotted red line representing Y-values equal to 20% of the X-values at each point.

Ranson observes, in his editorial,

"The feds assume a relationship between the economy and tax revenue that is divorced from reality. Six decades of history have established one far-reaching fact that needs to be built into fiscal calculations: Increases in federal tax rates, particularly if targeted at the higher brackets, produce no additional revenue. For politicians this is truly an inconvenient truth.

The nearby chart shows how tax revenue has grown over the past eight decades along with the size of the economy. It illustrates the empirical relationship first introduced on this page 20 years ago by the Hoover Institution's W. Kurt Hauser—a close proportionality between revenue and GDP since World War II, despite big changes in marginal tax rates in both directions. "Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP."

I confess to being completely surprised at the incredible consistency of this chart. There aren't the kind of significant swings above and below a regressed curve fitted through the actual data.

Rather, it's clear, assuming Ranson's numbers, as sources in his chart footer, are correct, that this relationship is very tight and dependable.

Why is this so? Ranson opines,

"What's the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue."

You can guess what the contemporary application of Ranson's version of "Hauser's Law" would be. Ranson considers current federal tax revenue and GDP projections,

"In this form, Hauser's Law provides a simple basis for testing the validity of any government's revenue projections. Today, since the economy already suffers from a large output gap that is expected to take many years to close, 18.3% must be a realistic upper limit on the ratio of budget revenues to GDP for years to come. Any major tax increase will reduce GDP and therefore revenues too.

But CBO projections based on the current budget show this ratio reaching 18.3% as early as 2013 and rising to 19.6% in 2020. Such numbers implicitly assume that the U.S. labor market will get back to sustainable "full employment" by 2013 and that GDP will exceed its potential thereafter. Not likely. When the projections are tempered by the constraints of Hauser's Law, it's clear that deficit spending will grow faster than the official estimates show."

What provides me with some odd comfort is that, no matter how heavily the government taxes us, jointly, we only pay up to about 18-19% of GDP. Thus, recent deficit-financed spending is not going to be repaid out of near-term taxes which rise precipitously.

Rather, it's pretty clear that the only way it will be repaid is through economic growth. And that's going to take a much different economic climate than our current federal government seems to be capable of delivering.

Another Perspective on Financial "Reform"

Harvey Pitt, the one-time SEC chairman, wrote an editorial in Monday's Wall Street Journal discussing how the ability to learn, or not learn, from history, informs the deeply-flawed Dodd bill.

Thought Pitt was never my favorite SEC chief, his recent article reminds us of some inconvenient facts.

For example, he notes that the S&L crisis of the late 1980s didn't feature any one or few large institutions. Never the less, it required Bill Siedman to create the RTC and took many years and billions of dollars to process and ultimately dispose of foreclosed properties.

Another point Pitt makes is that, once again, Congress seeks to add to layers of existing regulatory authority. This has been the trend since, well, anyone can recall. It seems no agency is ever destroyed. At worst, it morphs into something else. Rather like the principle of conservation of energy.

When is the last time you remember an entire federal agency and its workers being simply eliminated?

No, instead we'll get more oversight boards and agencies with more civil servants in lifetime jobs. Does this sound like the crew that will catch the next explicit, deliberate financial excess perpetrated by groups of very bright financial executives with masters degrees in finance and associated quantitative disciplines?

Congress' own FCIC hasn't even finished its job yet, and both Congress and the administration are pushing for immediate passage of a 1,400 page bill.

Where is the sense in that?

Finally, Pitt sagely observes that, almost certainly in any case, and certainly in this case, whatever legislation is rushed through Congress and signed into law will "assure that we will experience anew the law of unintended consequences."

To me, this last is perhaps the most troubling element of the current rush to over- and re-regulated the financial sector.

For once, could someone just assemble a practically-sized group of reasonably-objective experts, sift through the last 50 years of financial disasters, and consider what type of regulatory bodies and rules would have effectively and efficiently minimized said crisis?

Certainly, one aspect involves credit and leverage standards. The S&L's came to ruin from mismatching durations of liabilities and assets. So, for that matter, did Bear Stearns and Lehman. And, very nearly, Goldman Sachs and Morgan Stanley.

On the exchange front, regulatory authorities have allowed, for some time, the NYSE and the NASDAQ to run under vastly different rules concerning circuit-breakers at the level of individual equities. Promises or expectations of liquidity vanish when they are most wanted, triggering sudden elevator-rides down in equity prices.

We know this happens. Do we want to prevent it, or simply make everyone aware of its possibility? Because, right now, we do neither.

Harvey Pitt did a good job exposing several important truths which currently-proposed regulations do not fix.

I regret to conclude that, as usual, we'll end up with more, more expensive, cumbersome and unwieldy regulatory authorities and processes, but no greater protection from the financial excesses which we deem unacceptable.

Meredith Whitney On Financial "Reform," Small Businesses & State&Local Governments

Meredith Whitney wrote a simple, elegant editorial yesterday in the Wall Street Journal entitled The Small Business Credit Crunch.

In it, she drew a fairly short, straight line from the current Senate financial sector regulation bill to higher-cost or even unavailable consumer credit for use by small businesses. Added to that, Whitney noted how lower housing values have wiped out their use as a traditional small business financing source.

Thus, in her opinion, small business-based job creation, a traditional source of US economic expansion, will be crippled, as the small businesses face financing difficulties, as and should they desire to expand or be created.

To this already dark picture, Whitney added her prior views on municipal and state government budget shortfalls and, eventually, job cuts.

Whitney and former Merrill economist David Rosenberg each shared these views last winter on CNBC, from which I wrote the two linked posts.

Now, it seems that at least Whitney sees evidence of her predictions coming true and having meaningful consequences.

The punchline of her article is that the government job cuts will result in up to two million newly-unemployed at a time when Congressional legislative action will help dampen small business formation and/or growth.

Whitney believes it unlikely that large US businesses will turn around and hire nearly the same number of workers- three million- they just got finished laying off in the past three years.

Missing from the picture will be small businesses growing to take up the five million jobs they have cut in the recent recession.

Putting the pieces of the picture together, Whitney sees continuing jobless 'recovery,' with large businesses continuing to enjoy jobless productivity gains, small businesses crippled by consumer credit contraction, while municipal and state governments finally shed workers larded on in earlier expansions.

Hardly cause for optimism for a robust, high-employment recovery, is it?

The Ratings Agencies' Turn "In The Barrell"

With Moody's being assailed for misleading statements in a regulatory filing, and two opposing amendments to a Senate financial 'reform' bill dealing with the rating agencies, it looks like Moodys, Fitch and S&P are finally getting their turn for scrutiny from the fallout of the mortgage-backed securities-induced financial sector meltdown.

One of the amendments to Dodd's disastrous regulatory "reform" bill would strip the rating agencies of their special, government-designated status. Another amendment, by comedian, now Senator Al Franken, would wrap even more red tape around the ratings agencies, cocooning them under yet another special oversight board.

Guess Franken hasn't left the comedy field just yet.

Paradoxically, both amendments have passed votes to attach them to the Senate bill.

If you have much exposure to the financial sector, then you probably will be rooting for the 'less is more' approach that removes the agencies from any federal imprimatur of credibility. S&P, for the record, backs this step.

Back in the days of little information and poor communications, ratings agencies provided low-cost, widely-disseminated creditworthiness judgements when most investors lacked the resources to undertake their own due diligence.

That's no longer the case. The ratings agencies enjoy monopolies from a long-ago era, much like the airlines before Alfred Kahn liberated them from their anti-competitive industry structure.

It's high time institutional investors quit hiding behind the rating agencies, yet also taking money for allegedly making hard choices concerning investment instruments.

It's not clear there's even a role for the agencies anymore. If so, it's probably not going to be rating instruments for pay from the originators.

Something else will have to replace that now-tainted model.

It's long overdue.

Wealth In China

I read the details of a story in the Wall Street Journal concerning the murder of many young school children in the small provincial town of Lincheng.

The story is heartbreaking. An embittered man who had leased a building for the local school was angry at not being able to recover use of the house. In spite, he attacked the children and school teacher, hacking them to death, then killed himself.

What struck me, however, was the Journal piece's description of the town as "one of the poorer villages in China."

I can't locate the article, published last Thursday, in the Journal's online site. But it seems, at least to me, to belie the notion of what now constitutes the one of the poorer villages in China.

Centered in the image accompanying the article is a decently-dressed woman chatting on a cellphone. To the right, in the back of the photo, sits a man in a dark blazer, well-coiffed, in a collared shirt and loafers, his face grim. Next to him is a casually dressed woman, her face buried in her hand, in a tasteful, slim pair of jeans and dark top with metal buttons.

Other grieving parents, all waiting in a hospital or medical clinic, are surprisingly well-dressed, -groomed and modern-looking.

They'd put the people in the poorer sections of New York City or Chicago to shame.

I guess economic welfare in China is truly widespread and rising.

Congress Plans To Ration Consumer Credit

This morning and afternoon, CNBC has had fairly extensive coverage of the new and expanded consumer finance regulations making their way through the Senate and headed for the House.

Among other features, the bill cuts debit card usage fees. The general effects of the bill are for Congress to exercise price controls over consumer credit providers. This will, of course, result in the rationing of credit to consumers.

Imagine lower-income consumers finally getting to the point of affording credit or debit cards, only to discover that they are no longer available to them, on prior terms, due to increased costs of regulation.

Yesterday's Wall Street Journal carried an editorial co-authored by Cliff Asness, founder of hedge fund AQR. His piece called attention to the very many vague and unspecified instances of language in the horribly-written Dodd financial 'reform' bill. Language making it unclear what is illegal and how penalties will be assessed.

Bill Isaacs, the former FDIC head, was on CNBC expressing his hope that more insane and unworkable concepts get added to the bill, thus making it completely incapable of being passed during this session of Congress.

Between the badly-written, so-called 'reforms,' public and legal attacks on investment banks, and, now, new attempts to curtail, proscribe and limit profitability of consumer lending, the recent federal government actions aimed at the financial sector point to less available capital or credit, higher costs of capital, and the effective rationing of credit and capital on non-price bases.

None of which are good things for our nation or its future economic growth.

Starbucks Expands Its "Fighting Brand"- Seattle's Best Coffee

Wednesday's Wall Street Journal called attention to Starbucks' plans to push its lower-priced brand, Seattle's Best Coffee, through various distribution channels. The wholly-owned unit, once a Starbucks competitor, is now headed by Michelle Gass, the parent's CEO's one-time strategy aide.

Essentially, rather than repeat its mistake of the past few years by taking the Starbucks brand down-market, causing temporary sales growth but diluting the brand's image, the company is tapping its lower-priced coffee brand to implement this strategy.

One pundit likens it to the Gap's Old Navy brand, but I'm not so sure that comparison works. After all, style, quality of material and price all serve to differentiate Old Navy, while, in the end, moderate-priced coffee is moderate-priced coffee.

Seattle's Best is to be marketed through franchisees, sales of beans in grocers, and the like. I suppose that, if done successfully, this Starbucks division can earn a respectable return. Perhaps, at first, it will add some growth to the parent's income statement and total return through raw revenue growth.

But, over time, what's the likelihood that a middle-market coffee roaster, competing with Dunkin' Donuts and McDonalds, will somehow break out in the segment and prove to dominate a segment known more for its very lack of distinguished flavor?

More than anything, isn't the plan to push growth at Seattle's Best Coffee an implicit admission by Howard Schultz that the Starbucks brand isn't as capable of delivering profitable growth which will enhance shareholder value and consistent total returns in the near future? That the main Starbucks brand is essentially devoid of significant opportunities for growth, having saturated its markets in recent years?

GM Wants A New Captive Finance Unit

The headline in yesterday's Wall Street Journal, "GM Looks At Return To Auto Lending," caught me completely off guard when I saw it.

Is Ed Whitacre nuts?

The lead paragraph in the Journal article stated,

"General Motors Co. is weighing an attempt to buy back its old auto-lending arm or start a new finance company in a bid to become more competitive and bolster the company's appeal ahead of an initial public stock offering...."

This is surely among the more wrong-headed, disastrous moves I've read regarding the failed auto maker.

If the 'core competence' notion has any value, this is one stupendously dumb idea. GM has shown over several decades that it couldn't even build attractive, competitively priced gasoline-engine cars.

Its financing arm, GMAC, eventually grew to be its own entity, pursuing profitability through....sigh.....residential finance. Where it went fabulously wrong and lost billions.

True, an equally-naive Cerberus bought into the unit before the implosion. But my point is that finance is, or should be, a related but non-core function for making and selling vehicles.

The temptation has been, in past decades, for US auto makers to cut price through finance terms, making their financing arms the repository of losses while their vehicle operations look healthier.

Granted, the Journal piece went on to note,

"GMAC, which recently renamed itself Ally Financial, made $653 million on its North American automotive operations in 2010's first quarter."

Of course, operational profit on auto lending may, and probably does not address the balance sheet risks for Ally of holding, selling or hedging its portfolio of auto loans.

Like any financial institution which has borrowed in the credit markets, is highly leveraged, and makes loans, Ally and, thus, GM, when it either repurchases part of Ally or starts its own new finance unit, has to manage asset/liability risks.

How is Ally doing on that score right now? If GM owned Ally, and continued its infamous 0% rate financing programs, to which it has seemed to always turn when tempted by slow sales or share erosion, how would it manage borrowing money at positive interest rates and lending it at lower ones?

Sounds to me like yet another recipe for disaster at GM.

My proprietary research has shown that financial services firms which concentrate on just one, or a few businesses, tend to have higher, more consistent total returns over time. Broadening a firm's business mix, especially when the businesses don't share many fundamental functions, tends to overtax management and promote the lack of attention to the core businesses.

In GM's case, the only link between the two businesses is that the finance arm would be making loans whose collateral was the cars GM made and sold. Aside from that, the real question is whether auto financing, as a standalone business, can generate long term superior returns relative to GM's auto making business.

If so, shouldn't any US investor, who, by definition, as a taxpayer, is already long GM, have the option of buying equity in the finance company that services GM, rather than be forced to own that, too?

TARP Oversight Chief Scold Elizabeth Warren Whines On CNBC This Morning

It was my unfortunate fate to sit through more whining this morning from the head of the Congressional panel looking into the financial crisis, Elizabeth Warren, on CNBC.

Every time I hear this woman talk, my sense that there is nothing she says that is new is reinforced. As well as my sense of how much she doesn't understand about the financial sector.

She began her typical rant by excoriating large US banks for not lending out the TARP money they had been "given." Never mind much has been repaid.

Warren then added the usual pundit's rant about small businesses. Small businesses, she insisted, were being hurt at the expense of larger businesses by the failure of those big, bad banks to lend to the bedrock of the US economy....blah blah blah....small businesses.

Several other guests on the CNBC set countered Warren on two issues. Bob Barbera, chief economist at ITG, noted that small businesses had been disproportionately hurt by the drop in real estate values and, thus, were in no position to borrow any more money. Another guest, perhaps Rich Bernstein, a former Merrill Lynch senior strategist, noted that there wasn't really any real loan demand by small business, just based on economic conditions of late 2008 through late 2009. Further, they were absolutely not hiring anyone.

Nobody on the panel offered another key piece of evidence, i.e., at Fed-induced ultra-low interest rates, how could any bank possibly justify, in hindsight, throwing money given them by the Treasury into risky, low-rate loans to small businesses?

If those banks charged appropriate, higher rates, they would no doubt by garroted by Warren at a later date for daring to profit unfairly on the gift of Federal largess. If they lost money on low-interest loans, they'd be lectured for more foolish lending, just like their original real estate finance excesses.

Warren would have none of the panel's contrary views, insisting she was correct.

Then someone asked if the FCIC was investigating the potential for securitizing small business loans.

I have to say, at this point, I nearly spit out my coffee from shock. What the hell is anyone doing wanting securitization of small business loans when we still are cleaning up the mess from subprime and Alt-A home loans and their securitized offspring?

Warren charged ahead, though, informing everyone that, gosh, small businesses are very unique and require a different kind of lending than simply marking up prime and opening a credit facility for, say, Boeing or Cisco. Only she didn't say it that elegantly. So they are difficult to package up and sell in securities.

Liz Warren is 61 years old, born in 1949, according to her bio. So in 1974-75, when, as a freshmant at Saint Louis University, I was learning the basics of corporate finance in Dr. Fred Yeager's Introduction to Finance 100 course, Warren would have, I guess, been in law school, or already practicing.

Over thirty years ago, I learned in Dr. Yeager's course that conventional business lending was a very qualitative affair. Back then, the standard Brigham & Weston text referred to the "five Cs" of credit: character, capacity to pay, collateral, capital and conditions.

Now, an excited Liz Warren informs CNBC's viewers all about how individualistic is the nature of each small business loan.

Give me a break!

Hundreds of thousands of trained business school graduates working in the financial services sector already know this, Liz. You're only about, what, a few decades late to the party?

Why is it that the head of Congress' vaunted TARP Oversight panel is a liberal lawyer with obviously no practical understanding of finance? How useful are her 'insights' ever going to be? She doesn't even understand how the business works.

To be fair, for all of us, regardless of political persuasion, the challenge of staffing a Congressionally-appointed, outside panel is going to be finding informed but objective members.

The informed experts could well have an industry bias. Financial academics are a potential hybrid which could hold promise, but even some of the more revered theoreticians aren't all that steeped in the reality of fast-moving markets and real instruments, like CDOs.

The more objective candidates from outside the sector, like Warren, simply look clueless and naive. Further, their conclusions are likely to be wrong because they don't fully understand the issues with which they are charged to resolve.

It's hard for me to take seriously anything Warren says from her soapbox perch. When it's an informed comment, which is rare, it's not news. When it's not informed, Warren is just wrong.

The FCC Puts US Communications Technology Growth In Jeopardy

Nothing scares off investment capital like uncertainty. Whether measured by higher required rates of return or lower 'certainty equivalents,' uncertainty of return of capital makes projects less attractive.

Thus, the FCC's recent second attempt to regulate the internet is likely to slow or halt growth of that important communications tool and the economic benefits it would otherwise create.

Having watched Congress rebuff 'net neutrality' earlier this year, the FCC is trying again by unilaterally declaring that the internet may be regulated under the 1996 Telecommunications Act.

Noting the year of that act, one already realizes that the Act came just at the dawn of the internet's rapid growth in the late 1990s. The notorious "dot com" bubble.

So, not only did the Act not even foresee developments only a few years hence, but, now, over ten years later, it is most assuredly out of date, drafted, as it was, with the intent of regulating telephony.

Having worked for ATT years ago, in the early years of my business career, I can attest that the last ten years of growth of internet-related services is beyond all comparison to growth in telephony for the last thirty. Once telephony went to wireless, the rest of the changes were of magnitude, more than type.

Other than that, companies like Verizon have only introduced innovation by expanding outside of voice communications to look more like cable companies.

The FCC's unilateral power play is sure to have very negative consequences for one vibrant sector of the US economy.

Think of how many new initiatives, perhaps along the lines of Facebook, Google, or the thousands of apps for iPhones, will now be choked off by uncertain returns to capital as the FCC clouds the business operating environment for such services.

It's bad enough that our government uses taxpayer money to prop up old, antiquated and unproductive sectors like auto manufacture. To now turn to the other end of the spectrum and move to limit growth in new economic sectors will surely lead to a moribund US economy in the not too distant future.

Rick Santelli v. Paul Kanjorski

If you enjoy Rick Santelli, here's a clip of the exchange between him and this morning's CNBC guest host Rep. Paul Kanjorski, about whom I wrote here earlier today. Once again, thanks to a reader's search, this time for the video of the exchange, I was alerted to go find it.

In my earlier post, I wrote, in part,

"And, as I'm writing this, Kanjorski is lampooning voters who blame CRAs, Fannie and Freddie for causing much of the recent mortgage-backed financial meltdown. That, alone, should tell you that Kanjorski is living in an alternative universe where Congress has never done anything to damage our financial system."

This exchange occurred right after I wrote that.....

More Reflections On The ECB Greek Bailout

The big news in US equity markets this week continues to be the weekend announcement of the ECB bailout of Greece and, prospectively, Spain and Portugal.

The US pre-market open S&P futures were down to 1141 at one point this morning, from yesterday's close of nearly 1160. As of 10AM, the S&P index is around 1154, still down slightly.

Already, before the open of the US equity markets, pundits were warning of the potential risks and negative consequences, for equities, of the ECB's bailout.

One, of course, is that the Euro isn't a reserve currency. Thus, the relatively benign effects, so far, on the dollar, of the late-2008 massive printing and borrowing of dollars, may not accrue to the Euro or the Eurozone economies.

Second, the austerity measures called for in the bailout will probably result in real economic slowing for the Eurozone economies. That isn't good for short term GDP growth and, by extension, will affect those companies doing much business there.

Third, there's some non-trivial political uncertainty accompanying the ECB actions. The British still don't know the shape of their new government, in the wake of Brown's defeat. And Angela Merkel's party lost an important state election, which will result in her party's loss of control of Germany's upper legislative chamber. Simply put, it's too early to tell if most Germans really approve of using their economic strength and savings to pay off the debts of their relatively less hard-working and less prudent Greek Euro-neighbors.

And Spain is still to come.

All of which means that, after the predictable one-day jump in equities, the longer-term consequences of the ECB action may be quite different.

According to my measures, equity market volatility has not yet abated, and returns are by no means assuredly back to a long, steady march upwards. Seeing just what sort of market dynamics predominate in the days and weeks ahead is still unclear.

Who's Minding Our Markets?

This morning, CNBC's morning program is still beating a loud drum regarding the sudden drop in equity prices on Thursday afternoon. To facilitate the process, they invited Pennsylvania Democrat Representative Paul Kanjorski to be a guest host. Kanjorski is a member of the House Financial Services Committee, thus, his attraction for CNBC. Talk about one hand washing the other......

It's ironic for CNBC to have Kanjorski guest host to discuss Thursday's alleged trading scandal, because Kanjorski is actually a scandal-tainted legislator, himself. I found this out due to an accident a month or so ago. At the time, I had written a post on one of my blogs involving Kanjorski. Reading through my Sitemeter details of visits, I found that one reader had found my post from a search for 'Kanjorski scandal.'

Sure enough, Kanjorski, a Representative since 1984, has a big earmarking scandal in his past apparently involving using millions of dollars of federal money to enrich his family. Wasn't Kanjorski's regionally-close, Pennsylvania Democratic House colleague John Murtha, also known for excessive, often self-serving earmarks, too? Must be something in the water up in Northeast Pennsylvania.

Anyway, knowing this makes Kanjorski's earnest-looking, solemn attitude regarding finding and punishing equity market traders and 'insiders' much more of a joke. After all, it seems Kanjorski is a veteran 'insider' himself.

But, back to the issue. Kanjorski has been spewing all manner of hot air this morning, no doubt to make ideal campaign sound bites and video clips. Particularly, he went to great lengths to extol the current financial market regulatory personnel as just the best "in 25 years." Really. Honestly.

No matter that a Democratic administration staffed those agencies. And Democratically-controlled committees are taking a 'hands off' approach with Mary Shapiro in the wake of the incident.

And, as I'm writing this, Kanjorski is lampooning voters who blame CRAs, Fannie and Freddie for causing much of the recent mortgage-backed financial meltdown. That, alone, should tell you that Kanjorski is living in an alternative universe where Congress has never done anything to damage our financial system.

By now, though, it's pretty clear what happened on Thursday. The NYSE used its human specialists to engage a trading slowdown. Claiming that a two minute pause in trading does not constitute 'stepping away' from the market, the NYSE chief and his colleagues and defenders all claim they were merely bringing 'order' to markets run amok from too much electronics.

When the NYSE's specialists essentially took a hike on selected equities, the order flow immediately went to the NASDAQ, which, because of the NYSE's absence, had to order match in a less-liquid market. With more sell orders than buy orders, the 'real,' instant market prices fell.

I really don't think what happened is much more complicated than that.

You can conjure up all manner of conspiracy theories, but, in reality, it does seem to be a case of the regulatory authorities allowing for one exchange to engage equity-specific trading halts, while allowing another exchange to trade through.

What do you think will happen in cases where this differential treatment of individual equities occurs? In down markets, prices will gap down. If Thursday had been an up day, prices would have been skipping up discontinuously, and buyers would have complained about missing bids and being filled at what they considered to be ridiculously high prices.

The truth is, the definition of a "market" involves several dimensions. No one buyer or seller can set prices. Prices must be continuous. Price discovery has to be ubiquitous.

If any of these tenets are violated, it's not a 'market' anymore. Therefore, 'market' orders aren't really going to have their desired effect.

Funny how it's become pretty obvious that the cause of Thursday's ultra-sharp sell-off is a regulatory mistake of keeping exchanges in step with each other. But, because it was a regulatory lapse, the party in power is looking elsewhere for someone to blame.

The ECB Bailout

The business media airwaves are still filled with arguments about the cause of the Thursday elevator-shaft ride of US equity markets late in the afternoon.

No real news there. This morning's CNBC "debate" with the usual regulatory suspects, including Ned Reilly, Elizabeth Nowicki and Jacob Frenkel, got nowhere. Ms. Nowicki was decidedly more informed and credible on this topic than the last one on which I saw her opine on CNBC.

Together, though, the various pundits shed no real new light on the existing gulf between the NYSE human, stock-specific 'circuit breakers,' and the NASDAQ's lack of human intervention. It doesn't take a genius to realize that if one exchange, with most of the liquidity, takes "breaks" at its own discretion, while other markets trade on, then discontinuities are going to occur. Nobody has yet provided justification for breaking those NASDAQ trades. And there are none. If you elected to trade during a market downdraft, you should get that for which you asked. The arbitrary trade-breaking after the fact is unconscionable. No matter that the NYSE, which caused the problem, is finger-pointing at the NASDAQ for breaking trades.

At this point, you can assail Congress and the SEC for allowing this situation to even occur.

But the real news is the spectacular rebound of the S&P, up to 1155 in pre-trading futures at 9:20, on the strength of the ECB bailout of the Euro and all the potential Eurozone countries requiring help.

The US equities market will no doubt open on an upward tear for the morning.

Of course, the longer term consequences of the ECB $1T bailout fund is much more sobering, and hardly cause for this bounce.

First, the ECB isn't the Fed. Europe's economy isn't the same as the US economy.

Just where is the value to be found underpinning this sudden materialization of one trillion Euros?

Sure, we hear that there will be Euro-quantitative easing, just like in the US in late 2008. Greek bonds are trading up and spreads are down.

Everyone feels that the bottom has been put in, once again, by a financial regulatory authority.

Hooray!

Where is all this money actually coming from? Is it real, or just a printed, time-shifted value play by sovereign governments, and their agents, to cover sovereign shortfalls for a few years?

By the way, in case you hadn't noticed, between the IMF and the Fed's own promise to join the party on quantitative easing, this means the US sovereign balance sheet, already stuffed with subprime mortgages and other financial toxic waste, is going to get some more.

Funny, weren't we just debating how overstretched the US balance sheet is? How much debt we'e created and excess money we've printed?

Maybe investor confidence has returned relative to last Thursday and Friday, which, together, accounted for a loss of 4.7% on the S&P.

Can it last?

Already this morning, before the open, many pundits were looking to today's close and warning of a false rally and more equity declines ahead.