KKR Demonstrates Why Public Banks Don't Need Capital

Thursday's Wall Street Journal carried a detailed piece on KKR's preparation for a larger, broader role in the financial services sector.

For now, according to the article, the firm is adding syndication of its own investment assets and infrastructure finance as new businesses.

Whether the private equity shop actually goes public seems less material to me than that they demonstrate what I contended in this recent post.

Why should we think KKR will stop with these few new businesses? Once they build a larger infrastructure to manage a broader range of financial units, can basic loans, various types of equity underwriting, and asset management be far behind?

Having moved to wean itself from the simple leverage buyouts for which KKR became famous in the 1980s, there wouldn't seem to be a natural stopping point.

Of course, with each new business will come some more watering-down of returns, competition for capital and expense dollars, more resources spent managing the internal efforts of the businesses, etc. Which will gradually mean lower returns on a larger income stream for partners.

But in the meantime, wouldn't it make more sense for KKR to just hire the necessary people, raise capital and do the businesses which make sense, than to buy into badly-managed banks, commerical or investment, which are publicly-held and in bad shape?

The Mess at UBS- More of the Same

Yesterday's Wall Street Journal profiled the new chairman of UBS, Peter Kurer, and his putative "Legal To-Do list," which read,

"1. Write down more subprime sercurities by Aug. 12?

2. Turn over names of wealthy American clients.

2a. Try to limit fallout at private bank.

3. Defend bank against Massachusetts acution-rate fraud claims.

4. Split the bank in two?

5. Find four new board members.

6. Mollify activist investor Lugman Arnold.

7. Find time to complete strategic review by Oct. 2."

This bank is a mess!

I had forgotten the totality of its trouble.

The lawsuit regarding alleged tax evasion by American private banking clients. The auction-rate securities fraud case. And the end result of UBS's split over valuation of the same subprime CDOs for itself and customers.

The irony, though, is that, when you look at a five year chart of UBS compared to the major US commercial banks- BofA, Wachovia, Chase and Citi, plus the S&P500 Index- it just looks like one of the bunch.

Because I don't regularly follow UBS, it being a Swiss-based bank, I didn't realize how badly it had slipped, to the point of easily being confused, on a performance basis, for a large, mediocre bank.

In fact, it's right with the four large US banks on five-year price performance, just behind Chase. UBS actually outperformed the index and the other banks for 2005-06, but then the seeds of trouble sown then began to sprout, and it nosedived like the other banks over the past 18 months.

The next Yahoo-sourced chart shows the same players over the last two years.

In this timeframe, UBS is squarely in the middle of its fellow large banks, plummeting disastrously to lose more than 60% of its value in two years.

And, now, beyond the operating issues of the subprime assets, auction-rate securities mess, and tax evasion matters, it has to fix its own management and strategy.

With a new leader.

I guess maybe the good news is that it's clearly not just US banks that have performed so badly and gotten risk management so wrong in the past half-decade.

About Those Credit Default Swaps Prices....

A recent Wall Street Journal article bemoaned the high price of MBIA and GM credit default swaps.

As if, somehow, the world was coming to an end because holders of debt of these two antiquated, flawed companies were paying up for default protection. And that maybe this suggested an overall continuing credit crisis.

It doesn't.

These prices ought to be higher now. Both firms are clearly in danger of bankruptcy, not to mention it's unclear that either is any longer needed in the US economy.

Other than the usual Congressional suspects, and the local economies around their production facilities, would anyone really miss GM if it just died? The market share will be filled in by some other auto maker, meaning replacement jobs and facilities. Only, this time, they might be ones with prospects for growth, rather than fear of how much they'll be shrinking due to CEO Wagoner's continuing inept management of the firm.

As for MBIA, it probably has a very small footprint, economically. As Doug Dachille noted on CNBC some months ago, the model for bond insurance is no longer viable. Between better information access and fully-priced risks in the underlying instruments, the kind of 'guarantee' that MBIA and its ilk offer is simply worth less today, if its even credible.

Plus, the industry didn't help itself by plunging into a risky area, mortgages, to try to stoke growth, as I noted in this post.

Sometimes it seems like the sky is falling, when, in reality, it's just a small piece of it.

Why don't people just let go and acknowledge that companies die. They sometimes lose their reason for being. Their approach to the market is wrong and out of date. They have become irrelevant.

Currently, it looks as if the bond insurers and America's poorly-run, largest automaker, GM, are either already there, or very close.

But that doesn't mean the entire financial market, nor the economy, is in crisis.

It's Official.....Time To Go Short!!!!

I am very, very sorry to note that my proprietary equity allocation signal has finally gone to "short" for the first time since 2001.

Believe it or not, even January's rollercoaster ride and March's collapse didn't trigger it. Almost, but the April bounce lifted the S&P just enough to keep us long for a while.

For my partner and I, now, that means calls rather than puts, since we have moved on from straight equities. But the message from the underlying equity markets is still important, and not to be taken lightly.

June's S&P return of at best -9%, on first glance using a simple Yahoo-sourced price difference, is the worst in ages, and sends my proprietary market turbulence/allocation signal firmly into short/put territory.

It will take at least a +3% July S&P return to reverse this, based on my tools.

I don't predict the S&P, and I don't market time. My tools are more like hurricane warnings than daily weather forecasts. And right now, I'd be boarding up the windows and filling the bathtub with water. At least for the next few weeks.

More as conditions develop later this month. But for now, we are almost certainly going to be buying puts next week, when end-of-June Compustat data arrives to drive July selections and weights.

Why Should Private Equity Invest In US Commercial Banks?

There has been a lot of ink spilled recently on how the Fed and other related US bank regulators need to adapt various rules so that "private equity" can rescue crippled commercial banks by supplying new capital, but without the onerous current restrictions.

The Wall Street Journal devoted a front page piece to the topic on Friday, and gave space to two Carlyle group directors to opine on the same topic Thursday.

I think this concern over how to allow private equity to invest in commercial banks is misplaced. It's entirely the wrong solution.

Let's understand what the current situation among large commercial- BofA, Citi, Wachovia, Chase- and three of the four large public investment banks- Merrill, Morgan Stanley and Lehman- really mean.

These financial institutions committed grave and expensive errors of risk management and timing of investments and trades, resulting in very large and continuing losses. These operating losses, realized in ever-more regular fashion, have depleted capital among these eight large publicly-held US financial institutions.

Don't such losses imply excess capacity in the sector, which led to injudicious, risky behavior on the part of the competitors?

Isn't the obvious solution to consolidate the sector's participants? How much loan origination, underwriting and trading capacity do we really need? Surely not so much that it goes off in search of bad deals and blows holes in the balance sheets of the sector's competitors.

In fact, if/once you fence off simple deposit-taking activities, which are federally insured, all other banking businesses are quite competitive and, thus, subject to cyclical losses.

What we're seeing now is not really anything new, but, rather, a confluence of several bad financial bets by these large banks at once. Combining overly-aggressive mortgage financing with securitization resulted in them messing up both a real economic sector- housing- and the entire financial sector with it.

The result has been material losses of shareholder capital from these boneheaded moves on the part of the eight large firms mentioned above, plus, of course, the now-dead Bear Stearns.

But that's no reason to lament the availability of capital for publicly-held financial institutions.

You can bet your bottom dollar that private equity shops only want in because they think there will be a feast as economic and financial conditions recover, and probably a few regulatory sweeteners tossed in for good measure.

But why worry about the temporarily shrinking capacity of US commercial and investment banks? If private capital can buy into these institutions, to filter their capital into loans, etc., why can't they just enter the businesses directly?

Private equity shops could, if they chose, hire commercial and personal loan employees from publicly-held banks and go forward with their own fresh capital, replacing the questionable business practices and judgments of the commercial and investment banks.

Why throw good money after bad, and into the hands of inept CEOs and senior managements at the existing eight large commercial and investment banks?

I don't see a crisis here at all. In fact, I don't see a need for any regulatory intervention whatsoever. What I see is a need for mergers of weak commercial and investment banks. Or maybe just the death of the worst-performers.

There's nothing wrong with the financial sector that segregating deposit-taking and then allowing mergers of weak institutions won't fix. With less taxpayer 'help' and modification of regulations.

But letting private equity into the picture is just mistaken. Those guys are smart enough to just take on the businesses and do it themselves. They don't need to be buying into the management of inept commercial and investment banks.

Angelo Mozillo's Corporate Conduct

Back in the spring and summer of last year, Angelo Mozillo made several appearances on CNBC's morning program. At the time, he was viewed as a dynamic, informed and successful architect of the nation's largest independent mortgage lender.

The twenty-year price chart of Countrywide and the S&P500 Index nearby displays how well Mozillo managed to consistently create value for his shareholders during many of these years.

However, upon learning recently that he had formed a special "Friends of Angelo" group of influential industry executives and Senate members for whom he arranged sweetheart loans, my opinion of Mozillo has declined considerably.

The knowledge that past heads of Fannie Mae, as well as Democratic Senators Chris Dodd and Kent Conrad all knowingly received preferential loan terms from Mozillo's company clearly shows that the lender's CEO didn't want to leave his firm's fortunes to chance anymore.

He evidently bought Fannie Mae's allegiance to Countrywide, and its acceptance of the private-sector lender's low- and no-doc loans with bribes to the quasi-government loan packaging entity.

In the case of Senators Dodd and Conrad, Mozillo took care to buy the consent of two members of a key oversight committee to Countrywide's practices during the mortgage lending boom, and, even now, to the bailout of its worst loans during these challenging times for the industry.

It's hard to now view Mozillo as simply a hardworking CEO who built his firm from scratch and ran afoul of tough market conditions.

It's evident now that Mozillo must have known his firm was stoking growth via 'innovative,' a/k/a risky loans, for which he needed to grease some important institutional buyers and Senatorial overseers.

At this point, I hope Mozillo is charged with, and serves prison time for his actions. What he did, based on recently-disclosed evidence, is nothing less than bribery of business associates and government officials. I hope the executives and government office-holders who took the bribes, including Dodd, Conrad and Fannie Mae executives, are also charged, convicted and sentenced to serious hard time in prison for their misdeeds.

Ordinarily, I'm all for the market dispensing justice. But in this case, it appears Mozillo went far beyond what was ethical and legal in his operation of Countrywide. I hope he and those who collaborated with him all suffer for their betrayal of shareholder and public trust.

The Buschs' Shameful Behavior

Annheuser-Busch's and its CEO, August Busch IV's responses to InBev's offer to buy the firm and reward the American brewer's shareholders more richly than the current management has been able to do, have been disappointing and shameful.

Predictable, but disappointing.

Not only has the Busch family dug in its heels to claim the right to continue to impoverish their shareholders, as I noted in this recent post, but they have recruited various local government officials to aid them in this disgusting enterprise.

I've written more on the sorry Busch saga here and here. Holman Jenkins, Jr., of the Wall Street Journal, wrote an entertaining piece last week lampooning the Busch family's attempt to screw shareholders of the firm the family founded, but sold to the public years ago.

Wouldn't you like to see, just once, a family-founded firm which has gone public do the right thing for shareholders?

Oh, wait. One did. Bill Wrigley!

I suppose it's way too much to hope that August Busch IV would ever take inspiration from Wrigley and do the right thing for his shareholders, isn't it?

Steve Ballmer's Idiocy- "Pondering Change" at Microsoft

Friday's Wall Street Journal ran a rather curious article concerning Microsoft, entitled "Ballmer Ponders Changes at Microsoft."

The piece begins,

"As Bill Gates ends three decades in Microsoft Corp.'s top management, Chief Executive Steve Ballmer faces a major question: How do you make a 100,000-employee software giant much more agile?

There are no easy answers. But in a memo last summer to his top lieutenants, Mr. Ballmer drew lessons from two other U.S. business icons -- Wal-Mart Stores Inc., known for the central management of its retail outlets, and General Electric Co., known for businesses that operate autonomously. His conclusion: Microsoft needs more elements of both."

This is a joke. Ballmer is a pompous fool.

The nearby Yahoo-sourced price chart for Microsoft and the S&P500 Index tell a very clear story.

After an astounding performance for shareholders from its IPO in 1986 to 2000, the company has simply declined, then stalled for the last eight years.

Eight years.

Isn't it a little late for Ballmer to wonder what's gone wrong? Where were he and Bill in, oh, say 2002? After the stock price was falling through the floor much faster than the index.

The Journal article continues by noting,

"At the center of Mr. Ballmer's dilemma is ongoing tension over whether Microsoft's huge business divisions should have wide freedom to set their own course -- or be more centrally planned, a strategy that could meld expertise across the company in ways that provide an advantage over rivals with narrower technology portfolios. In the memo, according to Microsoft executives, Mr. Ballmer cites lessons from both the Wal-Mart and GE experiences.

"We're not a conglomerate, but we're not a monolithic operating company," Mr. Ballmer said in a recent interview. "The question is, 'are we always hitting the right balance?'" "

Let's humor Mr. Ballmer. After all, did he not also leave Harvard prior to completing his degree? No matter. Neither he, nor Gates have any sort of disciplined management education, and it shows in the way their company simply stopped performing after 15 years.

Here's another Yahoo-sourced price chart. This time, it depicts the past five year performances of Microsoft, the S&P500 Index, and Ballmer's choice of role models, Wal-Mart and GE.

It's just pathetic, isn't it? Not one of the three firms has managed to outperform the index at all for five years, nevermind doing it consistently.

Give Ballmer credit for knowing how to choose two other turkeys with which to compare his company.

I'm not going to go searching for contrary examples, but I think we all know that Google looks a hell of a lot better than any of these three firms.

My point is, Ballmer is missing the point!

As recently as in this post from earlier this month, I again called for Microsoft's breakup, as I first did in May of 2006. You can read through the many posts I've written about Microsoft to see how I have argued for its divestiture of the company's operations into four independent businesses: operating systems, desktop applications, online, and gaming.

GE has the same problems, and has been under fire for over a year now to be broken up, too. My posts on GE are now somewhat well-known for this view, only way before it became popular last year.

Wal-Mart is simply a retailer which has pretty much saturated its primary markets, and failed in its attempt to move upmarket. It is only doing better lately as the recent slowing of economic growth has brought some of its former customers back from stores like Target and Kohls.

However, the key point is that Ballmer chose, for companies to emulate, two other losers.

If that doesn't tell you all you need to know about Ballmer's and Microsoft's probable future performance, I don't know what else will.

GM vs. Toyota

Nearly three years ago, I wrote this post as one of my first on this blog.

Entitled "Queens of Denial," the post contained this passage,

"I’ve done quite a bit of research on drivers of consistently superior company performances, looking over long timeframes among many large-cap companies. The very best companies consistently grow revenues at high rates. This typically involves both repurchases by customers, as well as an ability to sustain price levels. This type of customer behavior, repurchasing and paying full price, is usually seen when a company adapts its offerings to evolving customer needs over time in a competitively-advantaged manner.

GM and Ford don’t appear to be able to do either one. That’s their real problem. Failure to solve this problem will overwhelm the resolution of any of their other apparent problems, including those involving workforce healthcare.

Judging from where GM and Ford appear to be putting much of their energies these days, I’d say we’re going to be shy at least one major US-based car manufacturer before the decade is out."

Tuesday's Wall Street Journal article concerning Toyota's imminent dethroning of the once-vaunted GM as the largest vehicle seller in the US merely adds more evidence to my point.

But the really stunning information in the article which caught the attention of both my partner and me was this: GM's market value now stands at about $8B, while Toyota's is $154B.

That's nearly a 20x difference.

The nearby Yahoo-sourced price chart for Toyota, Ford, GM and the S&P500 Index tell a pretty clear story.

Since 1993, when, I'm guessing, Toyota was traded publicly in the US, the Japanese-based automaker has never really underperformed its American counterparts.

Since as far back as the late 1990s both Ford and GM have been on a downward drift, first flattening before gently sliding below their initial value early in the decade.

For an automaker, Toyota has actually done well, matching the S&P over nearly the entire period.

Looking more closely at the last two years, the same information shows that all three companies tracked the index closely until late last year. After a brief rise, GM began to slide severely, while Ford maintained its momentum with the index until its recent surprise announcement of unexpectedly low sales.

Zooming in on the last year, however, we see that GM really has deteriorated more rapidly and severely than Ford, while Toyota, while underperforming the S&P, has had a much milder decline of only -20%.

By contrast, Ford lost 40% of its market value in the last twelve months, while GM has now plunged by more than 60% in market value.

No wonder a recent stock price chart for GM on CNBC showed the current price below that of the late 1950s.

The Yahoo equivalent chart only goes back to 1962, but that is, sadly, sufficient time to show the same picture.

GM CEO Rick Wagoner has now taken shareholders back to a time when John Kennedy was still alive. All of the value (less dividends) created in the intervening 40+ years has been wiped out by Wagoner and his team of inept executives.

It's no wonder, with an eight-year decline in stock price, that the forward value ascribed by investors to GM is only 5% of that of Toyota.

That's a startling expression of the same information which I cited earlier from the Journal article. But that's what the numbers mean.

A stunning commentary on the total failure of the management of America's largest automaker in under a decade.

Is it any wonder that I believe GM is finally on the edge of death? Even my foreign exchange trading friend whom I mentioned in this recent post agreed that while Ford might survive, GM is likely to die before the economy recovers, barring some stupid political intervention.

GE's Continuing Woes

Judging by this morning's Wall Street Journal article, Jeff Immelt and GE just can't catch a break these days.

It's not enough that Bill O'Reilly's Fox News Factor program bashed Immelt and GE yet again last night. It's become an almost twice-monthly event now, since he first did it in April, when I appeared as O'Reilly's guest to discuss Immelt's awful performance leading GE since late 2001.

The nearby Yahoo-sourced five year performance chart of GE and the S&P500 Index continues to show the diversified industrial giant struggling to even match the market index. And it's only gotten worse in the past two months.

Now it appears that Immelt can't even sell GE's private label credit card business.

It seems, believe it or not, that when you want to unload a turkey, other people actually notice and shy away.

Imagine that! Didn't Immelt and his minions figure other business people can do the math, too, on GE's card portfolio's weak returns?

According to the Journal article, GE, which does a lot of card issuance and processing for so-called private label accounts, runs a card business which is riskier and less profitable than the average major bankcard- Visa and Mastercard- business at a large commercial bank.

These days, your local department store or big box chain's credit card is, in all probability, actually outsourced to GE for the operation of the program.

What I find, well, arrogant, is that the senior guys at GE, including Immelt, think that they can just nonchalantly dump their mediocre card business onto some other company- preferably a bank- and the buyer won't notice the portfolio's problems.

The Journal article notes that Chase and other commercial banks have now retreated from considering the purchase of GE's business.

It's one thing when you have a rare crown jewel in your company, or a well-performing misfit with the rest of your business portfolio, and you expect to get some interest from prospective buyers when you want to sell the business.

In this case, however, GE is trying to peddle an also-ran credit card business as the whole sector is experiencing rising chargeoffs.

These guys at GE just don't get it, do they? Not only are they not the smartest guys in the room. Everyone else is not just stupid, either.

How much longer will GE's board put up with Immelt's follies? Probably a long time. But shareholders can sell now, and contribute to a further slide in the company's stock price and total returns.

George Soros' World-Class Ego

This past weekend's Wall Street Journal edition carried a piece on George Soros' latest warning- an asset 'superbubble.'

Like Julian Robertson and Michael Steinhardt, George Soros seems to get lavish attention long after his period of successful trading, or investing, if you prefer, has ended.

The Journal article notes that Soros made large fortunes in 1992 and 1997 by betting, respectively, against the pound and the bhat. While never proven, rumors have always swirled around Soros concerning whether or not he was the recipient of insider leaks about the British financial authority's intentions regarding the pound.

Now, writes Greg Ip, Soros,

"wants to be remembered most as a philosopher. Since he was a student in 1952, he has been promoting his economic theory, which he calls 'reflexivity.'

In essence, he argues that markets don't simply reflect fundamental determinants but can change those determinants in a way that causes asset prices to go to extremes. In his latest book, "The New Paradigm for Financial Markets," he argues a "superbubble" has developed in the past 25 years and it is now collapsing."

Ip notes that Soros' predictions have routinely falled wide of the mark. He prematurely sounded the death of the US dollar in 1987, yet neither the world-wide depression, nor global conflict of which he warned have arrived. In 1998, he claimed that

"The global capitalist system....is coming apart at the seams."

Actually, it would seem that in the decade since Soros wrote that somber prediction, global capitalism has contributed to more trade, wealth creation and freedom than ever before in man's history.

Believe it or not, Soros actually alleges that, because in the story about 'the boy who cried wolf,' the wolf really arrived after three warnings, his three most recent books warning of global economic catastrophe mean he is now probably correct.

I'm serious. Greg Ip's piece quotes that comparison by Soros. You cannot make up stories this silly.

To prove how important his ideas are, Soros notes,

"The most popular reaction to my philosophy is....success has gone to his head and he wants to be more than what he is....But I would like my ideas to be judged on their own merit. I think I'm on the verge. For the first time, this book is a best seller. I was asked to testify (before the Senate Commerce Committee) because a staff member read the book."

Well, if I told George Soros that I happened to see a copy of his book in the garbage, would he promptly declare it to be garbage, too?

If he seriously believes that because some no-name staffer to some Senatorial windbag read his book, it now is important, his long-ago success has gone to his head.

I laughed when I read the next passage, where Soros answers Ip's question about whether policy or academic heavyweights are noticing his ideas,

"It has certainly not penetrated academia, and not policy makers, either. I wish I could engage in a discussion with (the Federal Reserve). I'm waiting for a phone call. I'm (meeting with) Alan Greenspan."

These days, I don't think Greenspan's such a hot economic ticket, George.

At the end of Ip's piece, he quotes Soros actually saying something interesting,

"This is, of course, [Joseph] Schumpeter's creative destruction idea. However ... going overboard in generating change is not necessarily a good thing. Financial innovation may not be an unmixed blessing because it really prevents proper regulation.

If you look at the 19th century, you had creative destruction going on, one financial crisis after another. But each time you had a crisis, you had an examination of what went wrong, and you put in some instrument or some institution to prevent it from happening.

I'm not advocating ... central planning because that's worse than markets. But the regulators need to learn from the mistakes that they have made. I think it's pretty clear that you've got to accept responsibility for moderating asset bubbles. ... That involves regulating credit as well as [interest rates]."

It's not clear what Soros is actually saying here beyond the existing awareness that some regulation of financial services is a beneficial activity. He does not speak to the perennial difficulty of staffing such governmental entities with employees who are as motivated and intelligent as those whom they would regulate.

Perhaps what would satisfy Soros, and it would satisfy me, is to regulate certain classes of financial services activities, such as insured deposit-taking, residential mortgage, consumer and conventional business lending, and transactions processing, very strictly and heavily, so as to safeguard these core economic activities.

Non-commercial banking practices involving riskier investments will always be subject to loss of capital and liquidity risks, to name just two. It's unclear how much regulation can function effectively, other than to try to herd over the counter markets, such as swaps, into exchanges. The Treasury, under Paulson, is already headed that way.

As I wrote here a while ago, in response to Henry Kaufman's tirade against financial innovation, I think, over time, we've been far better served by the phenomenon than we've been hurt by it.

I think Soros' thinking here is muddled, if it's anything relevant at all.

Why does anyone pay attention to him? Because, I guess, like Robertson and Steinhardt, once, years ago, in different market conditions, George Soros made a lot of money. And even he confirms it was due in no small measure to luck.

So on this basis, we should all listen to his personal crackpot theory of 'reflexivity?'

God help us if that's what we've sunk to in the US.

Current Market Signals

Things sure have changed in the equity markets since March.

Back in the final weeks of that month, as the Fed opened the discount window to investment banks and assisted in the retention of trades on the books of the failing Bear Stearns, my partner and I saw signals that the worst of the equity and options markets for long positions was over. The Fed, as my partner put it, was not going to allow money to be made on the short side anymore.

At that time, the risk was to the financial services sector and, it was believed, the credit markets in general.

We carefully monitored our new signaling/risk management tools and bought calls in April and May. By June, we again bought calls, but with a sense that maybe we should have straddled.

We were right.

In just two months' time, we sold call options with returns of over 150%, and roughly 50% on the April portfolios. May's options were less profitable, but still returned positive results, with one call exercised for a very significant return.

Now our signals look very similar to those of both December and March. Our S&P-based volatility measure has risen significantly to levels near that of mid-March, while the S&P returns in trailing months has been dropping.

Without divulging our specific proprietary measures, this combination is a lethal one for equities.

What has stunned my partner and me is that we don't really think there has been much in the way of new, fresh, bad economic news. But the business media and political machines of both parties seem to be dwelling on the worst economic and sentiment measures they can find.

Housing is compared to the Great Depression, as is joblessness, though both are wrong.

Energy producers are maligned, as are derivatives markets investors who provide liquidity and price discovery services to energy futures markets.

Now, they are labelled 'profiteers' and 'speculators.' Talk of windfall profit taxes and stiffer regulation or prohibition of 'speculation' is rampant among our King Canutes in Congress.

In fact, I don't think economic measures have declined as precipitously as the S&P and its futures have. Perhaps the one new development is more awareness of higher, if not crippling, inflation, and a potential rise in the Fed rate sometime in the next few months.

But these two factors alone seem to be offsetting the less-than-catastrophic business and economic news occurring recently.

Back in April, I thought we had a good 4-5 months of call options portfolios before we had to worry about weakening markets.

Instead, in only six weeks, we're somewhere between neutral and short in our evolving outlook for equity allocations in the next month.

You Read It Hear First...... Reuniting Commercial & Investment Banks

Late in March, I wrote this post concerning the ultimate result of the Fed's decision to open the discount window to investment banks. In that post, I wrote,

"Looking beyond simply Bear Stearns, can anyone truly justify the existence of all four of Goldman Sachs, Merrill, Lehman and Morgan Stanley? Especially in the modern world of large private equity firms and hedge funds? The former provide additional underwriting, M&A advisory and asset management, while the latter focus on providing trading capacity and investment management.

Other than emotional reaction of former employees seeing their old firm's name vanish, what would be different if one or more of those names were bought by or merged with a commercial bank?

Contrary to Andy Kessler's view, in the Wall Street Journal this past January, about which I wrote here, it's unlikely now that an investment bank will do the buying. With their high leverage and dependence upon commercial banks for funding, I suspect the investment banks are the more vulnerable. Now having access to the Fed discount window, it's only a matter of time before the regulators get around to levying a new regulatory framework on the investment banks."

In today's Wall Street Journal, Dennis Berman writes, in an article entitled, "Maybe It's Time To Put the Banks And Wall Street Dealers Back Together,"

"Speculation has in recent weeks mounted that one of the Street's brokers may even buy a commercial bank. Whether true, the rumors speak to three deep changes under way.
First, looming Federal Reserve assistance and regulation could force brokers to keep reserve ratios similar to that of deposit-taking banks. Second, short-term bank funding now is regarded with suspicion. It is capable of being yanked at a moment's notice, sending a bank such as Bear Stearns to the brink of bankruptcy (it is now part of J.P. Morgan Chase). Third, the securitization markets also have contracted, which is in turn forcing the investment banks to shrink their balance sheets.

In theory, these problems are all solved by putting a large, plodding typical bank -- with stable deposits and returns -- next to the more-speculative realms of investment banking and trading.
Citigroup, the prime "universal bank" sounded good in theory, too. It has performed miserably since its creation after Congress rolled back the Depression-era limits a decade ago. That misses the relative success of J.P. Morgan Chase and Bank of America, the country's two other big universals."

I'd disagree with Berman's evaluation of Chase's and BofA's 'relative success,' as I described the entire publicly-held financial sector's woeful performance in yesterday's post.

But Berman has finally arrived at the same conclusion I did last three months ago. He further observes,

"Three or four years out, the investment-banking model is coming to an end," says Brian J. Sterling, co-head of investment banking for boutique adviser Sandler O'Neill & Partners. "If it walks like a bank and quacks like a bank, it's going to have capital ratios like a bank." "

No argument from me. In fact, I concluded that March post with these thoughts,

"A natural consequence to this will probably be even more smart financial services people migrating back to the privately-financed arena. Just like consumer goods merchandising has the 'wheel of retailing,' whereby new entrants compete at the low-cost end of the market, as existing players migrate upwards in terms of quality, service, selection and price, so, too, it seems, will financial services now have its own version of this 'wheel.'

Only in financial services, the 'wheel' is between publicly- and privately-held concentrations of capital and risk management. Again, viewed from afar over decades, the story of commercial and investment banking for the past forty years has been a gradual selling of transactions, asset and risk management businesses at their 'tops,' as formerly-private banks of both stripes went public, followed by managerial ineptitude, decline in risk management, and excesses in pursuit of growth via more risk.

Now that the public is absorbing the brunt of the losses, via equity ownership of these firms, the logical next step is for the better executives to join the early-adopters in forming new, or joining existing private equity and hedge fund shops."

It seems nearly everybody missed the real event of late March. It wasn't helping Bear Stearns avoid the unraveling of its entire book of credit default positions. It was the opening of the Fed window to investment banks, and the inevitable changes in regulation and/or capitalization requirements that will follow.

Yes, you read it here first. Three months ago.

On The US Financial Service Sector

I ran into an old friend this weekend who works as a senior foreign exchange trader at one of the larger NYC commercial banks.

This particular trader is very common-sensible and experienced, both in trading and banking. Conversations with him are always a pleasure.

After discussing the volatility in the currency and energy equity markets, he asked what I thought about financial service equities.

When I related the opinions contained in these recent posts about commercial and investment banks- here, here, here and here- he readily agreed.

Furthermore, he concurred with me that among investment banks, there only seems to be sufficient talent and cultural maturity to staff one successful publicly-held investment bank, i.e., Goldman Sachs. Other than that, he agreed that private equity and hedge funds employ the next-best non-commercial bankers, with the other, smaller three investment banks- Merrill, Lehman and Morgan Stanley- now populated by also-rans.

The nearby Yahoo-sourced price chart for Goldman, Merrill, Morgan Stanley and Lehman clearly shows that only the first one has outperformed the S&P500 Index over the past five years. And even Goldman hasn't done that consistently.

On the commercial banking side, my friend prophesied dismal prospects for growth on the order of perhaps 5% per annum, like a bond return. In this, he shares the view of my friend B and me that the largest US commercial banks are now so large as to prohibit effective management of both risk and growth.

Again, the nearby five year Yahoo-sourced price chart shows that Chase, BofA, Wachovia and Citi have all underperformed the Index for the past five year period.

As I told my friend, I wouldn't hold any financial services equity right now. Or, perhaps better put, I don't see my quantitative equity selection process producing any financial service equities anytime soon. I suppose it's technically possible, but, given these charts, barely.

I sure hope so.

Robert Mundell's Nobel-Quality Economic Insights

Economic Nobel Laureate Robert Mundell's interview with Kyle Wingfield of the Wall Street Journal appeared in the weekend edition of that publication.


What ought to concentrate the mind of any business person wonderfully is Mundell's clear, explicit assertion that the failure to make the Bush tax cuts permanent will push the US "into a big recession, a nosedive."

Mundell continued,

"This would be devastating to the world economy, to the United States, and it would be, I think, political suicide."

The economist opined that his own view of the best corporate tax rate is that it be set at 25%.

On the seemingly-endlessly debated topic of whether we are currently at risk of a new round of serious stagflation, Wingfield relates,

"With prices again rising as growth slows, some economists are worried that stagflation could be making a comeback. Not Mr. Mundell- not yet.

He draws a comparison with the situation in 1979-1980. Start with the dollar price of oil, which he calls "one of the two most important prices in the world" (the other being the dollar-euro exchange rate).

"If you look at the price level since 1980," he begins, "oil prices would naturally double by the year 2000. So from $34 a barrel in 1980 to $68 a barrel. And then...because the inflation rate's about 3.5%, it would double again by 2020. So the natural price...would be something like $136 in2020.

"Now, we already got to $130-something, but...I really think the price is going to settle down, probably below $100, if not below $90. What I'm saying is we're not so far off track."

"The price of gold in 1980 was $850 an ounce. And the price of gold today is about the same. It's astonishing," he says. "It's true, gold did go up" to more than $1,000 an ounce earlier this year, "but the public doesn't believe that there is inflation. If there was big inflation coming, then you'd see the price of gold going up to $1,500 an ounce very quickly, and that hasn't happened."

I found Mundell's opinions to be both reassuring and troubling. Reassuring that gold prices indicate we are not necessarily in for a serious, long-term bout of inflation.

Troubling about the absolute necessity of making Bush's tax cuts permanent. McCain wants to do so, but doesn't really prostyletize that convincingly. We know Obama wants to run the other way and raise taxes everywhere possible.

At least I can take comfort in the likelihood, per Brian Wesbury's observations about political gaffes being punished in internet time now, in this post, that if Obama is elected, and he conspires with Congress to raise taxes, that mistake should be rectified at the ballot box in, first, two years, then four.

It took a Carter to bring us Reagan. We may have to suffer through Obama to revitalize our economy, in terms of lower tax rates and government spending, with another fiscally conservative President, regardless of his party.

The New Socialism

Missouri Democratic Senator Claire McCaskill is busy abrogating the rights of shareholders of Anheuser-Busch this week.

As I wrote in these recent posts, here and here, Busch would do their shareholders a favor by selling to InBev.

Now, McCaskill is weighing in to try to block any purchase of the ailing, underperforming brewer by the international beer giant.

Is this a member of the same US Senate that squawks about shareholder democracy and voting on CEO compensation?

So it's okay to strip shareholders of their right to a better return by selling the company to an acquirer offering a higher price than the inept Busch family can deliver. That, evidently, is not abrogating shareholder democracy principles.

Sounds like another bout of federal government socialism to me. Of course what McCaskill really wants is to preserve jobs in St. Louis, no matter how that affects the actual owners of the Anheuser-Busch company.

Yesterday, on Fox News, I saw an interview with a Democratic House member from New York who actually called for all US oil refineries to be nationalized, so that,

'the people of America can decide how much gasoline they want to produce.'

Can it get any scarier than that?

At a time of US recovery from financial excesses in the mortgage market- which, we now learn, was abetted by the apparent bribery of Democratic Senators Dodd and Conrad by Angelo Mozillo of Countrywide- and a softening of growth, why does anyone think that bureaucratic functionaries and politicians in Washington know anything more about how to run businesses, create jobs and/or wealth than the millions of Americans who actually do that everyday throughout the country?

From the Senate witch hunt among the American oil company CEOs to their desire to bail out the very mortgage companies who bribed Senators, with taxpayer money, it seems that we are suddenly in the grip of a big wave of socialism in our federal government.

Hopefully, American business will survive this round of flirtations with the creeping socialism of our economy, but I'm getting worried.

About Oil, Futures, Governmental Mandates & Speculation

It's a strange month when Fox News' Bill O'Reilly and uber-liberal Illinois Democratic Senator Dick Durbin agree on something- anything.


This month, both of them have called for the severe restraint of, if not total prohibition against, investor trading in oil commodity futures.


Durbin wants trading in oil futures curtailed so that if you buy oil on the open market, you must take physical delivery. O'Reilly calls for substantially higher margins to be put down on oil future trading.

Both accuse 'speculators' of driving the price of oil up to the $130 neighborhood. I don't know what Durbin's estimate is, but O'Reilly makes a big deal out of the cost of oil when pumped out of the Arabian peninsular sands, and alleges that most of the rest of the price of a barrel of oil is what 'OPEC charges.' Further, he calls for governmental mandates to force American automakers to produce a certain amount of flex-fuel vehicles.

I like a lot about O'Reilly, but I don't agree with him on this issue.


First, I don't think the current price of oil is being manipulated by a group of speculating investors. Rather, it's the natural result of oil refiners gradually tightening capacity to match demand, after decades of losing money on the downstream business due to grossly excess capacity.


Second, OPEC does not 'charge' a price. Oil is bought and sold in competitive financial markets. It's the right of the owner of a non-renewable commodity to decide how much of it they will sell at what price they take. O'Reilly is wrong to castigate those owners of petroleum for exercising their right to decide how much to sell.


Third, if oil prices were being manipulated artificially by speculators, I would expect to see a lot of selling of oil futures by large hedge funds. Contrary to what a friend in institutional money management alleges about banks not extending credit to short sellers, those shorting equities don't need loans. And derivatives aren't equities. They dwarf the equity markets in terms of commodities.


It bothers me that both Durbin and O'Reilly demonize American oil companies as if they should be punished for doing well for their shareholders in a world in which they are slowly being squeezed out of ownership of the resource they refine.


As to governmental mandates for building flex-fuel vehicles, that's nonsense. Washington's artificial 'fuel economy standards' have put the American automakers in the poor house by forcing them to pump out cheap, unprofitable, largely-unwanted small cars to offset sales of the SUVs and pickups that Americans actually bought. Requiring flex-fuel cars will just do more of the same.


If Americans want flex-fuel cars at prices that Detroit can build them, they'll sell. As Dick Armey notes, whenever government mandates something, it means the public won't buy it any other way.


Both Durbin and O'Reilly are mistaken, in my opinion, in their rush to legislate large-scale governmental mandates to what is a passing economic situation. Do they both really believe some governmental functionaries will do a better job than American entrepreneurs and businessmen motivated by profit?

I can believe that Durbin really believes they will, but I think O'Reilly has just temporarily let his anger overrule his common sense.

All we will get out of governmental interference will be predictable graft, corruption, and favoritism of selected businesses by civil servants, instead of truly market-tested solutions to energy challenges.

My Saga of Ken Lewis' Awful Retail BofA: The End

Beginning about a month ago, I wrote two posts concerning my appalling treatment at the hand of Ken Lewis' Bank of America, here and here.

Now I can write the end of that sad story of Ken Lewis' hapless, gigantic money center bank.

Having had no acceptable follow-up from any BofA employee in the wake of their unexplained loss of sensitive customer data and related issuance of new debit/ATM cards, I had proceeded to open a new account with the new branch of an old, small local commercial bank.

When I balanced my BofA account this week, there was a new $12 'monthly account maintenance fee.' That did it.

It had been my intention to retain the BofA account, in case there was a reason to switch back. But when I saw them engaging in high-handed, extraneous fee-charging, I knew I had to act fast.

The next day, I wrote a check for the bulk of the balance of my account and deposited the check in my new account at the other bank. Then I visited the local BofA branch in Summit to close my personal account there.

Upon finally catching the eye of one of the platform officers, as his loud guffaws on an obviously personal phone call filled the cavernous old 1930s, echo-chamber style marble building, I announced in a loud voice that I had come to close my account.

Amidst some discussion of account numbers, drivers license IDs, etc., he informed me that I'd have to wait until all outstanding checks had cleared. I replied that, since his bank was now charging me monthly maintenance fees, I had absolutely no intention of allowing that to happen.

He must process my request now and close the account. With a defiant look, he said he couldn't, because he didn't know how much was left in the account. I told him I had just drained most of the funds into my new account at the other bank, and he then triumphantly claimed that now he'd have to wait for that to clear, unless I happened to know the amount of the check.

"Of course I know the amount. It's $382," I calmly replied.

With a scowl, the junior bank officer turned to his screen and typed in some figures, announcing a final, cleared balance, adding,

"Of course, that's not precise. The actual number might be slightly different."

"It had better be precise," I said, "I've been a VP at Chase, so I think I know that one of the basic, core functions of a bank is to know exactly what a customer's balance is."

More scowling from the bank employee, who heatedly said,

"I don't need your attitude!"

"Would you like to call your branch manager over here now?" I coolly replied.

"That's your choice," he said.

"No, it's yours," I responded, "but I think your manager would be surprised to hear you, in his presence, repeat your statement that your bank can't give me an exact accounting of my balance in the account at your branch."

More frowns and huffy breaths. Then the officer announced a final balance, had me sign a withdrawal, and disappeared for a few minutes to retrieve my cash.

When he returned, he handed me the envelope, printed an account closing confirmation document, and wished me well.

Memo to Ken Lewis, CEO of BofA:

Ken-

Nowhere in this process did your junior bank exec in the Springfield Avenue branch of your super-giant-sized bank ever ask me why I was closing my account. Or what, if anything, he or his manager, or anyone at BofA, could do to retain my business.

Instead, your young platform officer, having been forced to end his jocular personal call to attend to my business, merely performed the account closing as efficiently as possible, even dispensing some free attitude of his own to a departing customer.

A departing customer with a brain and mouth, Ken. Who has friends in the community, Ken.

Truth is, in the weeks since my first post, I helped two other members of my fitness club decide to close their BofA accounts, too.

How easy it would have been, Ken, for your bank to have flagged my account, so that if/when I came to close it, I would have been immediately sent to the branch manager's office to discuss how your bank might retain my account and business.

That might have caused me to think your employees and, by extension, you, actually cared about my business. But you don't. And they don't.

And it shows. It showed from the first ham-handed form letter from "Gordon Rains" announcing you had probably compromised some of my personal financial information, so you needed to send me a new ATM card.

No wonder why your bank is in such trouble Ken.

Best of luck sorting out this mess. Everyone knew you were overmatched when you tried investment banking. The Countrywide debacle isn't looking so good, either, lately. All those bribes Angelo allegedly gave to his Fannie Mae and Democratic Senate friends in the form of sweetheart jumbo mortgage loans.

At least we all thought you and your crew knew how to run a simple, basic retail bank branch business.

Well, we were all wrong.

Brian Wesbury On Change In America

Last Wednesday's Wall Street Journal featured an editorial by one of my favorite economists, Brian Wesbury, entitled "Change We Can Believe In Is All Around Us."

Wesbury's piece was nearly a full half-page in the Journal, so I won't go into excruciating detail. The headline themes will suffice for my purposes.

Partway through his piece, Wesbury wrote,

"Look at the chart nearby. America's manufacturing output, as measured by the Federal Reserve, is up seven-fold since 1950, but manufacturing jobs as a share of all jobs have fallen to 10% from 30%. Your grandfather and father may have worked for General Motors (and joined the UAW), but it's likely that you don't and won't.

The problem, if it really is one, is not foreign competition or evil financiers. It is technology and productivity. In the 10 years ending in 2007, durable goods manufacturing productivity averaged an annual growth rate of 4.8%. In other words, if real growth is less than 4.8%, the sector needs fewer workers year after year.

For the economy as a whole, overall U.S. business productivity rose 2.7% at an average annual rate during the decade ending in 2007, 1.7% in the decade ending in 1997 and 1.4% in the 10 years through 1987. Change is everywhere, and it's accelerating."

Wesbury thus notes that if you want change, baby, you're already getting it- in spades! As with rapid economic and social change throughout the centuries, this sort of change can actually make politicians fearful of blood running in the streets.

Back in the 1920s and '30s, when Schumpeter was writing about creative destruction, the hot economic topic of the day was whether unbridled American capitalism would destroy itself by depressing wages so low as to create social unrest and overthrow of our economic and governmental systems. Socialism was perceived as the greatest threat, and it actually came in the person of FDR and his many ill-considered New Deal programs- NRA, court packing, etc.

In a manner similar to Milton Friedman's and Anna Schwartz' "A Monetary History of the United States," Wesbury goes on to view American history as a collision of productivity and innovation with populism which has tried- and still tries- to control that economic vitality,

"This has happened before – in the Industrial Revolution – where the political environment bred America's first real populists, people like William Jennings Bryan and Theodore Roosevelt. Bryan was perhaps the best orator of American political history, and like Mr. Obama, he could affect people emotionally. Roosevelt, like Mr. McCain today, was a true American hero and one tough guy. History may not be exactly repetitive, but it sure seems to move to similar rhythms.

Unfortunately for the American economy, the populist movement of the late 19th and early 20th centuries led to a rapid growth in government intrusion into business activity. The populists didn't like the gold standard and demanded more government regulation.

In 1913, the Federal Reserve System was created and the income tax was introduced to pay for a growing government. And then, during the Great Depression – which was caused by the new Fed, trade protectionism and tax rate increases – a massive expansion in government took place.

Forty years later, in the malaise of the late 1970s and early 1980s, the U.S. finally figured out what it was doing wrong. By returning to hard money under Paul Volcker, and lower taxes and less regulation under Ronald Reagan, the high-tech leg of the Industrial Revolution began.

The fruits of this are plain to see. Rather than watching the sun set on the U.S., as many believed would happen in the early 1980s, the U.S. has experienced one of the greatest booms in wealth creation in world history. And the impact of our technological innovation has helped lift untold numbers out of poverty."

So to Wesbury, the American experiment has been a revolving door between economic wealth creation and lifting of all incomes by resulting economic expansion, and governmental attempts to restrain this vitality, tax it and use the proceeds to misallocate resources to 'the poor.'

Wesbury continues in that vein, noting,

"This technology has created massive amounts of change. Like the Industrial Revolution before it, the current transformation is anything but pain-free. It's what Joseph Schumpeter called creative destruction. Google, Craigslist and Microsoft have been prospering. General Motors, United Airlines and the New York Times have not. In the midst of layoffs in the newsroom, it's hard to see anything good happening in the rest of the economy.

Americans have had it so good, for so long, that they seem to have forgotten what government's heavy hand does to living standards and economic growth. But the same technological innovation that is causing all this dislocation and anxiety has also created an information network that is as near to real-time as the world has ever experienced.

Decades ago the feedback mechanism was slow. The unintended consequences of the New Deal took too long to show up in the economy. As a result, by the time the pain was publicized, the connection to misguided government policy could not be made. Today, in the midst of Internet Time, this is no longer a problem. So, despite protestations from staff at the White House, most people understand that food riots in foreign lands and higher prices at U.S. grocery stores are linked to ethanol subsidies in the U.S., which have sent shock waves through the global system.

This is the good news. Policy mistakes will be ferreted out very quickly. As a result, any politician who attempts to change things will be blamed for the unintended consequences right away."

Thus, Wesbury notes that because of recent rapid change, originally economic-based, in information technology, boneheaded governmental changes will be quickly penalized in the next election cycle, rather than, as in the last century, 30-40 years later.

This is important as both Presidential candidates and Congress have turned increasingly protectionist, focused on meddling in American business, and provincial with respect to US energy policy and the global energy situation.

Thus, Wesbury concludes,

"Both Mr. McCain and Mr. Obama view the world from a legislative perspective. Like the populists before them, they seem to believe that government can fix problems in the economy. They seem to believe that what the world needs is a change in the way government attacks problems and fixes the anxiety of voters. This command-and-control approach, however, forces a misallocation of resources. And in Internet Time this will become visible in almost real-time, creating real political pain for the new president.

In contrast to what some people seem to believe, having the government take over the health-care system is not change. It's just a culmination of previous moves by government. And the areas with the worst problems today are areas that have the most government interference – education, health care and energy.

The best course of action is to allow a free-market economy to reallocate resources to the place of highest returns. In the midst of all the natural change, the last thing the U.S. economy needs is more government involvement, whether it's called change or not."

Consider Mr. Wesbury's points when you read about Obama's desire to tax and spend millions on government-directed technology. Or McCain's neo-environmentalistic refusal to let private enterprise drill for oil within sensible parameters for protecting said environment.

We've had great, productive change in America since the reversal of the economic malaise that ended with the Carter era. If we want it to continue, creating wealth and jobs for Americans who want to work and accept the American proposition of positive change, we had better listen to Brian Wesbury.