Jamie Dimon's Stupid Remarks on "Mark to Market"

I worked for the Chase Manhattan Bank in the late 1980s. During that time, while reporting to the company's chief planning officer, I was fortunate to be exposed to all the Vice-Chairmen, COOs, CEOs and Chairmen of the firm.

Thus, I had close contact with then-Chairman Bill Butcher and President Tom Labrecque. Particularly the latter, as a long-running project necessitated periodic contact with him over several years.

Between my personal interactions with the senior managers of the bank, and its performance during the period, I would say that these were not particularly effective managers. Nor, outside of their original respective areas of competence, did they give any evidence of being smart about managing a large company, let alone a bank.

Butcher had been a corporate lending officer. A salesman. He had no particular expertise in management.

Labrecque had been an accountant at the bank. Apparently judged unsuitable for credit training, he was never a line lending officer, but, rather, a bean counter in a then-obscure funding unit engaged in trading Treasuries. His rise had much to do with some accidents which left positions above him unexpectedly open. And the rise of importance of his unit, as Fed Chairman Paul Volcker took the lid off of interest rates during the Carter era.

My point is, just because a person is the CEO or Chairman of Chase (Manhattan) Bank, or its successor banks, is absolutely no reason, alone, to accord him credibility beyond his actual, original area of business training or practice. Neither Butcher, nor Labrecque were, in the event, smart men when it came to operating one of the nation's largest money center banks.

The nearby chart shows the equity prices of Chase, Citigroup, from where Dimon and his mentor, Sandy Weill, hailed, and the S&P500 Index since 1977.

In that time, neither bank has managed to outperform the index. So much for vaunted wisdom from the CEOs of these two financial giants. Why would you expect brilliance from CEOs of companies that can't manage to outperform the broad index over 30 years?

Especially Chase, which has never outperformed the index?

After many mergers and acquisitions involving more than half of the major banks which existed on the island of Manhattan in 1990, and several in the Midwest, we come to Chase's current CEO, Jamie Dimon. The latest in a line of undistinguished CEOs of the large US money center bank.

There's nothing to indicate he's any smarter than his predecessors, Butcher and Labrecque, or even the undistinguished, though workmanlike head of the Chemical Bank which took over Chase, Walter Shipley.

On Friday, I heard a news story on CNBC alleging that Jamie had come out explicitly in favor of 'mark to market' as a valuation methodology.

Many have claimed this approach, mandated, in its simplest sense, by the Sarbanes-Oxley bill, in a fit of post-Enron pique, is largely responsible for the rapid evaporation of value from the balance sheets of US financial institutions in the past 15 months. In various posts on this blog, I have argued as much, too.

Let's recall from whence Jamie hails, professionally. As I wrote in this post, nearly a year ago,

"If you are familiar with Dimon's mentor, Sandy Weill's origins, then none of this should surprise you. Weill was the original low-cost consolidator of the brokerage industry wire houses in the 1970s and '80s. He was never an investment banker. Rather, his specialty was combining commodity-like retail brokers, combining back offices, sometimes improving technology, and reaping the improved margins. Eventually, he ran out of wire houses to buy and consolidate, so he sold out to American Express.

By the time he was ousted from Citigroup, Weill had demonstrated that he had learned no new tricks since he lost control of ShearsonLehmanBrothers to Amex. Citi's topsy-turvy growth and increased complexity resulted in serious lapses in risk management and attention to business details. Significant growth was not something Citi achieved, sans acquisition, under Weill.

Personally, I doubt that Dimon knows much that he did not learn from Weill. His signal achievement since being tossed out of Citigroup consisted of giving BancOne the "Weill treatment." It is not yet clear he's done anything more at Chase, nor that he is capable of more, either."

Lofty current title notwithstanding, Dimon is, in reality, little more than a fixer's fixer. Sandy Weill's erstwhile young bagman/apprentice.

I believe no credibility whatsoever should be accorded Dimon's pronouncements about anything beyond Chase's next quarter's performance, if that.

He's no leading light of finance, much less business in general. There is absolutely nothing in Dimon's background to suggest or give evidence that he is capable of uttering any sensible words on the concept of valuation and 'mark to market' rules thereof.

Lessons From Barry Diller?

Tuesday's Wall Street Journal featured an interview with Barry Diller. While not intending to, I think Shira Ovide's reporting on Diller's pearls of wisdom- and I use the term loosely- provides some managerial insights.


First, Ovide gives us the familiar legend concerning Diller's career. How he rose from the mailroom of some entertainment-related firm to eventually run Paramount Pictures. Recently, he drew attention for his very public fight with investor John Malone, culminating in a law suit, over the management of IAC/InteractiveCorp, Diller's latest media-related creation.



In answer to the question, "Why did you decide to break up IAC?," Diller replied,


"Because I thought the company was overly complex and unmanageable. What I've learned over the years is that focus and singular purpose is the best approach for businesses. How can you function across 12 different businesses from financial services to dating?

If you're going to run a public company, be absolutely certain of what the parameters are, what the clarity is, that you can explain it to yourselves and explain it externally."


Pardon me for noticing, but I don't think Diller has any classical management training whatsoever. And it shows.



Did it really take Diller some 40 years to realize what financial research has known for at least the past 30? I guess the silver lining is that Diller is very explicit as an apparently newly-converted apostle of focus and simplicity in business endeavors.



The interviewer goes on to ask, "If, as you say, having operations across multiple businesses didn't work for IAC, why does it work for General Electric Co. or Walt Disney Co.?" To which Diller answered,


"Companies like GE and Procter & Gamble have been in business for a long time. Over decades or a century you're bound to figure out a management structure that works. Disney is a single brand in essence, but then you can say, wait a minute, what about ESPN? Tell me why ESPN belongs in Disney. I don't think it gives Disney anything. It gives Disney money, but I think that money is discounted. Its true value, I think Disney would say, is disguised.



I don't have answers for anybody else. What I know is that internal complexity makes for superficiality. There's never essentially a pure story unless there's a pure product line that has its own shining clarity."




It's noteworthy that the Journal writer and Diller both confuse the issue of which other companies are 'operating across multiple businesses.' GE, P&G and Disney are far from similar in their business mixes.



The nearby, Yahoo-sourced chart illustrates my point. Stretching back to roughly 1962, it compares equity value growth for Disney, P&G, GE, IAC/Interactive and the S&P500 Index.



Disney is the best of the lot, followed by P&G. IACI is above P&G, but given it's late start, it's not clear that the beginning point for it is correct.



In any case, leaving aside IACI for now, Disney has been mostly about entertainment with a theme. Only with the purchase of CapCities/ABC and ESPN did it extend that interest, but those are still media/entertainment properties.



P&G has always had a consumer retail food, beverage and, more recently, cosmetics focus. It's not a diversified conglomerate.



GE, as I have written frequently, is diversified and, thus, a good example of Diller's and the writer's intent to identify a company with unconnected businesses.



What I find extremely disappointing, and a little frightening, is that Diller, who has run large companies for years, cannot distinguish the obvious and crucial difference between the nature of P&G and GE.

I'm not saying that every trained CEO with an MBA practices good, enlightened or inspired management. But I am saying that, observing Diller's rather primitive views on business structure, after so many years in senior positions, it gives one pause to consider letting an uneducated person run a large company.

It's one thing to perhaps have a flair for creating entertainment programming. That doesn't make a person skilled in the arts of leading a company to consistently superior total return performance.

Buybacks vs. Dividends: A Moot Point

Monday's Wall Street Journal contained an instructive article entitled "Corporate Buybacks Test Concept of Value," in its Heard On The Street column.

The proposition of the piece was that share buybacks, meant to boost earnings per share by cutting the denominator of shares outstanding, are merely a gaming tool for corporate executives to manage EPS.

The article's author, Liam Denning, then argues that dividend payments enforce better financial discipline.

To me, these points are moot.

Denning cites stock buybacks of $1.4 trillion among S&P500 companies between 2005 and 2007.

What this tells me is that these firms failed to find adequate investment opportunities. My proprietary performance research indicates that consistently superior firms add employees, capital and expenses over time. They don't shrink their capital base.

Perhaps it is my focus on fundamentals which leads me to ignore EPS. Years of corporate management positions taught me that what can be gamed, probably will be gamed. Thus, any performance measure with a controllable term in a ratio is suspect.

Total return is a ratio of two market values. EPS is the ratios of two controllable (by management) values- one from the income statement, the other from the balance sheet.

Among the companies Denning mentions in his piece are GE, Lehman Brothers, Exxon Mobil and AIG. None of which I have owned.

Back when I was in graduate school for business, we were taught that dividend policy didn't matter. If anything, as the Chicago School determined, taxes made dividends less preferable than leaving it on the firm's balance sheet, to be invested in operations.

To argue whether buybacks or dividends are better for 'financial discipline,' in my opinion, misses the point.

Why invest in a company that is signaling that it isn't growing? That is literally returning capital to owners and shrinking?

My original research further revealed that growing firms had a greater chance of consistently outperforming market average total returns, and by a greater margin, than slow- or non-growth firms.

Knowing that, why would an investor even want to own a firm that is publicly marking itself as a less-capable firm, in terms of market outperformance?

Nationalize Large US Commercial Banks?

My friend B's predictions from 1993 about the shape of banking have finally come true, as I noted in this recent post.


Not only did he correctly prophesy the consolidation of all publicly-held banking into 3 mega-utilities. He also opined that, in time, all of their activities would be so heavily regulated as to make them quasi-governmental entities.

In effect, B believed that the remaining commercial banks would become more tightly-leashed, duller, larger GSEs than the failed Fannie and Freddie.


Edmund Phelps' editorial in a recent edition of the Wall Street Journal contained a clue to this possibility. He argues for direct investment of US Treasury funds in commercial banks, in exchange for warrants.

What if, rather than this temporary investment, the US government simply funded basic consumer banking in this country?

By stripping large US commercial banks of any risk-taking businesses besides heavily quantifiable, easily-regulated activities such as mortgages, small business lending and credit cards- the government would effectively nationalize the basic consumer savings and lending activities of our economy.

Given the turmoil experienced by the financial sector over the past 50 years, this might not be a bad thing. The financial behemoths left standing- Chase, Wells, maybe Citigroup, and BofA- have equity that will most likely perform like a bond anyway. They are too large to consistently create value at an above-average rate.

Rather than allow these giants to be universal banks, including underwriting and securities trading, why not just go the other way, strip them of asset management, underwriting, trading and any esoteric lending businesses that can't be operated by rule-based procedures involving credit scores, down payments, balance sheets, etc?

By removing all scope for innovation in these banks, the bedrock deposit-taking, savings safekeeping and lending functions in America would be insured, protected, and firewalled from any other riskier financial activities.

As we observe Congressional reaction to its own seminal role in the current financial debacle, we can probably expect the same dimwitted approach to re-regulating financial services as we saw to their deregulation a decade ago. It's a fair bet that now Congress will legislate mortgage lending to a point of near-unprofitability. Perfect for a heavily-restricted and regulated financial utility to handle.

With the current Treasury purchases of mortgage-backed securities, including CDOs, you may as well just put the government explicitly in the mortgage lending business. They mandated the lending to poor credit risks that started the current financial situation. Why not just nationalize housing lending for home values below some multiple of the median US home price?

All of the other activities which have led to financial sector troubles- derivatives, swaps, asset-backed securities, trading, 'creative' mortgages, subprime credit cards, and the like- will be prohibited to commercial banks, but allowed for private financial institutions and non-bank, publicly-held entities. But even these latter institutions would have leverage restrictions. Plus, Federal agencies could, by setting down rules for counterparty dealings, limit the shape and leverage of unregulated entities by making them unsuitable counterparties for regulated ones.


I honestly believe we are heading toward this point. With such a major structural change in financial services providers in the past few months, it's clear that these recent events are spurring an oversized backlash. This will probably result in a replacement of Glass-Steagall with some assemblage of rules which will make commercial banking virtually publicly-owned. In order to avoid risky activities, banks which take consumer deposits, do basic secured or credit-score-based lending and transact financial transfers will be effectively government-guaranteed, and perhaps even owned.

This actually isn't such a bad idea, given the gradual concentration of crucial banking functions into so few, publicly-held companies. With such a dearth of diversity among financial institution options now, it may well be prudent for our society to simply nationalize basic banking functions.

Ironically, financial services has, by dint of technology, become so commoditized, yet able to destabilize our economy by taking undue, ill-advised risk, that basic financial services are, truly, a form of 'utility.' Like power and rail transport.

We seem to have arrived at a point where, truthfully, there's not a nickel's worth of difference between the surviving financial juggernauts. Citigroup, Chase, BofA, Wells Fargo- they all do the same core functions in the same way, using similar risk-scoring and processes.

They may as well become federally-guaranteed, heavily-restricted agents of the government, licensed to purvey basic, unspectacular financial services.

In another twist, this will return Glass-Steagall to our country's financial service sector, by simple, draconian government control of basic banking. Anything else will have to be done elsewhere. Probably, again, with heavy regulation, if publicly-held, on leverage, margin positions, and use of exchanges for allowed instruments.

Do I think this would be wise? Yes. And, I think, so does my friend, B, whose idea this originally was.

We've seen that financial institutions, when publicly-held, will test regulatory boundaries and ignore systemic effects of their actions. They are paid to enrich shareholders, not the public at large. So long as innovative, growth-oriented financial services are allowed to be pursued in conjunction with economically-sensitive businesses such as deposits, consumer loans, mortgages, and mutual funds, they will poison the entire system with the risks of their growth-oriented businesses.

And, eventually, as occurred in this latest round of financial mismanagement, they will even throw risk-management to the winds in basic, non-growth businesses like mortgage lending.

The only way to firmly stop this is to completely firewall those core financial functions.

It may take 5 years, or a decade, but we will probably get to that point eventually. And, in light of recent observations on human behavior for profit-making, but less acuity on risk management, in the financial sector, it's almost certainly a good thing.

Lehman's Choices

I've written 11 posts which include a "Lehman" label. The first was this one on April 7th of this year. In that piece, I wrote,

"Is it possible that only one, perhaps two investment banks- Goldman Sachs and Merrill Lynch- are now sufficiently diversely funded and large to avoid the ultimate negative consequence of their leverage- insolvency?

Maybe Lehman, for all its efforts, just still isn't sufficiently diverse, large, and long term funded. Maybe Morgan Stanley isn't, either.

You have to wonder if this is about to be an opportune time for Dick Fuld, Lehman's hardnosed CEO, to exit via a sale of his firm to a commercial bank.

Once Fed funding is off-limits again, what will Lehman's stock price do? For how long will investors really believe that an investment bank is safe, now that SEC Chairman Chris Cox noted that Bear Stearns lost slightly less than 90% of its liquid assets in one day last month?

Lehman still has significant exposure to mortgage loans. And Bear's experience demonstrates how quickly the loans from commercial banks, on which all brokers/investment banks depend, can be pulled.

Per my recent posts in the wake of the Fed's window opening to investment banks, I just don't see, long term, why any but perhaps the very best one or two investment banks can remain independent."

Fuld's claims that he never turned down an offer to buy Lehman are beside the point. Fuld should have been seeking a buyer by the Friday before the weekend that marked Bear Stearns' death.

How hard a knock on his noggin did Fuld require to see the end coming? In this post, written only a few weeks ago, I related John Gutfreund's comments on CNBC one mid-September morning. Significant among his remarks were these, which I reported in my post,

"Gutfreund was asked how Lehman's demise came about, and he said something to the effect,

"By the over-optimistic actions of the firm's CEO and his senior managers."

Pressed further, he allowed as how the firm was unrealistic, in this era and environment, to believe it could remain independent while grappling with its writedown problems. Gutfreund never used Fuld's name, but pointed out that Lehman had had months in which to gracefully sell itself before coming to Chapter 11.

It was refreshing to see a sensible, blunt Wall Street veteran avoid needless emotion and hysteria, while simply calling yesterday's events as he saw them. Nothing to be panicked about.

Rather, one company, Lehman, prolonging its own agony...."

Once again, I'm in good company. Gutfreund feels, as do I, that Fuld had plenty of time to see the end coming and sell Lehman to a commercial bank. He chose not to.

He now blames short sellers for destroying his firm. But, in truth, Fuld had at least a full month, post-Bear Stearns' demise, to arrange a sale of Lehman from a position of some strength.

Worse, he seems to have put his executives, especially Erin Callan, the short-timer Lehman CFO, up to allaying fears among counterparties and investors as to Lehman's solvency. While publicly proclaiming that Lehman had no need for more capital, privately, the firm's senior executives were constantly discussing plans to raise needed additional capital throughout this past summer.

Yes, Lehman, as run by Dick Fuld, had ample opportunity to end its life in a different manner than it did.

We'll never know for certain, but it's a fair bet that Dick Fuld's ego cost all Lehman's shareholders, including many then-current, and past employees a considerable chunk of their assets. How much might have a commercial bank- foreign or domestic- paid for a still-breathing Lehman in April of this year?

A lot more than the zero value remaining shareholders realized by the firm's bankruptcy. And, for that, you have to blame Dick Fuld.

Dick Fuld's Miserable Performance On Capitol Hill

I happened to see/hear the first twenty or so minutes of former Lehman CEO Dick Fuld's appearance before a House Committee yesterday morning.

It wasn't pretty.


What's worse, it was entirely preventable.


Think about it. Dick Fuld had been Lehman's CEO since 1994. He possesses a hulking, intimidating physique, along with the reputation for being a fairly demanding taskmaster. You just don't see him as a soft, cuddly, sensitive type of CEO.

In appearing before Henry Waxman's (D-CA) House committee, Fuld must have known he was to be the sacrificial offering from the capital markets to the US voting populace.


Despite losing a large percentage of his personal fortune as Lehman's stock declined in value, and, ultimately, became worthless, Fuld has enough assets to hire a public relations firm.


Didn't Fuld know, as everyone else did, that the lead questions would be about Fuld's multi-hundred-million dollar compensation, relative to wrecking the US capital markets and banking system?


An old friend of mine with some Army training once told me about how soldiers are trained to respond to an ambush.

Attack!


The reasoning is, ambushed soldiers are probably going to die anyway. So they may as well immediately counter-attack the enemy, hoping for surprise, disorganized resistance, and confusion.

Fuld should have realized he was walking into an ambush. And, thus, attacked immediately.


Since Fuld had the initiative, because of his opening statement, he was in a perfect position to begin with something like these hypothetical remarks,


'Good morning Members.


I'm Richard Fuld, former CEO, since 1994, of now-defunct Lehman Brothers Holdings.


Rather than go into detail about my firm's role in the current financial markets turmoil, I want to address the issue which, I am quite sure, is on everyone's mind. And one with which you will, no doubt, wish to paint me as the lead villain in this drama.


"How can I justify my total compensation, while CEO of Lehman for 14 years, of nearly $500MM?"

I'm sure that to many Americans watching this hearing, I seem to be a prime example of what many call 'greed' and 'excess' in the US financial services sector. They, and you, will ask,

"How can anyone possibly be worth that much money? How could anyone do something that merits him earning nearly half a billion dollars over 14 years?"


Well, Members, and fellow Americans, let me start by saying I am not ashamed of earning that money. And I emphasize EARNING that compensation. I EARNED every penny of it.


I worked as CEO for Lehman Brothers Holdings. Not the Federal government, the Red Cross, or a small local retail shop in a neighborhood shopping mall.


Lehman Brothers was a publicly-traded company with many shareholders. A board of directors- not me- determined my level of compensation. The shareholders elected that board.


Over my term as CEO, I increased the value of Lehman shareholders' investment in my firm from $3/share in 1994 to, at its peak, $80/share last year. The market value of Lehman Brothers rose from $__B to $____B during that time.



The team I built at Lehman created that value for our shareholders. Much of my personal wealth was either paid in, and/or remained in Lehman stock.



On a percentage basis, of the $__B in shareholder value we created at Lehman, the total pool of bonuses over 14 years was $__MM. My own share of compensation, as a percentage of the increase in Lehman's market value, was __%.



In short, Lehman was in a business which allowed us to borrow money from banks and make a lot of money for people- institutions, pension funds of union workers, teachers, municipal workers, and others- who owned our stock. As such, our board of directors saw fit to pay us a small percentage, but, in actual dollar terms, large amounts of money, for doing so.



We, my team and I, and I, personally, were paid a small share of the value we created.

I feel very strongly that I, and my executive team and all the employees of Lehman Brothers, are a fine example of the American economic system. We were well-paid when we created value. We made money for those who invested in our company.



Does anyone begrudge a Hollywood director for making millions of dollars from a movie? Is Steven Spielberg here being cross-examined for making a huge fortune while directing and producing movies for which millions of people pay to see?



How about Steve Jobs, the CEO of Apple? Are you going to bring him in to face scrutiny for being a highly-paid CEO who created massive wealth for his shareholders?



I represent the successful pursuit of the American dream. I worked hard, built a good team, made money for my firm's owners, and was highly-paid for doing that.



That's supposed to be what a person with ambition, skill and luck can do in America.

I won't apologize for that.



Members, I made nearly half a billion dollars over 14 years because I worked hard and created value for others.



That is, I submit, much more than any of you have ever done in your jobs. I made more money than you do because I worked hard making money for others.



Who are you to judge, let alone ask, whether I made too much money? You are members of an institution- Congress- with an approval rating so low- 10%- as to be embarrassing to even BE a member.



Now, I will take your questions....."



In addition to this, were I Dick Fuld, I would have had my public relations consultant obtain whatever embarrassing and incriminating information available on Waxman and the other Democratic House members on the Committee. Republicans, too, for that matter.



Sadly, pathetically, Fuld began by reading from a dry, uninteresting history of his career with Lehman. He approached the Committee almost apologetically, meekly, and timidly.

Predictably, after his meandering opening statement, Waxman launched his first salvo in the form of a slide with Fuld's annual compensation, a recounting of the current situation, and the question,

"Is this fair?"

The video of this appears below.





What was Fuld thinking? He reduced himself to tentatively acquiesing to the correctness of the numbers, and argued that he had to exercise options. It looked bad. Really bad.

Granted, he made some of the points I make in my hypothetical speech. But it would have been so much more forceful had Fuld gotten there first with his own framework.



I don't particularly like Fuld. From yesterday's Wall Street Journal article detailing Lehman's summer activities- both public and hidden- it sure looks like Fuld and his team misled the investing public about Lehman's true health.



If it were up to me, Fuld and his senior managers would be charged with fraud, because they privately doubted their firm could survive, but publicly made statements otherwise.



But Dick Fuld's day in court is a different matter than his being lynched by innuendo in a televised House Committee hearing.



Fuld's performance- if you can call it that- was an embarrassment to himself, his firm and CEOs in general.

Highspeed Cable Cannabilizes Cable Television Sooner Than Expected

Back in August of 2006, I wrote this post regarding the potential for residential video viewers to begin disconnecting their cable television subscriptions. Instead, I suggested, they would make use of the soon-to-come boxes allowing wireless internet access from highspeed cable directly to their televisions.


That day seems to have arrived sooner than anyone expected for quite a few American viewers. Specifically, several friends, including a consultant, S, all warned me that I was overly optimistic in my belief that we were only a few years from the point at which fairly average people would begin to unplug their cable television service.

Friday's Wall Street Journal featured an article entitled, "Turn On, Tune Out, Click Here," in the Technology section. The piece begins with this passage,

"Kenny Johnson, a senior credit analyst for Fox Home Entertainment in Garden Grove, Calif., recently took a hard look at his finances -- and canceled his c-television subscription.
With a newborn child at home and growing household expenses, he says the decision saved him and his wife more than $40 a month -- or roughly the increase he is paying at the gas pump every month for his commute to work. The couple held onto their DSL Internet connection, which costs about $38 a month.

Now the Johnsons access most of their television shows online, through Web sites like Hulu.com, in addition to the free broadcasts they pick up over the airwaves. They also bought a set-top box that allows them to stream shows via Netflix.com to their television set, including episodes of NBC's "The Office" and Showtime's "Weeds."

"To me, it looks just like my cable," Mr. Johnson says.

In the past two years, nearly every major network show and many of the biggest cable programs have become available on the Internet. The virtual library of content includes everything from "Desperate Housewives" and "CSI" to "The Colbert Report" and "Mad Men.""

This last sentence is, of course, the key change in the past few years. I cannot say I foresaw this over two years ago, but I did envision something similar, but actually more costly. Rather than charging for this programming, networks are actually giving them away for free, with a smattering of advertising.

How lucky can viewers get? We might have had to pay by the view at individual network, program or producer websites. Instead, the same television executives who paid for their programming with ad revenues have graciously replicated that model online.

The piece further notes,

"Many shows can be viewed for free and are accompanied by a dollop of ads that's small when compared with the number of commercial breaks on television. As a result, some cost-conscious consumers are ditching their cable subscriptions altogether.

"I'm saving a lot of money," says Tony Leach, a product manager at an online stock brokerage firm in the Bay Area. Mr. Leach canceled his $60-a-month cable subscription two years ago and has watched all of his favorite television shows on the Internet ever since.

The online television bonanza reflects a scramble by networks and cable stations to avoid the fate of the music business, which is still reeling from the effects of piracy and early missed opportunities to capitalize on the Internet.

Complete episodes of about 90% of prime-time network television shows and roughly 20% of cable shows are now available online, according to Forrester Research analyst James McQuivey. There are still notable holdouts, such as Fox's "American Idol" and current seasons of HBO series like "Entourage."

The number of people watching all of their programs online is still small; some estimates put the number at just 1% of the total television audience. In part, that's because watching online isn't as easy as channel surfing on the couch, TV remote in hand. Viewers must either watch shows on their personal computers, or use a device like Apple TV, which allows them to download shows from the Internet onto their television sets.

Within the next several years, however, media and technology executives say that a host of new technologies will make television access to online video a mainstream phenomenon. Vudu Inc. already sells a $299 set-top box with a remote control that allows users to download television shows for $1.99 per episode. Microsoft and Sony both sell television shows that users of their Xbox 360 and PlayStation 3 videogame consoles can download over the Internet for viewing on television sets.

Netflix subscribers can buy a $99 set-top box from Roku Inc. that streams videos on their television sets. The service is included at no extra charge in the monthly Netflix fee for renting DVDs."

This, of course, is key. I have written a few posts about the set-top box issue in the past. Now, with more options than just AppleTV, it's a fair bet that in only a year or two, the current trend away from cable television subscriptions will increase markedly. For example, again, from the Journal article,

"Still, research firm Nielsen Online estimates that in June, 3.2 million Internet users watched more than 106 million video streams on Hulu.com, a site that wasn't available to the public until March. Walt Disney Co.'s ABC.com delivered nearly 27 million streams to 2.9 million viewers that same month, according to Nielsen. The data include everything from behind-the-scenes clips and segments of shows to complete episodes.

Other research indicates that online video-watching is cannibalizing television audiences. According to a spring survey by Integrated Media Measurement Inc., a research firm that tracks media consumption, more than 20% of viewers in the firm's 3,200-person panel watched some prime-time network television online, up from roughly 6% in the fall. Half of those online viewers said they were no longer watching those shows on television.

"What this study is showing is that the long-vaunted convergence of the TV and the computer is happening faster than anybody thought it was happening," says Tom Zito, Integrated Media's company's CEO."

Eventually, one would conjecture that this will affect the economics of the current cable distribution system. And, on that topic, the article reports,

"Tensions are beginning to heat up between cable operators and cable channels over free Web video. Glenn Britt, CEO of Time Warner Cable Inc., has been one of the most outspoken people on the topic, telling cable program executives to not expect to continue sharing subscription revenue if they keep giving their top shows away for free online. When asked how programmers have been responding to such comments, Mr. Britt says, "Not well."

Executives at several cable channels were reluctant to discuss the topic, at the risk of further straining discussions about Internet television with their cable-operator partners. "We can't just cut the cable companies out," says one of those executives."

Meaning, as I understand it, that cable system operators intend to keep more money if their content suppliers continue to give that content away freely on their own websites.

"Last year, the average home received 118.6 cable channels but only tuned into about 16 of them, or 13% of the total available to them, according to the Nielsen Co."

This, too, is one of the reasons I predicted this effect a few years ago. I can personally attest to watching only about 5-8 channels, while my daughter uses perhaps an additional 3. She, too, has no compunction about watching video content on one of the two wireless laptops to which she has access on a regular basis.

Thus, the closing passage of the Journal piece is prophetic,

"Jeff Pulver, founder of PrimetimeRewind.tv Inc., which makes it easier to locate Web television shows, says he believes the Facebook and Google generation won't look askance at getting television shows from the Internet.

Still, adds Mr. Pulver, who also co-founded the Internet phone company Vonage, "Some people will [continue] to subscribe to cable, the way their grandparents did.""

That's pretty much how I feel, too.

Only this weekend, my daughter and I discussed buying a Tivo unit to secure better content access, as well as, of course, the digital recording capabilities which will restore my 'watch one record another' channel feature which I lost when Comcast insisted that I use their digital set top box. In fact, my daughter even counseled against going with the cable operator's digital video recorder, based on her knowledge of the units' flaws and failure statistics.

It won't be surprising to me at all if we unplug from Comcast's television services within two years. I'll save about $600/year, which means the most expensive of the new wireless internet-to-television boxes will have a 6 month payback. Schumpeterian dynamics are quickly moving internet-based video content, that is not business news, into a competitively-advantaged position relative to packaged video content services offered by cable operators.

I rather doubt I'm alone on this issue, as the Journal article notes.

A Simple View of Government Purchase of Structured Finance Instruments

Michelle Caruso-Cabrera and Rick Santelli made a stunningly simple but important point about the proposed Treasury purchase of distressed structured financial instruments earlier this week on CNBC.

Amid the usual on-air drivel of various co-anchors and guests which has been gushing for the past week, Caruso Cabrera asked the question, paraphrased, below

'If there's such profit opportunity in buying these assets that the taxpayer should fund doing so, why aren't private investors doing so already?'

Santelli immediately chimed in with his agreement. I think they are right.

We've seen the reports on private equity funds being amassed for eventual purchase of these mortgage-backed instruments. We've seen the Merrill Lynch deal with the Texas investment group for 22 cents on the dollar, with recourse.

But if no significant purchases are being made by those who don't have unlimited credit, why should taxpayers believe that Treasury purchases of the same securities will be profitable?

Even Bill Seidman, one-time head of the RTC, allowed that, if skilled private investors were buying and managing these portfolios, money might be made. But not in government hands.

To me, that's a very important missing signal. If savvy private investors don't feel they know enough about the value of these instruments, regardless of mark to market issues, about which they, and the Federal government, do not need to be concerned, why should we believe that Treasury knows at what prices its purchases will yield profit, while simultaneously recapitalizing the current owners of those securities.

As I wrote here last week, If the Federal government is aiming to rescue banks, it can't pay low prices. If it's aiming to profit, it can't pay high prices.

Which will it be? If private investors aren't even bidding low prices, or banks aren't hitting those bids, that tells you something about how unprofitable this expensive plunge by Treasury into structured securities is likely to become.

Wachovia Goes To Wells Fargo- Citigroup Considers Lawsuit

Things are moving at lightning speed in the banking sector, Congressional rescue package or not.

Since I wrote this post on Monday of this week, Wells Fargo has stepped in to buy Wachovia at an actual market price. This is so recent that it didn't even make the print edition of today's Wall Street Journal.

Meanwhile, Citigroup is left standing at the altar, FDIC-brokered deal in tatters.

For the FDIC and, of course, the public, the Wells Fargo deal is much better. No government-shouldered losses. No qualifications. Just a straight combination at an offered price to Wachovia shareholders.

It's likely better for the US commercial banking sector in the longer term, too. It's doubtful Vikram Pandit & Co. over at Citigroup could have actually prospered with the Wachovia acquisition. It's closer to the mark to say that mere survival of the resulting mess would have been heroic, and probably almost too much to hope for.

Now, at least a healthier bank with adult management, meaning the CEO of Wells Fargo, will take over the wreck of Ken Thompson's- excuse me, Bob Steel's- Wachovia.

As the nearby, Yahoo-sourced chart of price performance for the S&P500 Index and Chase, Wells Fargo, Citigroup, BofA and Wachovia for the past five years indicates, Wachovia will be in better hands with Wells.

Citigroup and Wachovia have been the two worst-performing of the bunch. Chase and Wells are nearly equal, just managing a positive return. Not exactly glowing, but it beats the huge losses of the other banks.

If you're going to continue life as a boring, huge, regulated financial utility, at least you can be average. And Wells Fargo appears to be.

What's hanging over the deal, of course, is Citigroup's noises about being jilted. And possibly suing.

Just what we need, eh? At this point in the history of the US financial sector, a limping, near-failing Citigroup would sue for the right to combine with the other worst wreck of a major commercial bank, Wachovia.

You cannot make this stuff up.

Near-Record Market Volatilty

My partner and I have developed several proprietary measures for risk management.

Among them is a proprietary volatility metric based on S&P daily returns.

The accompanying chart displays this measure from 1950 through the end of last month.

Should you be in any doubt about current market volatility, this chart will end it. We are currently experiencing greater equity market volatility, on a daily basis, than at any time in the past 50+ years, except for the month surrounding the crash of 1987.

The peak measure of our volatility measure during the crash was 6.1%. Today's new high for this period is 3.6%.

Although we only actively invest in equity calls and puts now, we still track the underlying equity portfolios. Based upon our equity risk management tools, we would have shifted to a short portfolio in July. That portfolio is up over 23% as of this morning. Combined with modest losses in the first half of the year, the overall equity strategy would be up about 20% on a gross basis.

With the chart above as a guide, we are once again focusing on buying puts for the near term. The record volatility in the S&P confirms that we are in very rare market conditions, but, never the less, conditions that support being short, not long.

Buffett Plays On Immelt's & GE's Weakness

Yesterday, Warren Buffett gave GE the 'Goldman' treatment. I wrote about Buffett's expensive loan to Goldman Sachs here last week.

It's a tribute to GE CEO Immelt's ineptitude and the weak position to which he has misled his firm that he had to pay such a high cost to secure a $3B loan from Buffett.

Some pundits have hailed Buffett's recent moves as 'investing in' Goldman and GE. Nothing could be further from the truth. If that were the case, he'd have plunked down his money for shares of GE's (and Goldman's) common equity.

No, instead, Buffett just lent GE $3B, in the form of preferred equity, at the spectacular rate of 10%. Plus received warrants to buy $3B of common equity at $22.25/share.

With 'friends' like Buffett, you wonder what Immelt's enemies would have charged him.

As the nearby, Yahoo-sourced price chart for GE and the S&P500 Index for the past year indicate, GE has fallen almost twice as far as the index over the period.

It's actually a bit worse, in that the two were at equal points of loss as recently as April of this year.

Of course, Immelt is spinning this as some sort of 'vote of confidence' and financial victory for GE.

How do you think Immelt's CFO would be treated if he came in and proudly announced giving that deal to the market at large?

Yes, I know. Everyone says Buffett's name is magic and will save GE (and Goldman). I think, instead, that Buffett knows these two firms will not vanish during the term of his investment. He said as much this morning on a phone interview with CNBC.

Oddly, Buffett actually mentioned Jack Welch twice during his explanation of his admiration for GE. Well, Warren, Jack's been gone for over seven years now. Or hadn't you noticed?

I doubt you'll see Buffett lending to many other firms. But if he does, rest assured, they will be the safest of the lot. And he will be carefully lending, not 'investing,' per se. The warrants in both Goldman's and GE's cases are sweeteners that came virtually for free.

How's that for crafting a great deal?

And Immelt? Well, he must be secretly praying in thanks for this current economic situation. Now, it's almost impossible for the private equity crowd to force him to dismantle GE. And Immelt will cry that he can't sell businesses at these too-cheap prices. He was never going to agree to a breakup/spinoff, and he certainly won't now. He'll complain that the financial markets are too turbulent to take the risk of each of GE's gigantic business units to be self-run and -funded.

And, now, the press is already opining that, with Buffett's preferred shares, Immelt can't break GE up. Which, of course, is nonsense.

It's a shame, really. Now Immelt has more excuses to mistreat his shareholders, while being paid over $10MM/year doing so.

Others Agree- The Culprit is A Foolish Congressional Insistence On "Mark To Market" Accounting

According to my search of this blog for 'mark to market,' I first touched on the topic in this post back in February of this year.

Among my favorite, later posts on the topic are these, here, here, here and here. In that first linked post, I wrote,

"You see, this entire financial services debacle is unique because it involves tradeable instruments. Whole loans could be valued at par so long as they were performing. But once magically transformed via financial engineering into CDOs and their ilk, market price became the dominating valuation metric. And, as I and others have noted for some time now, markets for structured instruments can vanish in an instant. Thus, zero price.

There is no ability for anyone to know how much is a sufficient writedown of an asset with no trading market, except 100%. And who wants to do that?

Yes, financials are still reeling. And it won't stop until all the CDOs are basically written off. Totally.

Or, short of that, a vibrant market suddenly erupts all at once as a few hedge funds and private equity groups, like Paulson's ,written about in yesterday's Journal, swoop in and briefly create a market in the instruments for pennies on the dollar.

The holders will get to value the instruments, though probably at lower values than they wished. But above zero.

As I've written elsewhere, these private firms will then enjoy a spectacular rise in value of these structured instruments which are mostly still performing assets.

But for publicly-held companies, there's absolutely no reason for any investor to take a chance on what has become a blind pool of assets which are valued based upon non-existent markets for complex instruments."

I wrote those passages assuming that mark-to-market regulations would not be modified.

Why another post on this? In today's edition of the Wall Street Journal, three of my favorite writers- two of them distinguished economists- write about the current financial sector debacle.

Holman Jenkins, Jr., spotlights mark-to-market accounting in his editorial, as does Brian Wesbury, in his piece. Nobel Laureate Edmund Phelps does not mention it, but, instead, in his piece entitled "We Need To Recapitalize the Banks," weighs various government interventionist proposals to remedy the current situation.

Taking Phelps' article's title as a perspective, one may think of the current financial sector mess as having four possible solutions, ranked below from simplest and least expensive, to most complex and expensive:

1. Per this post, scrap the current mark-to-market regulations and, instead, allow use of net present valuation for performing instruments. Remove the requirement that lower, 'fire sale' current values pertaining to 'non-active' trading markets be used in lieu of 'hold-to-maturity' values for performing assets.

2. Congress authorizes Treasury to sell default insurance on structured finance instruments, thus allowing banks to value the assets at economic value on their balance sheets.

3. Congress authorizes Treasury to invest directly in US commercial banks, taking warrants as a sweetener, so that taxpayers will benefit when the equity values of the banks recover. Capital is rebuilt, with taxpayers afforded some protection.

4. Paulson's plan of simply using $700B of taxpayer funds to buy distressed structured finance securities from bank balance sheets, at undetermined prices.

Jenkins and Wesbury both are in agreement with me on this issue. They believe that the first solution is sufficient to effectively recapitalize banks by allowing them to value structured financial instruments on their balance sheets at long-term, economic values which will not require massive writedowns.

To be honest, I feel very comfortable in such intellectual company. Wesbury wrote,

"So what is to blame for the "worst financial crisis since the Great Depression"?

The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.

Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.

Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.

Despite all this evidence, the government has yet to provide relief from mark-to-market accounting. However, the Financial Accounting Standards Board will meet today to discuss potential changes. One thing it ought to consider is that the Treasury plan tips its hat to the problem by acknowledging that its goal is to put a floor under distressed security prices. Warren Buffet understood this and invested in Goldman Sachs before the law had passed, but with full expectation that it would. Other investors will follow. There is no shortage of liquidity in the world.

Nor would relaxing mark-to-market rules temporarily in the U.S. -- let's say for three years, for troubled assets issued between 2003 and 2007 -- undermine our standing internationally, as some allege. If a $700 billion bailout fund and the takeover of Fannie Mae, Freddie Mac and AIG have not already undermined foreign confidence, then nothing will. On the same day the bailout bill failed in the U.S. House of Representatives, the dollar soared."

In his remarks, Wesbury sees the same scenario I did earlier this year. Without a reform of mark-to-market accounting, only private equity will be capable of holding structured financial assets which have no actively-traded market. And they will make a killing, buying for pennies on the dollar and recovering the full economic value over time.

Wesbury ends his piece as follows,

"Once private investors know they cannot be taken out by accounting rules and illiquid markets, their cash will flow freely. And if the real issue is to find a proposal that will help fix the problems in our financial markets urgently, then the current Treasury plan fails the test. Because of government bureaucracy and legal issues, the first purchases by the Treasury plan will not be made for at least two weeks and possibly four weeks. Mark-to-market accounting changes could start the healing overnight and prevent the U.S. from moving further away from free-market capitalism."

It's a brilliant insight, as he notes that, until mark-to-market is suspended or modified, private investors won't touch bank equities, because they know the government if forcing those institutions to incur punitive valuations.

Holman Jenkins, similarly, writes,

"The Paulson plan's defeat on Monday was not the end of the world, and may not even be lasting. But it does invite us to revisit the sideshow of mark-to-market accounting.

Even as this agnostic column was giving birth to itself, the SEC's chief accountant released a new "interpretation" late yesterday meant to relax these vexatious rules. The Dow jumped 485 points. Were investors reacting to the SEC announcement -- or hope of the Paulson plan being revived in Congress? Perhaps they concluded that the two are one in the same.

Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.

Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.

Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.

But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.

Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.

A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.

A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.

No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?

Let's find out."

The third writer, Phelps, didn't mention mark-to-market explicitly. Instead, he revisited macroeconomics, and ended up simply judging default insurance to be, to him, not necessarily better than purchasing the assets. I don't agree.

Phelps reviews several other alternatives, including the Paulson plan, and prefers simply injecting capital into banks, in exchange for warrants.

But Phelps provides the important overview of the real issue- how to most efficiently, effectively and, then, quickly recapitalize banks.

And if this can be done via accounting rule modifications, that would be the route that trumps the other three. On all dimensions.

The Market Solves While Congress Debates A Bad Bill

As I wrote yesterday, in this post, it seems that several steps to rationalizing the US financial services sector are already underway, with or without Congressional action.

For example, Glass-Steagall has, in a sense, been re-instituted in a de facto manner. No large, publicly-held investment bank exists anymore, nor will one likely again for at least a few decades.

The integrated commercial banks which absorbed Bears Stearns, Merrill Lynch and parts of Lehman are unlikely to ever operate those remnants with the leverage or innovation- for better or worse- as they were in the past.

FDIC and SIPC insurance provides some measure of safety for depositors in those institutions that were absent before the original Glass-Steagall bill of the 1930s.

The emergence of three gigantic financial 'utilities'- Chase, Citigroup and BofA- marks the evolution of financial services, after a period of expansive innovation, to a quasi-governmental oligopoly.

John Bogle, the farsighted founder of the Vanguard Group, has stated for years that, as a sector, financial services cannot add value, per se, and certainly not at a rate greater than the long term growth of the economy. He's right.

Thus, as I wrote here, after a nearly 50-year period in which private investment banks sold themselves at peak prices to the public, the sector had taken on too much risk and caused so much counterparty risk as to result in the seizure of credit flows among large financial service players.

Excess capacity has been removed. Excessively risky activities such as securitizing mortgages and selling credit default swaps have been curtailed.

And all this before any Congressional action.

At this point, a very minimal solution from Congress would provide the needed respite for publicly-held banks. The Republican House idea of using Federally-sold credit default insurance for structured finance instruments, backed by mortgages of dubious, or unknown quality, would effectively solve the counterparty risk debacle now affecting financial markets.

I don't know why Paulson and his team either failed to conceive of that brilliant idea, or dismissed it. In no way is it necessary for the Federal government to purchase structured finance paper in the amount of some $700B. All that is required is to cause that paper to be valued on bank balance sheets at their longer term, economic, 'hold to maturity' value, rather than the near-zero value they have in current, non-actively traded markets.

Perhaps the 107 point drop in the S&P reflects the market's concern over the basic lack of understanding of this issue in Washington. Because, as Ben Graham noted some 50 years ago, it's unlikely that the real, tangible value of US business assets in the S&P500 fell by over a trillion dollars yesterday.

Gasparino v. Liesman On CNBC

This morning's CNBC Squawkbox program featured a wild verbal free-for-all between Charlie Gasparino, Steve Liesman, Becky Quick and Joe Kernen.

Mostly, however, it was a one-on-one match between Gasparino and the always-hapless, under-brained Liesman.

I'm no long term fan of Gasparino. He used to verbally bully the esteemed Wall Street Journal editor Alan Murray.

But this morning, I found myself in complete agreement with Charlie. He correctly noted that, prior to the House Republicans standing up and demanding to be heard in the negotiations on the Washington financial sector rescue legislation, it was largely a Democrat/Liberal Republican venture.

Forget John Harwood, CNBC's ultra-liberal apologist. He has no credibility, nor any shred of objectivity left. Leave it to Gasparino to point out that Paulson is a fairly liberal, East Coast Republican, and he chose to deal directly with only Democrats on the Hill- Barney Frank and Chris Dodd.

Given that those two are largely responsible for the GSE train wreck, it's arguable that Paulson made a serious error in his tactical approach.

Gasparino noted that, until the House Republicans slowed down the rush to take taxpayer funds, nobody even considered a simple, innovative idea like government-issued insurance that would actually make money initially, rather than ladle out most of $700B.

In response, Liesman and Quick squawked about how they thought it was a bi-partisan bill, and everybody said so. That Paulson initiated it, so it must be bi-partisan. Liesman further blathered something like,

'Sure, take more time to craft the bill, and let a few more banks go bust.'

Further proof that Liesman is incapable of any valuable thoughts on his own, but is a conduit for accepted wisdom from any liberal he can cite.

I don't know whether to laugh or cry. How thick must those two be? Any slam-dunk legislation was always going to be railroaded by Dodd and Frank. It took a lot of courage for Boehner, for whom I also typically have little use, to protest the bums rush being orchestrated by Congressional Democrats and non-conservative administration officials.

I was stunned with how savvy and observant Gasparino is in this situation.

Financial Sector Self Healing? WaMu & Wachovia

A lot has transpired in the financial sector in just the last five days.



With lightning speed, the OTS sold WaMu to Chase, while Wachovia, one of the five largest banks, and seemingly healthy only last year, desperately seeks a buyer to keep it from insolvency.



So, let's review the past month or so.



Treasury finally seized the badly-run, bloated and badly-designed Fannie Mae and Freddie Mac, after their ability to raise capital to continue operations became doubtful. Then Lehman Brothers was allowed to fail when its capital-raising abilities fell short of its needs.



AIG was taken over with 80% ownership by Treasury, to avoid a Chapter 11 filing which would have thrown into doubt the firm's insurance and asset management's units ability to function normally.



Merrill Lynch sold itself to BofA just shy of also being forced to go Chapter 11, due to capital shortfalls and it being the next logical target, after Lehman's exit.



A week later, Goldman Sachs and Morgan Stanley both applied for Federal bank charters, completing the exit of the last large, publicly-held investment banks from the US financial services sector.





Does it not appear that, with Schumpeterian certainty, excess capacity among the weakest, worst-managed financial service competitors is being removed without massive, excess Federal intervention?



I don't count Fannie and Freddie because, to be honest, these two mistakes were Congressional piggy banks to start with. Their excesses were purely Congressionally-sourced, so their takeover is, if anything, merely a recognition of the reality that they were an organizational fiction when considered 'publicly-held.'



AIG was a takeover, to be sure. I do not fully understand why the insurance and asset management units were not bundled together and spun into a separate unit, allowing the other, riskier part to fail. Probably a matter of time available to avoid various debt covenant defaults.



Since insurance in America is a state-regulated business, there was no pre-existing Federal authority to handle the AIG mess.



Still, seen from a distance, because of the nature of short-term lending, counterparty risk management, and confidence, the rapid consolidation of this over-capacity sector was really not all that surprising. Unlike sectors such as energy, metals, or transportation, which consolidate over months or years, financial services tends to consolidate due to some institutions' failures, and, thus, happens much more rapidly.



Does this still require a Federal outlay of hundreds of billions of dollars?



I'm actually not so sure. The consolidation of Merrill Lynch, WaMu and Wachovia will already remove quite a bit of excess capacity, while also allowing some significant bad-asset writedowns. In just a week, the size of publicly-held, face-value held CDOs have plummeted. And will fall by more when Wachovia is bought.



What's left to worry about? The badly-run investment banks are gone. The remaining two- one well-run, the other mediocre- are temporarily independent commercial banks, pending their sale to banks with actual branch networks. The remaining large US banks are healthier than the ones that have gone under.





It's fairly comical that Citigroup could be seen as a potential rescuer of Wachovia. With so many lingering, serious problems of its own, Citigroup would only be adding to its inability to create value for its shareholders.



As I am writing this paragraph, at 8:30AM, the news on the wire is that Citigroup is, indeed, buying Wachovia's retail banking operations. Wells Fargo dropped out of the running. Citigroup has its writedowns capped at $42B, with the FDIC apparently on the hook for anything north of that, in consideration for Citigroup agreeing to raise more capital.



Thus, in just a few weeks, my friend B's 1996 prediction of the evolution of US financial services to a point at which only 3 commercial bank 'utilities' would exist has come true. Citigroup, Chase and Bank of America, the original three money center banks with international networks, are, at least in name, the survivors.

The first of two nearby Yahoo-sourced price charts for the past three months for Chase, Citigroup, BofA and the S&P500 Index show the old money center institutions gaining as the riskier financial services players have exited the scene.

As I am writing this section, my friend B emailed me with the press release on the Citi-Wachovia purchase, noting,

"The inevitable agglomeration accelerates. The separation of the bank market into the three major components is becoming more stark, yet the proper business models and their regulatory, etc. environment have not been resolved. We run the risk of the financial utilities becoming government entities. They will most likely behave that way regardless of whether they remain private or not. Innovation departs "Wall Street", which has quite a while ago become more a symbol than a location for innovation, and moves to the ether and its various nodes around the globe."

Over the past five years, however, the same three banks underperform the index. Expect more of the same going forward.

As B predicts, these banks will behave like government-run institutions, if they don't actually have the Treasury as a major shareholder.

B is an extremely smart financial services veteran with a PhD in finance.

He correctly predicted, over a decade ago, that this agglomeration would occur, resulting in hulking, musclebound financial utilities which are incapable of being managed to outperform the equity markets. In effect, he prophesied, they will be the repository for 'safe' banking businesses- deposit taking, basic lending and transaction processing.

Financial innovation, such as it will exist, has departed to private equity firms and, to some extent, their organizational brother, the hedge fund.