3Q GDP Results

This morning's Wall Street Journal has a good, short piece by Liam Denning under the Heard On The Street column.

Before you join yesterday's exuberant equity investors who bid up the market by 2%, consider Denning's remarks about the quality of the initial 3Q GDP number of +3.5% annualized growth.

He writes,

"Fully 2.2 percentage points of the third quarter's 3.5% growth figure related to vehicle purchases and residential construction, both juiced by government support. Federal spending added 0.6%

If these GDP data were company earnings, they would be what analysts euphemistically call "low quality." Investors buying into the market off the back of them are ignoring weekly unemployment-claims data that came in above 500,000 again on the same day."

Count me in Denning's camp, rather than those optimistic equity managers and analysts flocking to praise the recently-arrived US economic recovery.

Even this morning on CNBC, senior economic idiot Steve Liesman verbally assaulted former New Hampshire Senator John Sununu about supply-side economics, claiming that currently-low inventories and strong inventory liquidation of the past few quarters virtually guarantees a robust US economic recovery. Grinning as only a self-deluded moron can, Liesman insisted that Sununu quoted Say's Law to him last year in a sort of economic debate. Sununu denied it, although admitting to favoring supply-side economics.

Sununu then went on to note that, while cheering a possible rebuilding of inventories, observers should also acknowledge the several trillion dollars of debt recently printed in the form of dollars or dollar-denominated obligations to fund this juicing of GDP growth.

Beyond the near term effects of this corruption of the GDP number, Denning also suggested,

"The danger is that all these short-term fixes leave the economy dangerously addicted to taxpayer-funded steroids. The circularity in the housing market, whereby Washington provides tax breaks to first-time buyers, guarantees most of the mortgages written, and then buys most of those, beggars belief, and suggests a worrying case of amnesia following the bursting of the housing bubble."

This, I agree, is a genuine concern. Along with teaching car buyers to wait for a government subsidy, we've added teaching home buyers to expect government aid for that, too. No matter that many quickly use the government-supplied cash to leverage up their debt even further.

What this all means, in the larger sense, as Denning so effectively highlights, is that we can't even trust GDP numbers now. The 3.5% was already somewhat expected, given the depth of decline since late-2007. But knowing that, after government-subsidized activity and spending growth are removed, the remaining 3Q GDP annualized growth was only an anemic +0.7% is no cause for celebration.

This doesn't mean one cannot take advantage of misplaced enthusiasm on the part of many equity investors. But I don't think the 3Q GDP number should be a basis for declaring the US economy healthy and in full recovery.

Sandy Weill's Regulatory Suggestions

Monday's edition of the Wall Street Journal featured an editorial by Sandy Weill, ex-CEO of Citigroup, and Judah Kraushaar. In it, Weill articulated six steps which he believes will "revitalize" the US financial system.

I was a little surprised to find that I actually agreed with several of Weill's ideas, given that he is responsible for assembling the failed mess that is today's Citigroup.

Weill starts out on the wrong foot by, as you'd expect, defending the concept of "too big to fail" as moot and irrelevant. By choosing to see the recent financial mess as caused by Lehman's failure, which isn't, strictly speaking, true, he feels he can simply declare bank size of no practical importance.

I would beg to differ. What got the ball rolling on this crisis was the mid-2007 failure of two Bear Stearns mortgage-related mutual funds. By year end, Citigroup, Merrill Lynch and others were hastily writing off a combined hundreds of billions of dollars of marked-to-market mortgage-backed holdings.

Lehman marked the end of the valuation-based failures of private sector, publicly-held firms, not the beginning.

However, despite Weill's very biased view on this point, which might be expected to color his entire analysis, several of his other points actually make sense.

The first one, unfortunately, does not. Weill wants the Fed to be the financial super-cop. There's so much wrong with this idea that I couldn't deal with it, and Weill's other remarks, in one post. Suffice to say, you don't give more power to the guy who just misused the considerable power he already had. Also, I'd note that Weill was, for nearly his entire career, a securities industry operator. I'm not entirely sure he really understands Fed regulation.

His second point is worthwhile. He, like me, believes that "complex instruments," by which I assume he includes derivatives, should have regular market pricing and be traded through exchanges. The much-feared daisy chain effect of AIG's financial products unit failing would have been eliminated, had its derivatives positions been held via an exchange which required posted collateral. Exchanges remove counterparty failure risk, and would have removed most of the concern over an AIG or Lehman failure in the first place.

Another point Weill makes, which echoes my own prior posts, is to force underwriters of structured financial instruments to retain a healthy portion of the issues, and regularly sell portions to affirm their pricing.

His desire for regulators to somehow oversee the ratings agencies isn't really sensible at all. Just from stories I've heard from senior rating agency employees, it's clear to me that they face undue pressure from their clients, as well as intellectual and technical intimidation. It's unlikely that a bunch of mid-level civil servants at regulatory agencies will ever be capable of going toe to toe with Wall Street financial engineers and produce a useful result. Bank regulators are used to simply counting things and comparing existing reserves to required ratios, reviewing loan documents, and generally checking accounting and paperwork. They aren't securities valuation experts.

Perhaps the best of Weill's suggestions is that regulators stop messing with bank loan loss reserves. According to Weill, the regulators have been pressuring financial institutions to lower reserves in the healthy portion of the lending cycle, then take larger reserves as losses mount. He's correct to note that classical banking does the reverse- fund the loss provisions in good times, both to match losses to when the loans were made, and to smooth out the effects of loss recognition.

Finally, again, reinforcing published work of mine going back to the mid-1990s, he endorses making more senior executive compensation dependent upon and only vested after longer time periods. While he advocates the wrong metric, ROE, his basic instinct is correct. Long term vesting, lagged average total-return based compensation will put a stop to executives reaping quick cash bonuses while avoiding longer term consequences of risky strategies.

Overall, I was pleasantly surprised with Weill's ideas. For a guy whose best years in the financial service industry were spent hoovering up ailing wire houses and rationalizing their back offices, he actually seems to understand more about risky front office behavior than you'd guess from his failure in creating the monstrosity called Citigroup.

Today's Housing Price Data & An Old Post

Back a few weeks ago, I wrote this post concerning the effects of government-directed rewriting of mortgage contracts. Of particular interest that day were the comments of former Lehman economist, now Barclays Capital chief economist, Michelle Meyer.


Coincidentally, I noticed an explosion of hits on this blog today due to searches on Miss Meyer.


How propitious. Because this morning, new housing data was released.


Listening to CNBC's reporting of the breaking data this morning, it was clear that various measures of housing activity failed to meet expectations, helping to send the S&P500 Index, my and most institutional money managers' preferred measure, skidding nearly 2% as of 3:30PM, as I write this.


On the subject of housing prices, the Wall Street Journal noted in today's edition,

"Real-estate prices increased for the fourth consecutive month, but consumers are feeling more glum, a disconnect that shows how rising unemployment continues to weigh on households even as the economy improves.


Analysts warn that prices are being propped up by the government and may resume falling in the coming months as that support fades away. The first-time home-buyer tax credit has sparked demand, in the process pulling sales that might have happened in late 2009 and early 2010 and jammed them into the past few months. The supply of foreclosed homes on the market, meantime, has temporarily decreased as a result of rules that require banks to consider more people for loan modifications."

Perhaps Ms. Meyer spoke too soon earlier this month? We'll soon see.

CNBC's Celebrity "Business Journalism"

This morning, as I was reading and writing before breakfast, I listened, as usual, to the audio of CNBC, to which my television was tuned.

Around 8am, Mario Gabelli joined the program, along with Pimco's Bill Gross. The two traded views on various topics as economist David Malpass made an appearance to discuss his recent Journal article on the effects of currency depreciation on trade flows versus investment flows.

The adoration with which the CNBC co-anchors treated Gabelli was sort of stomach-turning.

Remember back in 2007, when Gabelli was being investigated by the SEC for defrauding the government in a frequency spectrum auction? As I recall, Gabelli recruited the wife of some colleague to front for him and take advantage of some minority set-aside benefits in the auction process. There was apparently some evidence that Gabelli funded the whole effort, and the woman was just a figurehead.

News reports which I found by Googling this subject only note that Gabelli's firm settled with the SEC to vacate the charges.

Here's what occurred to me this morning as I listened to Gabelli hold forth on various topics.

In the two years since Gabelli's fraud incident, why hasn't CNBC's on-air staff ever had a proper interview with him over those charges? Why haven't they grilled him on exactly what really happened?

Here's a leading business channel deliberately ducking the opportunity to behave like a real news organization. They have a guy on as guest-host who was caught up in the sort of business behavior that sickens everyone.

Yet they never have laid a glove on his even once. Instead, Gabelli gets the celebrity treatment on every visit.

This sort of incident, more than most, cements my view that CNBC is all about business entertainment, and not at all about reporting.

Sure, they announce news and breaking development. But because essentially all of their 'in depth' reporting consists of recruiting industry figures to debate and argue points, the channel is entirely dependent upon those guests.

They have no real analytical staff of their own to serve up in-depth reporting. So they have to make nice to all of their guests, or else they have nothing but headlines to read.

You have to wonder why Murdoch's gang, with Roger Ailes at the helm, can't figure out how to combine the now-unused Wall Street Journal investigative reporting capabilities with Fox Business News and blow CNBC off the air.

Allan Meltzer On Excessive US Deficits & The Weakening Dollar

I've written quite a few posts recently regarding what I believe is the arrival of the US at a new tipping point involving the weakening dollar, excessive deficits and externally-held US debt, taxation, additional social spending programs, and coming inflation. As I explained in an email to a friend recently, for the first time in thirty years, I'm genuinely concerned that the predictions of the dollar's and US's economic and, eventually, military superiority's decline, are now within view of coming true.

In fact, with all the government intervention of the past year, posts focused on cases of firms chalking up consistently superior total return performance have declined. Instead, the most interesting topics seem to be the economics of the dollar and deficit spending, and massive government intervention in the private sector of the US economy.

In last Friday's Wall Street Journal, respected Carnegie Mellon political economy professor Allan Meltzer weighed in with a reinforcing editorial entitled "Preventing the Next Financial Crisis."

The crisis to which he refers is not a private sector banking crisis like last year. Instead, he begins his editorial,

"The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon."

Echoing others, and my own concerns, Meltzer then observes,

"Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.

Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows.

Many market participants reassure themselves that inflation won't come by noting the decline in yields on longer-term Treasury bonds and the spread between nominal Treasury yields and index-linked TIPS that protect against inflation. They measure expectations of higher inflation by the difference between these two rates, and imply long-term investors aren't demanding higher interest rates to protect themselves against it. But those traditional inflation-warning indicators are distorted because the Fed lends money at about a zero rate and the banks buy Treasury securities, reducing their yield and thus the size of the inflation premium.

Further, the Fed is buying massive amounts of mortgages to depress and distort the mortgage rate. This way of subsidizing bank profits and increasing their capital bails out these institutions but avoids going to Congress for more money to do so. It follows the Fed's usual practice of protecting big banks instead of the public.

The administration admits to about $1 trillion budget deficits per year, on average, for the next 10 years. That's clearly an underestimate, because it counts on the projected $200 billion to $300 billion of projected reductions in Medicare spending that will not be realized. And who can believe that the projected increase in state spending for Medicaid can be paid by the states, or that payments to doctors will be reduced by about 25%?"

There you have it. Meltzer does a great job of ticking off the sources of unease many, including me, feel about the current monetary and fiscal situation. It truly feels like a nearby bomb, the timer on which is finally, after some 60+ post-WWII years, nearing zero.

On the matter of who owns this mess, Meltzer, in a genuinely bi-partisan vein, writes,

"The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.

Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called "jobs saved" that has never been seen before, has no agreed meaning, and no academic standing."

And there's the rub. Anyone with a brain who has been watching federal government behavior since Reagan's exit from office knows that both parties have allowed our society to rack up huge debts to finance promises which are simply unable to be kept.

Having come of age in business during the Reagan years, with Volcker at the Fed, I never really thought that the lessons of the Carter, and post-Carter years could be forgotten, or simply denied. But, as Meltzer concludes,

"One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn't last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.

Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.

Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.

A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being."

I feel like I'm economically much older than my years, because I recall arguments concerning Arthur Burns' ineffective reign at the Fed. His inability to pre-empt inflation during the LBJ "guns and butter" years of the Vietnam war and the Great Society program spending.

Even this morning, as I write this, I have listened to CNBC's senior economic moron, Steve Liesman, argue that commodity price inflation has no information value for the coming storm of CPI inflation.

Milton Friedman reminded us that

"Inflation is always and everywhere a monetary phenomenon."

With the recent explosion of US dollar liabilities and the Fed funding our debt, Meltzer is clearly correct on the need for the Fed to begin tightening now. Burns' ineptitude was a classic example of waiting too long, then watching the inflation genie escape and run rampant for more than a decade.

Let's hope we are not going to experience that again, along with losing the dollar's reserve currency status.

Boudreaux On Insider Trading

In this weekend's Wall Street Journal, Donald Boudreaux wrote an excellent piece defending much insider trading while lampooning attempts to regulate it, over and above measures which corporations take to limit it.

Simply put, Boudreaux distinguishes between coming events which corporations will wish to keep secret, such as corporate acquisitions, and continuing situations and processes, such as accounting irregularities or incorrect investor expectations, of which anyone with full knowledge of the situation can take advantage, leading to more fully-informed market pricing.

Boudreaux makes a persuasive case that companies know better which information they want to protect, such as event-oriented acquisition information, far more so than federal regulators.

However, citing the Enron case, Boudreaux notes that insiders who would have had knowledge of Enron's fraudulent accounting and practices, and sold Enron shares on that basis, would have helped the market more correctly price the firm's shares lower.

Further, Boudreaux notes, current attempts to ferret out insider trading is biased. Regulators can only look for those who trade on generally-unknown news, not those who do not trade, but would have, absent generally-unknown news.

It's a very interesting and valid point. Insider knowledge of a failed drug certification, new product, etc., could lead someone to not buy shares. But this lack of otherwise-planned action will never be detected, leading to asymmetrical, unfair enforcement of the misguided federal notion of insider trading.

Boudreaux helpfully reminds us that markets serve to efficiently price securities by virtue of incorporating as much news as possible into their prices. The so-called 'price discovery' process.

Insider trading, he notes, contributes to this objective, rather than corrupts it. So why would we want to punish those who help make markets more efficient?

More Bad Research On Corporate Performance From Deloitte

I read a reference in a recent Wall Street Journal column by Holman Jenkins to a recently-popular piece of research by two Deloitte consultants, Michael Raynor and Mumtaz Ahmed, along with a "researcher" from the University of Texas, Andrew Henderson.

The book they wrote is described here, and the paper from which it sprang, may be found here in a Deloitte website post, and downloaded/read.

Whenever I read of a reference to some new empirically-based work purporting to diagnose the bases of corporate performance that is desirable to emulate or duplicate, I naturally am curious to learn who did the work, the methodology employed, and their conclusions.

In this case, it appears that Raynor is the leader of the group. His bio can easily be found, as well as his own website. From what I've gathered, he is clearly an intelligent individual, but doesn't seem to be described as having any significant working experience in business, outside of his academic pursuits at Harvard (DBA) and as a consultant at Deloitte. Deloitte, it should be noted, is not exactly in the vanguard of management consulting. Neither is Harvard known as a source for the best empirical approaches to business performance analysis. And it would appear that Raynor is in a sort of 'of counsel' role at Deloitte, as he has his own speaker's bureau representative and website.

In the beginning of their article, the authors state that they believe most prior studies of excellent US businesses have, in fact, been portraits of lucky, rather than skillful firms.

It's also not all that surprising, to me, at least, to learn that Raynor's methodology has little relationship to the real world in which most businesses operate, i.e., a need to produce results that create wealth for business owners. The most easily-accessible data for this, which, conveniently, also is the business form which accounts for the bulk of US business activity, is total returns of publicly-held corporations.

Because I linked to the authors' original article, I won't duplicate their text with reposted passages here.


In their piece, the authors essentially put down total returns as too reflective of future performance, as anticipated by investors, than actual management skill.

Instead, they chose ROA as their preferred measure.

As I mentioned to a colleague, this choice, alone, virtually guarantees the uselessness of all of their efforts.

Yes, they got their article in HBR, won a prize, expanded it to a book. Fine. Tom Peters got a lot of accolades, too, at first. But his work sunk like a stone into the vast sea of strategy and management 'how to' tomes. As, I would expect, will this latest effort by Raynor, Ahmed and Henderson.

Their description of what total returns are is wrong. It's not simply a measure of future "surprises" to investors. Taken as a pattern, over time, total return measures, in a presumably reasonably efficient market of investors and analysts, the ability of a firm's performance to exceed expectations. It does involve expectations, but it also involves expectations based upon prior and evolving performance.

And, more importantly, it is the measure of wealth created by management of the firm, regardless of the exact source of that wealth. It may have been a fortuitous purchase of a patent, a discovery in the research labs, a marketing edge, the discovery of some mineral deposit, or other unpredictable competitive advantage.

In fact, the very unpredictability of the advantage is what generates surprises and wealth. If all gains or excellent performance stemmed from reproducible methods, then those methods would quickly be copied, implemented, and all competitive advantage due to them would vanish.

Such performance can't, won't, and doesn't typically last for very long. But that timeframe can be years, not days or months.

In fact, my own research began with my simple quest to learn what the distribution of company performances was on the basis of being able to consistently outperform the equity markets averages on total return. From that knowledge, I was able to discern a range which constitutes an average length of time of outperformance.

In the same research, I tested ROA's association with patterns and levels of market outperformance, and found it absent for firms which grew revenues at above-average rates. Simply put, ROA is a point estimate of little value in deducing ongoing behavior of firms that are growing at a healthy pace.

And ROA doesn't automatically or tautologically translate into shareholder wealth. So it's going to be of passing interest to both investors and CEOs.

Thus, for all their extensive, hard quantitative work, the authors of the Deloitte study have pretty much doomed it to insignificance because it doesn't generate operable conclusions which directly lead to increased wealth for shareholders or their CEOs.

Then there's the matter of choice of patterns of outperformance.

In my research, I first reviewed real corporate performance over time. From these analyses, I constructed patterning variables which grouped companies by the pattern which their performance exhibited.

By contrast, the Deloitte study authors began by arbitrarily deciding to set a threshold of occurrence of 9 out of 10 years for a variety of unspecified fundamental performance measures.

Why should 9 out of 10 be the appropriate screening value? Why impose a value on the date a priori, instead of simply letting the data describe the true situation?

Thus, the authors proceeded down a path which features their own subjectively-chosen patterns for outperformance on a measure, ROA, which has no direct relationship to the growth of shareholder value in most companies.

As I read their paper, I reflected on my own background being a curious confluence of several important streams of influence. Over many years and with different companies, as a marketing and strategy professional, internal consultant, external consultant and research director, in several different sectors, including financial services, I happened to absorb several key lessons for this type of research.

Being in consulting at Oliver, Wyman & Co., I didn't approach research on the sources of consistently superior shareholder wealth creation with the scepticism that a true believer in efficient financial markets. When I produced my financial services sector results and presented them to retiring Chairman Alex Oliver, he exclaimed, to paraphrase,

'For years we've been saying we had knowledge of what drives superior performance, but we never really did. Now, with this, we do. This is a strategy consultant's ultimate tool.'

Alex was a lot of things, including cheap and petty, but he was arguably one of the best strategy consultants of his time. In his day, he headed Booz Allen Hamilton's strategy practice, leaving to co-found Oliver, Wyman. I took his praise as justifiable proof that my research approach was unique, effective and applicable in a very pragmatic manner.

When I extended the research, on my own, to the entire S&P 500, the results were even more powerful and applicable.

What Raynor, Ahmed and Henderson have produced has no real applicability other than a sort of minor confirmation that what can be easily duplicated is of little lasting value. And that what typically creates significant shareholder wealth can't be reduced to easily-duplicated management dicta.

So, there you have it. The Deloitte study authors and I agree that unexpected innovation can't be easily duplicated as a management style.

But I already knew that, and, if you read this blog regularly, so did you.

Is Bigger Really Better In Banking?

As I mentioned in this recent post, Charles Calomiris of the Columbia Business School wrote an editorial defending 'too big to fail' banks in last Tuesday's Wall Street Journal.

Calomiris clearly states his contention thus,

"Yet the challenge of coordinating the efforts among different countries' regulators can be met through prearranged, loss-sharing arrangements that assign assets to particular subsidiaries based on clear rules. This would make it possible to transfer control over the assets and operations of a large international financial institution in an orderly fashion, in case of its failure. This process could be handled by the courts for nonbank failures and the Federal Deposit Insurance Corp. for banks. With such arrangements in place, governments will have no reason (or excuse) to bail out large, international institutions.

But is it worth the trouble to preserve large financial institutions? Emphatically, it is."

It's worth noting that Calomiris postulates an entirely new, trans-national financial regulatory and accounting structure, after and on which he then bases his contention.

Realistically, what he envisions would be a good decade away from implementation, never mind that the sorts of accounting data supporting it would be gamed to high heaven by the smart financiers who would have time to discover and exploit the inevitable loopholes.

And, ironically, last year Calomiris claimed, in the Journal piece on which I wrote a post which is linked in that recent post, that the Basel accords' risk management prescriptions were the reason for the recent meltdown!

So, prior international financial regulatory attempts were bad. But now, Calomiris believes, they will magically become good.

Remember, modestly-paid civil servants write these sorts of regulations and procedures, while much smarter, better-educated sector practitioners, with plenty of capital behind them, immediately begin working to subvert, avoid and evade these same regulations.

Calomiris' vision will never be created, much less work as planned.

"This underlying reality is the background factor that helps explain why some financial firms also need to be large.

First and foremost, they need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.

Second, there are economies of scope when financial firms combine different products within the same firm (lending and foreign-exchange swaps, for example). A financial firm able to offer multiple products to a customer means savings in marketing costs and in the costs of information production (about the creditworthiness of clients, for example). Economies of scope among products also imply economies of scale within finance suppliers, since small financial firms cannot afford the overhead costs of building platforms with many complex products."

This is a rather common fairy tale in banking. The truth is, until the mid-1970s, the business of correspondent banking was alive and well. I didn't happen to include Calomiris' cite of Ollie Williamson's recent Nobel for his work on networks among businesses, but correspondent banking was the original implementation of this notion.

Simply described, regional and local banks across the US would use New York- or California-based money center banks for various financial markets activities, such as securities lending, upstreaming loans for risk layoffs, taking part in large loans from the money center, institutional trust, letters of credit, and so forth. There was no particular need for a regional bank to be everywhere, when it could basically share customer activities with a money center bank.

However, as money centers grew more complex, there was no accompanying increase in the skills of senior management in those banks, and the increased risks began to result in heavy losses. For example, recall Chase Manhattan's Drysdale Securities fiasco in securities lending, and the Penn Square energy lending debacle in the correspondent banking division.

If anything, finance has proven to be a sector where focused execution of fewer functions tends to result in greater wealth creation per invested dollar. Old line investment banks and brokerages were partnerships which only went public when the allure of cashing out to an unwitting public proved too great a temptation for the older partners.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. For example, my research shows that from 1980 to 1999, after controlling for changes in the mix of firms, the underwriting costs of accessing the public equity market fell by more than 20%. These declining costs encouraged an expanded use of the market particularly by young, growing firms.

One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.

This is hilarious. I would just love to know how the Fed's economist's study defined "bank productivity." I worked at Chase Manhattan for quite a few years, in many areas of the bank, including IT. One thing which is nearly impossible to do is provide a meaningful, cross-bank measure of productivity that has any sort of functional meaning.

As for Calomiris' finding of lower equity underwriting costs, this is precisely what my old boss at Chase, Gerry Weiss, predicted. However, Calomiris separates that cause from the effect it triggered on Wall Street, meaning investment banks. This loss of profitability in underwriting is what drove Merrill Lynch, Morgan Stanley, Bear Stearns, Lehman and the capital markets portion of Citibank to pile into mortgage banking and securitization. Thus, the causes of the ensuing bubble of poorly-originated and securitized mortgages by 'too big to fail' investment and commercial banks stemming from the ability of diversified financial institutions to move into product/markets with which they were not well acquainted. And whose risks with which they were inexperienced.

Fourth, global financial institutions also have made stock, bond and foreign exchange markets globally integrated and more efficient. Global financial institutions are the institutions that provide the funds for arbitrage across markets, which ensure global market integration.

But such "integrated and more efficient" "stock, bond and foreign exchange markets" can be accessed by smaller, single- or limited-product line firms, just as well as by financial utilities of unimaginable size and scope. That's the point of exchanges. They require counterparties to post collateral and stand between the counterparties, allowing small and large entities to safely trade with each other.

It was the old telephone markets which allowed large firms, in their day, like the old Salomon Brothers, to dominate specific markets, such as fixed income trading and origination, to the detriment of smaller rivals.

Today, we see thriving privately-owned M&A, hedge fund and private equity concerns. All primarily focused on specific niches in the financial services markets.

Until large commercial banks embarked on their buying spree, of dubious value, of standalone credit card issuers, that segment, too, had its own focused, skilled competitors.

Limiting the size, complexity and global reach of financial institutions is fraught with downsides for the international economy. We can solve the too-big-to-fail problem without destroying global finance. It certainly is worth a try."

As in his piece in October of last year, Calomiris avoids providing empirical evidence for his sweeping contentions. By contrast, merely observing which firms went under last year tells you a lot about how wrong Calomiris' positions are.

Merrill Lynch, Wachovia, WaMu, Bear Stearns and Lehman were all large financial institutions. They were either needlessly diversified, or growing into new areas at their peril. Citigroup and AIG came near dissolution, but were "saved" by government intervention. Morgan Stanley nearly failed, but found a gullible Asian savior just before the feds closed and merged them, as well.

One of the most memorable lessons I took away from my Chase Manhattan Bank experience was the manner in which executives in businesses that are part of a large, diversified financial institution lose a sense of individual risk-taking, assuming that poor performance or outright losses will be borne by the institution and its shareholders, while the near-term profits of risky and/or ill-conceived strategies will drive bonuses for the unit's management.

Financial services skills tend to be focused on and in particular products. Very few senior managers, CFOs and CEOs actually understand the intricacies of all of the businesses which report to them, and for which they are responsible and accountable. Notice how unprepared Vik Pandit was as he was given the CEO job at Citigroup, and how many months he took before claiming to have the slightest idea of what to do with the collection of businesses he inherited from Chuck Prince.

Among the most admired financial service firms, for their ability to generate consistently superior total returns, do not appear large, publicly-owned diversified banks. More often, firms such as Goldman Sachs, Blackstone, Blackrock, and a few hedge funds, are mentioned. Those firms operate in fewer, more focused collections of businesses.

As I wrote in that recent post concerning Mervyn King's and Paul Volcker's calls for the effective rebuilding of the Glass-Steagall wall between deposit-taking institutions and risk-taking investment banking institutions, it's simply unwise to allow large, diversified banking concerns to have a conduit into government-insured deposits. This allows them to essentially take risks with taxpayer-insured money, knowing that this will also prevent the firms from failing without some form of government-directed intervention or rescue.

In short, until and unless such insured activities are split from risk-taking ones, the moral hazard against which the two central bankers warn will continue to loom large.

Calomiris simply ignores this fact, provides no persuasive empirical evidence for his contentions, and then dreams up a non-existent international regulatory regime on which to base his conclusion that we need gigantic financial utilities.

Business Odds & Ends

Quite a bit of flap has arisen in business circles over the administrations "pay czar" slapping 90% salary cuts on a number of executives at firms which requested or took government aid, e.g., GM, Citigroup, AIG, BofA.

If anything, this illustrates the point of this post back in April about a lack of boundaries between government and business. I wrote,

"In my opinion, as well as others, such as William McGurn of the Wall Street Journal and even liberal Nobel Economics Laureate Joseph Stiglitz, the bankruptcy option has been avoided far too much in the past twelve months.

Bear Stearns, Lehman, BofA, AIG and Citigroup, upon appealing to the federal government for assistance, should all have been referred to bankruptcy court or the FDIC for closure. GM and Chrysler, too, should be in Chapter 11.

Somehow, corporate executives have come to expect their government to play favorites, pick winners, and temporarily prop up failing companies, rather than admit their own mistakes and close up shop.

By failing to observe the boundaries of responsible corporate behavior, boards of directors and CEOs unwisely opened a Pandora's Box of problems by requesting government financial aid.

This left them open to having their operations and decisions overseen and scrutinized by political officials who have used the excuse of looking after taxpayer money in order to move our economy down the road of fascism.

At the same time, government officials, beginning with the Bush administration, and continuing into the current one, have unwisely consented to helping private corporations, rather than declining, and sending them to their fate in the financial markets or bankruptcy courts.

By failing to observe the clear line between private and public spheres of activity, our government officials have compromised our economic system and given into the temptation to begin manipulating companies for political purposes and pet political agendas."

Right now, the political agenda on display is liberal America's desire to limit executive compensation. And, frankly, the companies involved right now deserve this treatment.

They ran themselves into a condition worthy of bankruptcy court. They begged for government aid. Now, having availed themselves of taxpayer funding, they have no excuse for having compensation become a political weapon to be used against their employees.

But I don't think there is any room for such government intervention in the rest of business.

You don't see the administration suggesting that entertainment or sports figures have their compensation limited, do you?

On another topic, I saw a laughable little piece on CNBC the other day. The topic was women in business, featuring some female MD from Deutsche Bank's derivatives unit.

Hilariously, the woman, whose name I cannot recall, blathered on about how a woman can now take time out of her career to have children, return to the workforce, and still reap substantial corporate success.

Michelle Caruso-Cabrera, a CNBC co-anchor, laughed and retorted that the only truly successful executives of either gender of whom she knew basically slaved like dogs, worked unending hours for years, sacrificed their family lives in order to climb to the top of the executive ladder at an investment bank. The other CNBC on-air personnel bobbed their heads in agreement.

The Deutsche Bank woman protested that this was wrong, and here she was, an MD at DB, to prove them wrong.

Look, let's be honest. DB is no Goldman Sachs, Morgan Stanley, or Blackstone. It's simply not a first-rank US investment bank or asset manager. DB is one of those second-rate-at-best, large European universal banks which bought a US bank, usually in distress. In DB's case, that would be the old, self-crippled Bankers Trust.

I don't think anyone equates rising to MD rank at DB with being a senior executive at Goldman, a first-rate private equity shop, or a hedge fund.

It's not clear just why CNBC even aired this segment. I guess they really wanted to focus on the notion that women can now rise to the top of an investment bank while happily and successfully juggling a family, too.

Unfortunately, I don't think women in senior management at truly first-rate investment banks, private equity groups or hedge funds would waste their time appearing on CNBC to crow about how much time they didn't work while rising to the top.

It seems to be very much a Groucho Marx sort of topic. Anyone foolish enough to self-identify as a successful female financial services exec who has it all probably either a) doesn't have it all, b) isn't that successful, or c) is about to have her career limited by appearing on CNBC to state that she has it all and is successful.

More Regulatory Pressure To Separate Commercial & Investment Banking

Way back in 1996, my friend B predicted that, going forward, US banks would become increasingly like utilities, with core lending and deposit-taking functions eventually separated from riskier investment banking. The former would become federally-insured activities, with lending subject to fairly rigorous standards in order to qualify for federal guarantees.

Otherwise, he noted, the few, large deposit-taking banks would subsidize risky investment banking with insured deposits and a "too big to fail" condition that would only lead to increasingly riskier trading and underwriting activities.

This week, Mervyn King, Governor of the Bank of England, and Paul Volcker, former US Fed chairman, once again called for separation of investment and commercial banking. For pretty much the same reasons B prophesied over a decade ago.

Both central bankers identified the increasingly risky behavior of commercial banks which have bulked up proprietary trading and underwriting activities.

Yet, one only has to look at this week's mortgage loan delinquencies at Wells Fargo to see that my old Chase Manhattan boss, Gerry Weiss, was prescient when he observed that money center banks didn't need to enter investment banking to lose money. They could do that in their regular businesses through the usual abandonment of credit standards in pursuit of market share as various product/markets exhibited strong growth in demand.

Is a return to an era of a Glass-Steagall type of separation of investment and commercial banking possible?

If the current administration and Congress have their way, quite possibly.

Given the quick return to risky trading activities at Chase this past quarter, it's clear that the combination of the two types of banking is going to once again, in time, lead to risk-based profits for shareholders and compensation for employees, while heavy losses will once again tax the FDIC and result in federal rescues.

Just a few days ago, on Tuesday, Columbia finance professor Charles Calomiris authored another flawed editorial in the Wall Street Journal, on the subject of universal banks combining investment and commercial banking. The last one one which I posted, here, was exactly a year ago.

Because Calomiris' piece was so long, and contains a number of fallacies, I'll touch on it in a subsequent post.

But, for me, King and Volcker represent far more objective, reasoned positions on the subject of separating riskier banking activities from those of insured deposit-taking institutions.

Wells Fargo's Mortgage Woes

My friend B predicted this at lunch late this summer.

As we discussed the expected continuing bank loan losses, he mused that Wells had bought a truckload of trouble via Wachovia's purchase of Golden West Financial some years ago.

You may recall that the Golden West acquisition was a material cause of Wachovia's slide into insolvency, leading to Ken Thompson's ouster.

When Wells swooped in to take Wachovia out of the arms of failing Citigroup last year, many thought it to be a clever purchase.

However, Wells' own California-focused mortgage business, coupled with the Golden West loans, is now stressing Well's loan loss reserves. California was certainly among the most over-priced areas in the US during the mortgage finance excesses of the past few yeas, and Well's mortgage portfolio's delinquencies are now reflecting that.

As the unemployment rate continues to remain high and probably go higher, expectations for these delinquencies to not become defaults are low.

And just this morning, the Boston Fed's president expressed his view, on CNBC, that the economy is still very fragile, and interest rates will have to remain low for some time.

This doesn't look like economic recovery to me.

FHA Mortgages: Buckle Your Seatbelts For More Defaults

In yesterday's Wall Street Journal, Nick Timiraos wrote,


"Some 59% of new home buyers are using government-backed loans from the FHA and other agencies, according to a survey of home builders by John Burns Real Estate Consulting, an Irvine, Calif.-based consultancy. The FHA accounts for nearly half of all mortgages, while loans from the Department of Agriculture and the Department of Veterans’ Affairs account for another 10% of all loans for new homes.

The government’s share of the market rises even higher in certain areas. In Northern California, for example, builders said that the government accounted for 76% of all mortgages, while the government share stood at 65% in the Midwest and 62% in South Florida."


Further, FHA mortgages may be had with as little as a 3% downpayment!


Mind you, FHA was originally intended to be the government-backed housing finance program for lower-income Americans. How in the world did it morph into accounting for more than half of new home loans? With the VA coming in for another 10%?

A few days earlier, on last Friday, to be precise, Peter Wallison of the American Enterprise Institute wrote a piece in the Journal entitled, "Barney Frank, Predatory Lender."

Wallison details Frank's push for governmental support of questionable mortgage lending, including requiring the GSEs to make 55% of their mortgage purchases "affordable," meaning lower-quality.

He notes, regarding the presumption that Wall Street firms cavalierly originated and securitized bad mortgages of their own volition,

"There was always a problem with this theory. Mortgage brokers had to be able to sell their mortgages to someone. They could only produce what those above them in the distribution chain wanted to buy. In other words, they could only respond to demand, not create it themselves. Who wanted these dicey loans? The data shows that the principal buyers were insured banks, government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and the FHA- all government agencies or private companies forced to comply with government mandates about mortgage lending."

Wallison's last sentence is a clear warning about a rerun of the past few years' mortgage mess,

"If the financial crisis was caused by subprime mortgages and predatory lending, the government's own policies made it happen."

Buckle up!

Amazon's Kindle's Coming Competition

Yesterday I wrote a post concerning the coming, unanticipated and unintended consequences of high volumes of high-bandwidth multi-media wireless communications applications.

Along the same lines, the colleague with whom I discussed that topic has led me through the logic behind another coming unanticipated consequence of a recent technological development.

Amazon's Kindle ereader is on its second or third version by now. And other entities are hot on their heels with competing products. It's clearly another opportunity for an iPod and iTunes sort of system competition.

My colleague then observed that, now, about the least-used and simplest of iPhone applications is voice communication. The screen, fonts, and apps on the iPhone are all superior to other multi-media phones and communications appliances. In fact, it appears that Steve Jobs' relentless focus on special fonts for his products is bearing fruit on the current generation of small, hard-to-read screens.

But my colleague noted that, soon, all Apple has to do is put the iPhone on steroids and produce it as a tablet-sized reader.

When that arrives, Amazon's Kindle is toast. It will be a one-app device in a new, multi-app world.

How attractive will a Kindle be in a world in which an iPhone and its competitors, with rich communications applications, including voice, text, video store and messaging, cameras, all contain ereader apps, too?

My colleague showed me how reasonably clear the type and presentation of a current iPhone are. Apparently, the Kindle still has clarity issues. It's weak on actual readability, but alone, for now, in providing electronic access to material.

That is probably going to change in a few years.

Jeff Bezos might well be enjoying the halcyon years of his firm's ereader right now. Because once Apple arrives with a competitive product, I don't think Amazon's core skills will allow it to keep pace with the dominant US consumer technology firm.

Unanticipated Consequences of Wireless Multi-Media

I recently had a long talk with a colleague on the subject of the evolving world of wireless multi-media communications and devices.

Of particular interest to us was the relatively new wireless cellular modem card for use in laptops. Verizon has been advertising its MiFi service and gear relentlessly in past weeks.

Essentially, this device allows a user to take 4-5 users through one cellular router up to a cell system, bypassing an initial wireless step into a conventional WiFi hotspot router and onto the wired internet.

Instead, internet connectivity is totally wireless through the cellular carrier, until it accesses the internet backbone.

Pricing, of course, can quickly reach hefty levels if more than one person is using this in a full-blown multi-media mode. But the capability never the less now exists, practically, for several people located in the middle of nowhere, in terms of wired internet access, to have reasonably high-speed wireless access to the internet.

A recent article in the Wall Street Journal noted iPhones and similar non-Apple devices being used for this sort of multi-media application, consuming huge amounts of wireless capacity. So much, it contended, that two local wireless slingbox users could effectively consume a neighborhood's total wireless bandwidth capacity.

Thus, pricing is probably going to move, rapidly, to a bandwidth-usage basis. After the initial pricing plans incenting large volumes of text messaging for fixed prices, the subsidizing of larger-bandwidth hogging video viewing is finally exhausting existing wireless system capacity.

The logical consequence is to move to usage-based pricing in order to both effectively ration bandwidth usage and fund further capacity increases in existing wireless systems.

Ironically, this might actually overshadow any similar move to wired internet usage pricing, as that begins to look like a comparative backwater.

As I'll mention in an imminent post about coming generations of wireless reader devices, this is just the tip of the iceberg for wireless usage, pricing and capacity issues. It's going to get much more interesting, as the Journal piece noted, for companies like Google.

In fact, the article observed how quickly Apple went from fighting Verizon's possible encroachment on applications on the iPhone to a partnership to make sure iPhones can work on the latter's network. Apple is evidently seeing that getting others to pay for the infrastructure that the iPhone requires is far cheaper than being forced, through a closed system, to pay for one itself. Thus, the article mused that Google, Yahoo and other non-network-owning content providers could soon find themselves in a difficult pricing situation.

They will be using large amounts of bandwidth to serve their customers, but won't own any pipes, and, thus, will be vulnerable to applications-based pricing from their servers.

This could get quite interesting in a hurry, causing some business models to become much less profitable almost overnight.

Jamie Dimon's Chase Increases Risk To Generate Earnings

After the celebrations over JPMorgan Chase's recent revenue and earnings announcements which exceeded "expectations," more sober analysts are noting the increased risks the bank took to generate those results.

On Thursday, the Wall Street Journal's Heard On The Street column called it "J.P. Morgan's Chilling Win."

The article detailed the decline in profitability of the bank's core businesses. Loan volume was down, while loan loss provisions went up, and credit card past-due volumes were up, as well.

According to the Journal, the bank's VAR measure rose as it relied on bond trading for its juiced-up profits.

But, wait!

Isn't excessive risk-taking in trading and non-core banking business precisely what Congress, the administration, regulators and the banks themselves all swore was what caused the recent financial meltdown? That such short-term, excessive risk was to be sworn off by our "too big to fail" financial titans?

Gee, that didn't last long, did it?

Here's a memo- short term fixed income trading isn't a core retail or wholesale commercial bank business. It's what investment banks and brokerages use to boost earnings, but not without accompanying increased risk.

Of course, this country no longer has any large investment banks. They either failed, or begged for commercial bank holding company licenses last year, the better to get access to the Fed borrowing window.

So Chase is basically following Goldman Sachs' lead in relying on risky trading to generate revenue and earnings surprises. Guess how long that's going to last?

So much for anyone having learned from last year's debacle. So much for regulators being serious about oversight and risk management.

Nothing essential has changed about the US financial services sector in the past year, other than a few badly-managed firms were left to fail, while a few others were kept on government-supplied life support.

Nor has anything changed about Jamie Dimon's lack of management skill. Those surprising earnings came courtesy of some fixed income traders and the risk they were allowed to take, not from core lending businesses.

But the Journal is correct. Chase isn't making its money on conventional commercial banking. It's taking extra risks by wagering its proprietary capital at the tables in that little casino we like to call the US fixed income markets.

The BofA Ken Lewis Succession Mess

By now, BofA's board must be lamenting the day its CEO, Ken Lewis, agreed to take federal funding. And agreed to buy Countrywide Financial. And agreed to buy Merrill Lynch. And agreed not to tell shareholders of the bonus payouts to Merrill employees prior to the sale's closing.

Now the administration's "pay czar" is refusing to agree to Lewis' compensation.

Isn't this all enough to prove why it's never a good thing for government to get in bed with private, publicly-held companies?

BofA probably should have just taken its lumps from the Countrywide purchase and soldiered on, rejecting federal "help."

It could have done what it liked with the Merrill purchase, including rescinding it for material changes. It could have paid its employees what it liked, and ignored Treasury's coercive behaviors.

Instead, the board has to scramble to replace its CEO, who is girding for an extended legal battle with the New York State. And has to submit its executive compensation to some nitwit in Washington.

Federal money was the root of all of this trouble for BofA.

They should have just said "no."

Mortgage Market Pablum from Barclay's Michelle Meyer

Another wacky segment which I caught yesterday afternoon featured a woman from Barclays named Michelle Meyer. Apparently she was a rising star at...ah..... Lehman. Now she's chief economist at Barclays Capital, having been absorbed along with some other remnants of Dick Fuld's failed investment bank.

The topic of interest to me was one on which I'm planning another post, as well- a return to poor lending standards and the abrogating of current mortgage contracts.

The various talking heads on the segment were discussing rising delinquencies and, ultimately, the foreclosures which will follow. One CNBC reporter noted the story of a realtor who simply stopped paying her family's home's mortgage because their loan is so deeply underwater. This was some nine months ago, so the story went, and she hasn't been contacted by her bank yet, effectively letting the family live mortgage payment-free in their own home.

As the CNBC on-air anchor introduced the topic of mortgage forgiveness and rewrites, she polled the discussion participants regarding how this treatment of investors will affect subsequent mortgage lending in years to come.

Meyer jumped in and missed the entire point with her comment. Instead, she blurted out something about the price bottom having been reached, so it's upwards from here for the market. Nothing in her comment indicated she understood in the least what the anchor's question implied.

I watched this, and Meyer, with curiosity. Meyer appears to be, at most, in her mid-30s. Most of her mortgage-related experience has thus been in one of the most bizarre, unusual markets of all time. Rates near historic lows, negligible down payments and easily-securitized liar loans, option-rate ARMS and other strange residential finance creatures. All in a surreal market of ultra-low rates.

By contrast, my friend and sometimes business partner, B, is a residential finance veteran of some thirty years. He built at least two mortgage businesses on Wall Street, and has consulted with several others. He and I have discussed how he has supervised and managed teams of twenty-something mortgage business personnel who were stymied when confronting recurring problems B had first seen, and solved, decades ago.

It struck me as disappointing that CNBC has sunk to basically having kids on their segments as experts.

Remember when Mary Meeker and Henry Blodgett were the queen and king of internet business analysis? That didn't end so well, did it? If I remember correctly, I think Blodgett signed a consent decree to refrain from being an analyst anymore.

Lehman wasn't exactly a successful, driving force in investment banking during its last incarnation. Color me sceptical (yes, note the blog's title), but the failed bank wouldn't be a place where I'd expect to find the sector's best economic analysis or talent.

Even Bear Stearns had, in its day, Larry Kudlow and David Malpass. Both economists of much greater depth and with longer experience than Meyer.

To appear on air and assure everyone that, despite mortgage loan covenants being torn up by government programs, future housing finance will be unaffected just seems ludicrous to me.

But that's what Meyer seemed to be saying with her rather irrelevant response to the question concerning how investors will now view the safety of mortgage-backed instruments.