Dusting Off the Bookshelf

One of the dustiest parts of my library is the business book section, and that's probably because most of these volumes are not worth rereading and have a short half-life. I'm getting better at not spending money on these "made for flight delays" books. However, I found one that I have always liked, "Memos from the Chairman," by Alan C. Greenburg of Bear Stearns. The foreword to the book is by Warren Buffett.

A 1984 memo to all general and limited partners contains the following advice from Haimchinkel Malintz Anaynikal--Greenburg's imaginary mentor. It resonates with me every time I read it:

1. Stick to thine own business
2. Watch thy shop
3. Limit thy loss
4. Watch thy expenses like a hawk
5. Stay humble, humble, humble
6. When dealing with a new account, know thy customer and know thy customer's money is up.

Reflecting on 2008's rubble of corporate and financial debacles, I think Haimchinkel's tenets could have helped stave off disaster. Banks didn't stick to their traditional lending businesses and standards and got involved with market segments, customers and instruments that they didn't understand. Nobody was watching the shop, and that means managements, internal and external auditors and boards of directors. Number three has been turned upside down in the world of exotic derivatives. Expenses were irrelevant, as the size of the book was all that mattered.

To talk about humility in financial markets or in corporate board rooms seems "New Age," but when I read Greenburg's book in 1996 it was really refreshing. I never thought of Alan Greenburg as a soft and squishy type of executive, but he lived his beliefs and expected Bear Stearns employees to do the same. Somehow, as the culture of Bear Stearns evolved after the retirement of the charismatic Greenburg, all of this sound thinking was abandoned.

Corporate cultures are not immutable. Instead, they seem to radiate downward from the C-suite and seem to be inextricably associated with one individual. This can create what Nikita Khruschev called the "cult of personality." When the personality departs, the culture does as well, which means that the culture was really not something alive and durable. In the case of Bear Stearns, the management succession process was not able to preserve the culture and values cherished by Greenburg. Pity.

Some Cultures Don't Fit--And We Know It.

When I started on Wall Street in the Eighties, I first encountered the fashion of commercial banks purchasing asset management companies. You know the justifications: diversification and entry into a high margin, recurring revenue stream business. Walking past the Chemical Bank on Park Avenue in New York City on the way to work, I read about Chemical buying an outfit named Favia Hill. Bankers Trust, which was across the street, soon followed with their own announcement, and the trend started in earnest.



Not too long afterwards, rumors of tensions started surfacing. Asset management companies gave free rein to their senior portfolio managers regarding decision-making, and the compensation arrangements were quite generous. Of course, the commercial bank owners, who were used to heavy regulation and lots of bureaucracy, could not abide the free wheeling culture, but especially could not accept the compensation levels in their asset management subsidiaries. A few years later, most of the banks disgorged their asset management groups, while time, management focus and shareholders' monies were wasted.



Here we are decades later, and Bank of America buys Merrill Lynch. The press releases sound similar, except they are written more in the vein of "we've created a true financial bazaar, including advisory services and retail brokerage." Now however, the pay gap between the two executive cultures has narrowed, as C-suites in banks also have robust pay packages. However, the cowboy culture of investment banks and high-end wealth management groups has also become more extreme. Remember the Internet Bubble and "PO!" stocks rated "Strong Buy?"

The cultural mismatch is exacerbated today by SOX concerns, conflicts of interest, the uncertain role of equity research, and quasi-independent wealth management groups operating under a corporate umbrella. This was never a match made in heaven, and it's hard to see why it would be different in the markets of today and tomorrow.

The 4.5% Solution

Again, Professors R. Glenn Hubbard and Christopher Mayer of the Columbia University Graduate School of Business have reiterated their idea for putting a floor under housing stock price declines, avoiding foreclosures, and for enabling consumers who refinance to increase their consumption. We've written about this idea for some time in previous posts, and it sounds as if something like it might be forthcoming.

This would be a much bolder move than the much-ballyhooed but largely symbolic easing announced yesterday. To paraphrase Alan Blinder, "A for effort by the Fed, but an Incomplete for results."

Given that the lateness of the calendar, we're a little concerned about the ability of the Congress,the Bush and incoming Obama administrations to agree on the Hubbard-Mayer plan, but there's always hope.

Here is the link again:
http://www4.gsb.columbia.edu/realestate/research/housingcrisis/mortgagemarket

Accountability

I've been in a number of discussions lately where everyone has cried out for greater accountability. The pleas for accountability are always directed away, at other groups, either on the same rung, or most often up the hierarchy.

In my soccer team coaching, I have always emphasized mutual accountability. A soccer field is too big, and the power of any one individual--no matter how skillful--is too small to carry the day in a match. So, a back line defense must be accountable to each other, in deciding how to patrol the defensive areas, how to shield the goalkeeper and how to supply the midfield. A goalkeeper is accountable to everybody, but especially to his back line in helping them manage their assets. The midfield is accountable to both the back line and to the attackers. Without being able to supply the attackers, the team can't score; without shielding the back line, the defense will eventually be pierced by a well-organized team moving the ball. The attackers are the ones with artistic license, but they too have to take their chances when they come and finish them. If the team is under pressure, attackers are accountable to defend.

Within each unit, the members are accountable to each other, so that if ball possession is lost it has be be recovered, as soon as possible, and it doesn't matter how. This means that there is constant communication within and across groups. By contrast,communication in corporate groups is episodic--daily or weekly meetings--and stylized. There's no time for that on a field. It's live, it's constant and it relates to an immediate problem.

High level executives love golf, the most solitary of games. This seems ironic to me, especially since team work is one of the most overused corporate cliches. A report about the former CEO of Merrill Lynch noted that he preferred to play golf alone. After the demise of the firm, a consultant to the board of directors noted that this might have been a red flag!

Accountability is really for everybody, and it should not solely be regarded as being directed upward, as it is in most organizations. Every working group or project team can employ the idea of mutual accountability to great benefit.

It's Not Rocket Science

As the details begin to emerge about a Guinness Book of Records-size Ponzi scheme by Bernie Madoff's "asset management" company, there were two interesting items about investors who passed on giving assets to the Madoff funds. In some cases they hired firms to perform due diligence. So, did these investigative firms send in laptop-toting, analysts with high-powered statistical packages to back test the firm's strategies? Not at all. They asked the very basic, but penetrating questions.

One firm simply looked at the name of the accountants overseeing the financial reporting for Madoff's $50 billion in assets under strategies that involved indexes and options. They actually called and then visited the accountants and discovered a three person firm, one of whose principals was 78 years old and lived in Florida (the office was in New York). You don't need to turn this over to your risk management committee. It makes no sense, smells bad, and it is highly improbable that they could exercise the proper level of auditing oversight and control. The investigative firm recommended that their investor pass. Bravo!

Another item relates to a simple thinking through of the most basic conflict of interest, namely the trustee that held the securities for the asset management business was indistinguishable from Madoff's entire enterprise. So, this investor rightly concluded that it would be extremely difficult, if not impossible, to independently verify the existence of assets, especially cash which had seemed problematical during several reporting periods. Simple, clean, elegant logic. Maintain independence and verifiability. Avoid conflicts. This same market professional wrote a letter to the SEC of his findings and characterized Madoff's investment firm as a Ponzi scheme in 1999.

Academic research has talked about why people sell winners early and hold onto losers for too long. One of the theories can be summarized by the phrase, "Pride and Regret." This phrase can also apply to the due diligence process for buying into alternative type investments. If you have to ask silly questions, like "Who holds the assets, and are they independent from you, the manager?" you probably don't have the native intelligence, didn't go to the right schools, and are otherwise not worthy of the high returns that are being handed out. Nobody wants to feel like they are unworthy, that is basic pride. Similarly, suppose that a friend at a cocktail party points out that she has never heard of your hedge fund accountants. You might start to feel a twinge of regret, not to mention anger at someone raising something that seems obvious after the fact. "Could she be right? Did I make a bad decision?" It's much easier to assuage the regret by feeling that you will surely cash out before anything catastrophic happens. Or, the "SEC and the regulators watch out for this stuff." Other rationalizations abound, but they revolve around "pride and regret."

Emotions still matter in the matters of money and markets.

Can You Spare $15 billion?

A hedge fund has come up with a great idea for Microsoft and Yahoo! Microsoft should immediately overpay in cash for Yahoo's search engine business, which is becoming less valuable by the minute. The $15 billion bonanza for Yahoo's shareholders would generate higher future cash flows and result in shares being bought back returning money to impatient shareholders, like the hedge fund. Microsoft may be anxious for a deal, but surely they haven't lost sight of reality.

What about carving out the search business into a separate entity? I would call it "Yahoo?", as opposed to the parent Yahoo! Let Microsoft buy a stake in the entity, take a board seat, and get some cooperative ventures signed and a right of first refusal to an unsolicited bid; sell the rest to the public. Over time, let's see where the value of the entity goes. Instead of a windfall bonanza to Yahoo!, this probably puts a floor to the valuations and could wind up developing more value over time and result in a bidding war later, when companies are more flush and valuations richer. In this model, cost-cutting benefits accrue to both parties in the form of higher earnings for the carve-out. A secondary benefit would be a large injection of fees into the beleaguered investment banking M&A business.

How Not to Get Better Corporate Governance

Professor Jonathan Macey of Yale Law School has written a book, "Corporate Governance: Promises Made, Promises Broken," which is the basis of his op ed piece today in the Wall Street Journal.

He proposes "market solutions" for improving governance. This certainly sounds like a well worn mantra. Then, he actually writes, "Hedge funds and activist investors...are the solution not the problem." Whether or not they are a problem can be debated, but it is unbelievable that they could be generically portrayed as a solution to corporate governance issues.

Hedge fund managers are transaction oriented, and they establish ownership positions with their agendas in mind. Witness, for example, Pershing Square Capital's ongoing dialogue with the management of Target Corporation. Perhaps in response to Pershing's first idea, Target sold off part of their credit card portfolio. Then came the "Big Idea," to sell off Target's entire real estate portfolio into a REIT and then to lease the properties back for seventy-five year terms! After lots of dueling press releases and competing analyst meetings, the company properly rejected the proposal as being against the long-term interests of the company, as it would reduce its financing flexibility, lower its debt rating, increase its expenses, and divert management attention from its core competencies of merchandising and retail management, all for a one-time payout.

The much ballyhooed combination of Sears and Kmart engineered by hedge fund manager Ed Lempert has been a disaster for both companies, their consumers, employees and investors. A merry-go-round of executive management changes has taken money and time, but produced nothing. This is better governance?

A well-run company, with a strong management team and an effective board of directors has to look to the long-term and not put the company at risk for a short-term transaction. News today of the Tribune Company's bankruptcy again shows the pitfalls of defining shareholder interests narrowly and exclusively, to the exclusion of other legitimate stakeholder interests, like employees. Those Tribune employees who took buyouts to facilitate a hare-brained transaction now stand to lose their promised payouts and stand in line as unsecured creditors. To treat important stakeholders like this is not enlightened good business practice and violates basic principles of fairness.

Hedge fund managers, and indeed many traditional, value-oriented institutional investors often come up with interesting thoughts for strategic initiatives in their portfolio companies. All of these suggestions should be listened to and considered thoughtfully. An open, constructive dialogue with the shareholders is something that benefits both parties. However, it is the responsibility of the board to keep its hand on the strategy tiller and to let management focus on execution and financial performance.

There are cases where an activist hedge fund has prodded a complacent company into better use of underperforming assets, most often through a transaction. However, the notion that hedge funds broadly are a panacea for better governance defies both history and logic.

The Fed Wakes Up to Foreclosures

Fed Chairman Bernanke expressed concern today about the foreclosure rate which he says is running on track for 2.25 million proceedings this year. Forcing lenders to lower published mortgage rates accomplishes nothing, because if home values are down, credit score requirements are more stringent, a household has a job loss and reduced income, and the lender's margin has risen, mortgages won't actually be closed at those rates to the people who really need help. The banking industry has never been set up to effectively and humanely handle large volumes of foreclosures, because it is something that they're not good at and something that was never anticipated on a large scale. The participants in the foreclosure business are yet another unregulated, unseemly lot. Unleashing this process on a large scale is like introducing termites into a house.

The Hubbard-Mayer plan, which we discussed in an earlier post aims to keep people in their homes, while resetting rates and loan amounts to realistic values. Lenders will have some write down issues, holders of securitized paper will cry foul, and there may be windfall gains to some homeowners. It certainly has some implementation challenges, but no more so than those created by the potpourri of ineffective plans and programs out there now. I believe that a form of this plan will in fact resurface, and hopefully we can decisively address the foreclosure problem in the near future.

Here is the earlier link to their publication:
http://www4.gsb.columbia.edu/realestate/research/mortgagemarket

GE Capital: Take Away the Doubts

Investors bid up the beleaguered shares of GE today, and looking at the slide presentation relating to GE Capital, there appeared to be some substantive reasons for to be optimistic.

The presentation conveyed the key strategic messages:

1. GE Capital was integral to the non-financial parts of the business going forward.
2. The business was going to be stabilized, refocused, and the business model tweaked to put it onto a more stable, long-term footing. Looking at the business model under drastically changed conditions is critical, and they did it.
3. There was no risk to the dividend from GE Capital. The whisper was that the dividend's in jeopardy. They took away that doubt.
4. GE Capital was number 1 or 2 in all of its key business segments. This is the long-held GE mantra that if they can't be a leader, they would exit the business. Thus, they measured themselves by the same strategic yardstick, not something new or invented on the spot.

This was a story that was well told. Of course, the devil is in some of the aspects of the markets unfreezing, but it looks like they have worked through likely scenarios.

Looking out beyond the current crisis, when investors are once again looking at global infrastructure plays, GE should look attractive on the commercial and industrial sides of the business.