Thursday, January 29, 2009

Loyalty on Wall Street: Not To the Customer

In the realm of financial services especially, a product originator, salesperson, broker, consultant or analyst owes a duty of loyalty to the customer. This is a bedrock first principle for us. Today, the New York Times reports that JPMorgan was pulling its funds out of Madoff's Fairfield funds in the autumn of 2008 without notifying their customers to whom they had sold a leveraged note product. The performance of the notes was directly tied to the Fairfield funds performance.

Worse still are the reasons for pulling the money out. "...the bank became concerned about the lack of transparency to some questions we (JPMorgan) posed as part of our review," according to the New York Times. This information clearly needed to be disclosed, as it was information that a prudent person would need to know in order to make an informed investment decision about the notes. Presumably, this was a complete change from the (presumed) due diligence that JPMorgan had undertaken prior to presenting the note product to their high net worth customers. There is no way that it should not have been disclosed, and the bank should not have been front-running their customers.

The completely inane, nonsensical excuse? "...under the sales agreements, the issues (?) did not meet the threshold necessary to permit the bank to restructure the notes....we (JPMorgan) did not have the right to disclose our concerns." (New York Times, 1/29/09, Business Day)

Despite having Chief Ethics Officers and compliance departments, the most basic ethical business principles continue to be flouted with impunity on Wall Street.

Thursday, January 22, 2009

The Deal from Hades

In our mid-December post, we warned about the incompatibility of cultures between traditional banking and investment brokers. Now, the toxic merger between Bank of America and Merrill Lynch has gone radioactive.

Where to begin? A $50 billion merger, based on 48 hours of due diligence? What responsible executive management team would agree to go ahead on this basis? Now, there are bleatings from Bank of America's CEO that he went ahead with a merger he believed in his heart was flawed, in the national interest. It makes one teary-eyed to listen to this story, but the problem is that this was not the CEO's decision to make on his own. On a "bet the ranch" kind of call like this, the board of directors is duty-bound to take the lead and drive both process and the decision, in the best interests of the shareholders who elected them.

Soon after the merger, the head of Merrill Lynch's Wealth Management group resigned. I wonder what he knew? One of the strategic pillars for the acquisition had to be brokers from the Thundering Herd and the assets of the high end clients in the wealth management group. So this executive must have felt that whatever was coming down the road was much less desirable than giving up his retention agreement, and so the exec bolted. It was also reported that the bankers representing BofA did not get the full books on Merrill's troubled portfolios until the transaction had already closed. Did anyone report this to the board? Shouldn't someone have pulled the brake and stopped the train?

Now the capitalization of one of the most widely-held banks in the financial services sector has been wiped down to $43 billion, after the $50 billion acquisition of Merrill Lynch. The Wall Street Journal now writes that things can be salvaged by offering retention bonuses to key Merrill Lynch brokers and re-educating them in the BofA culture. Here's a secret: brokers don't like to be educated by others, and they will not abide being "re-educated." The problem is that retention these payments will now be made under duress in a bear market for high-end, fee-based services, and so BofA's poor shareholders will have to overpay...again.

Remember Peter Finch in "Network?" "I'm mad as hell, and I'm not going to take this any more!" Shouldn't someone in a position of regulatory authority be saying this now?

To use Rober Bruner's term, this indeed is "A Deal From Hell."

Wednesday, January 21, 2009

Watch What You Wish For

Wells Fargo managed to snatch Wachovia away from Citigoup, and Wells is now running full page newspaper ads trumpeting the great benefits coming to average consumers and investors from the merger.

Dick Kovacevich and the investor thesis he presented for Norwest, then Wells, over the years was clear, simple, and well executed. Growth was to come from delivering multiple products and relationships (e.g. checking and savings accounts, mortgages, investment management) to retail and corporate customers. Associates were to be rewarded on the basis of growth in relationships. It went well, and shareholders did very well over time. The Wells merger really put things to the test, but after years more than anyone imagined, the merger seems to have worked. I remember hearing a quote from Mr. Kovacevich myself to the effect, "I'll never do a merger of equals again."

Now comes the merger with Wachovia. Wachovia itself is a hash blended from First Union, Wachovia, Prudential Securities, Metropolitan West, SouthTrust, Westcorp, Golden West, and A.G. Edwards. It's not obvious how this melange blends with the beef at Wells Fargo. The argument is that it gives the combined company deposit strength in the Southeast; sure, but at what cost? The next argument being advanced in the newspaper ads is that the combined companies will provide superior investment advice and asset management. From where? Which fund management company will carry the banner for the combined companies: Wells Asset Management or Evergreen? Neither one has delivered a consistent record of performance with reasonable fees. Finally, in this merger, Wells Fargo stepped out of character, which is something which always triggers alarms for us.

In the past, Norwest/Wells were very circumspect about acquisitions---we take our time, we don't compete or get into bidding wars, we don't overpay, and we make them where there is a cultural fit. In the Wachovia scenario, where Wells ran to the altar and took the bride away from Citigroup, it seems like a significant departure from the successful practice of the past. Also, instead of a graceful exit as planned, after the integration of Wells Fargo and Norwest, the CEO extends his tenure to handle another transaction. It is out of character. Sometimes, you get what you wish for, but is it what you need?

Friday, January 9, 2009

Indian Fire Drill

Following up our early post on Satyam, analysts suggest that IBM Consulting and Accenture may be the big winners in taking business from Satyam. It sounds logical, for some of the reasons we stated earlier.

As an aside, the regulatory fire drill has begun. According to the Wall Street Journal, "The Securities and Exchange Board of India, the chief markets regulator, said Friday it will carry out a review of auditors' working papers relating to companies in the Sensex and the National Stock Exchange Nifty 50-share index in a bid to boost investor confidence in financial disclosures." It's difficult to understand how this will work in practice. Auditors auditing auditors is a recipe for expense, lots of time-wasting, and arcane discussions about how "I would have done it a better way." Just have a look at the PCAOB's reports on auditor inspections. They are a total snooze, and contain almost no actionable information for an issuer. I don't understand what firms are going to carry out this exercise, what their outputs will be (another opinion?), and if investors will will be heartened or have heartburn.

Now, the regulators are talking about reconstituting the Satyam board. Sounds good, especially since the barn is empty anyway with the exit of several directors. However, the Chairmen of Wipro and of InfoSys are mentioned as great candidates. Aren't they also going to get re audited? Won't they be conflicted about preserving Satyam versus taking business from them and keeping it from falling into the hands of IBM Consulting? For the garden variety fraud described by Satyam's founder, one doesn't need IT experience to understand where the fixes should be established.

It is comforting to know that Indian regulators can run a fire drill in as chaotic and ill-conceived a manner as our own regulators.

Thursday, January 8, 2009

Commercial REITs

Some commercial REITs are yielding 8-9% and have been trumpeted by TV talking heads as good investments compared to retail REITs. I recall that some of these entities have debt maturing in the coming weeks. With the announcement of retail sales and a downgraded outlook from Wal-Mart, market eyes are focused on retail. However, what about the commercial sector? In my market, there are great deals on nice office space outside of the four block downtown Minneapolis golden rectangle. These deals have been in place for a while. If and how these refis get done will give another important observation about credit market confidence.

Behind the Scenes

The early reporting on the Satyam debacle seems to do little more than recast the founder's letter, followed by the requisite hand wringing. PWC is studying the situation, which is not very comforting. I'm sure that their attorneys have encouraged them not to be forthcoming in the press, which is also disappointing.

Press reports suggest that several Fortune 500 companies have engaged Satyam to run their "back offices," whatever that means. So, one would guess that for SOX compliance on IT general controls and enterprise level controls, these Fortune 500 companies probably relied on SAS 70 reports produced by Satyam. It would seem as if the IT czars at these same companies must now be scrambling to figure out if they can continue to rely on these reports.

The likelihood of companies like Nissan and Cisco standing pat on Satyam seems very small, unless the remnants were picked up by a larger, stronger competitor. However, if you were the CIO at Nissan, could you automatically feel comfortable with Wipro? It would seem like a great opportunity for one of the global big guns, like CapGemini, Bearing Point, or others to pick up some additional revenue at these big accounts. Nobody is showing their cards at this point. Stay tuned.

Wednesday, January 7, 2009

The Satyam Shall Set You Free

Satyam means "truth" in Sanskrit. Today, the founder and CEO of Satyam (NYSE:SAY) announced that he had unfortunately misrepresented company assets by about $1 billion, and that its cash balance was not $1 billion, but more like $16 million. The company, which is listed on three international exchanges, used Price Waterhouse Coopers as its external auditors.

The company had illustrious academics on its board of directors, and their resumes bristled with institutional affiliations like the Harvard Business School, the Kennedy School of Government, and the Indian School of Business. It's incomprehensible how any kind of financial oversight, internal auditing process, and external auditor reviews could not have surfaced an issue of this magnitude.

Remember as you consider your emerging markets mutual fund that, in most cases, you are dealing with "drive by" analysts who cover companies that are nowhere near as open and communicative as US companies, exchanges that are not efficient or liquid, and which exert minimal control over their listed companies. And, the fees for these funds are outrageous. This risk-reward ratio is not attractive going forward.

We may be in the middle-to-late innings of the flight to Treasuries. Then some aggressive institutional bond investors have staked out big bets on U.S.corporate bonds from the bigger issuers, where prices are purported to be factoring in 25% default rates. Finally, there are equities, and within equities, there are emerging markets stocks. It is really hard to make any case for being in these kinds of company investments. To some extent, companies in India, China, and Russia (to name a few markets) have taken on the trappings of attractive investments: good PR work, big agency IR, corporate governance mantras. However, few of the principles underlying good governance are in their DNA yet. It may be quite a while.

Friday, January 2, 2009

Dell's Change in Strategy

The Wall Street Journal ran a story today talking about Dell's executive changes and characterizing them as a change in strategy. I don't see anything like that in the news. It sounds like they are moving their org chart around to be focused on customer segments, e.g. public sector, small and medium businesses, versus geographies. So, for example, now they have a global consumer business, versus one embedded in different regions. This is neither a strategic change nor a breakthrough. They seem to be reaching a crossroads similar to the one HP faced a few years back, one which they responded to by acquiring COMPAQ. After digesting that acquisition, and changes in management teams, HP seems to be on a different strategic path. It's hard to get excited about this item at all if you are a Dell shareholder.