Monday, March 30, 2009

Afghanistan and Pakistan

Scholars and policy analysts have been writing extensively about the tinderbox in Afghanistan and Pakistan. Putting more soldiers on the ground in Afghanistan to train local security forces and to work selectively with different elements of the Afghan insurgency are two policy recommendations that seem to be preferred by several observers that we have spoken to over the past month.

Whatever the issues in Afghanistan, the one thing that unites Afghans whatever their tribe and ethnicity is a deep seated antipathy towards all non-Afghan, outside forces--including the British, Russians, Americans, Canadians, NATO and al Qaeda. Against this background, the Afghan insurgency is not a monolithic opponent, and so there is room to maneuver and to tactically gain ascendancy towards rebuilding the society and state for Afghans.

Pakistan as a state, is near collapse and the policy choices here are not attractive, in the short run. The Inter-Services Intelligence (ISI) is a shadow government in Pakistan, operating outside of the control of a moribund civilian government and of the divided, discouraged military. Outside interests include India, China, Iran, Tajikstan, Uzbekistan, Russia, and Saudi Arabia. A viable solution for Pakistan, and probably for Central Asia, has to include these players through multiple diplomatic channels. There are conversations to be held in April and May between Ambassador Holbrooke and state representatives; some of these conversations will also include international academic and policy experts as well. Here's hoping that the international credit crisis doesn't absorb all our national attention from this important area of strategic political, economic and humanitarian interest. American foreign policy will have to mobilize quickly on the Pakistan issue.

Who's In Charge of GM?

I couldn't believe what I read in this morning's Wall Street Journal about the Federal Government announcing the replacement of the GM CEO. The news was announced to Rick Wagoner by a Treasury Department official.

Unless I missed something, there is still a board of directors responsible for hiring and firing the management of the company. Wouldn't the board Chair been the one to have made the announcement personally to the CEO? Shouldn't the company's press release have been the disclosure announcing the thinking behind the decision? I've never thought well about the long-running, decades old mismanagement of GM, but have we abrogated our own laws of corporate and securities regulation?

I firmly believe that the Federal government has an obligation to act like an owner to protect taxpayer interests where it has invested TARP and other funds. However, to ride roughshod like this seems rash, inappropriate and overreaching of government power.

My legal scholar friends pointed out to me the unprecedented nature of issues raised by the Federal government being a dominant shareholder in public corporations. The concept of the Federal government having a fiduciary duty either to taxpayers or to minority shareholders was, if I understood, something outside the bounds of the legal canons.

So now, this kind of announcement should throw the investments of bond mutual funds with a high proportion of corporate bonds in their portfolios into a turmoil. How would one value their GM holdings?

Chrysler always seemed like a non-viable as a standalone auto maker, as we and many others have written about. Why was no action taken to change their management? How did the government pick and choose between the two troubled companies?

I'll be staying tuned on this one, but if there was concern about GM sales before, they should fall completely out of bed now. The Treasury Department would be honoring their new car warranties, apparently.

Wednesday, March 25, 2009

What Went Wrong?

I was fortunate enough to attend the Medtronic Business and Law Roundtable at the University of St. Thomas Law School on March 19th. The subject was, "Our National Challenge: A Blueprint for Restoring the Public Trust."

Professor Lyman Johnson of the University of St. Thomas and Washington & Lee University was the moderator. He noted that the loss in value of public companies from late 2007 until now was $35 trillion, not including the value of assets like homes. 88% of those polled in a recent survey did not trust the stock market. 75% of those who favor Federal regulatory intervention are less confident in the current menu of proposals on the table. He said that regulatory trust capital is as important as financial capital, and it needs to be rebuilt.

Professor John Coffee of Columbia Law School is one of the foremost commentators on corporate securities law, and he gave a very informative and provocative presentation. He noted that asset backed securities issuance was trivial in 1992-1993, but by 2002, issuance of asset backed securities had surpassed the total issuance of corporate bonds. Between 2001 and 2006, much of the available mortgage funding was channeled into "high latent demand" zip codes. These were zip codes in which the denial rate for traditional mortgages was 80% or higher. From 2001-2003, almost 80% of the applications in these same zip codes were accepted. Congressional pressure through the Community Reinvestment Act fed this process, as well as did the availability of funds. The loans issued were the so-called "liar loans," or "ninja loans." These loans had a very high rate of securitization, and they were sold by originators to unaffiliated financial firms. Professor Keys and other researchers at the University of Chicago School of Business note that a securitized loan portfolio was 20% more likely to default than a retained portfolio. By 2003, the loans to these same zip codes were showing significant increases in default rates. By 2006, these low documentation/no documentation loans accounted for 51% of all securitized loans and accounted for
92% of securitized loans that carried adjustable rates.

This activity would be irrational unless there were people willing to buy the loans, and the investment banks would increasingly buy a loan portfolio without any due diligence. This begins Act II of the tragedy in Professor Coffee's presentation. The investment banks bought loans because they knew that they could securitize them on a global basis if they could get "investment grade" ratings from two of the critical gatekeepers, names the rating agencies S&P and Moody's. Two ratings were needed for investor acceptance. So why did the gatekeepers fail to do their jobs?

When Moody's and S&P were focused on corporate bond issuance, no one client accounted for more than 1% of their business. When structured finance overtook corporate bond issuance, their business mix changed dramatically. In 2006, for example, 56% of Moody's revenues came from the top investment banks for structured finance product ratings. In addition, now the rating agencies generated consulting revenues from the same investment banks, counseling them on how to design a marketable structure. This concentrated their business and reduced their independence.

An additional wrinkle came with the acquisition of Fitch, and the new French owner's decision to grow its market share. Now, instead of a duopoly, you had three firms competing for the two ratings that had to accompany every "investment grade" deal. Professor Coffee had a dramatic slide that showed significant grade inflation for both investment-grade and below-investment grade securities. Act II now concludes with the top six banks (Lehman Brothers was number 1) issuing and distributing 52% of all the mortgage-backed securities worldwide in 2007.

Leverage ratios at the investment banks had been climbing since August 2006, Lehman, Morgan Stanley, and Bear Stearns were all about 33%. Because the SEC in 2004 had spared the global banks from coming under the scrutiny of European regulators through something called the Consolidated Supervised Entity program, there was no ceiling on the leverage ratio. This program also further neutered the SEC because it allowed each bank to develop its own risk model, and Professor Coffee describes the SEC review process as an army of PhD rocket scientists descending on three freshly minted SEC MBA's to get their assent. Remember Buffet's words, "Beware of geeks bearing formulas." Well, the geeks carried the day, and now the investment banks who were principals as well as agents were beyond any meaningful scrutiny.

In 2007, the banks reported their VAR (Value at Risk), and Lehman Brothers for example reported $124 million VAR, an increase of 400% from the prior year! By August of 2008, Lehman Brothers announced writedowns of $8.2 billion (!) related to subprime loans.

What are the lessons? Financial institutions are fragile and face a fundamental mismatch of assets and liabilities. Their "originate and distribute" model leads to excesses, inadequate screening and substantial moral hazard. "Competition is good, except when it is bad," according to Professor Coffee. Competition among the investment banks led to excess leverage and inadequate diversification.

Perhaps the defining quote in Act III comes from Charles Prince, the former CEO of Citigroup, who said, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Systemic Risk Regulation is the answer according to Professor Coffee. This SRR could be a centralized regulator, along the lines of the British Financial Services Authority, or a "Twin Peaks" model, with one regulator for the banking system and another for securities regulation. The relationship of such an SRR to the central bank is an open question. These two types of regulators will have significant cultural differences. A securities regulator will be focused on disclosure and transparency. A bank regulator will be worried about the free flow of information, especially in real time, because their overriding fear is a run on the bank.

So, on mark-to-market accounting, bank regulators would say "No," because it would require additional capital and stir up fear. Securities regulators would say "Yes" to mark-to-market accounting. He closed by saying that due diligence had to be restored to the process of securities issuance.

This was a great presentation, and I will continue with some of the other presentation summaries next week. Post questions and comments!

Tuesday, March 17, 2009

The Executive Pay Distraction

Executive pay is a fundamental, long-term issue for public companies, as well as for mutual fund managers who often lead the chorus for "reforming the other guy's pay." These issues can't be dealt with as part of the banking and credit crisis. Unfortunately, hand wringing about bonuses at AIG comes after the horse has left the barn, and it is a diversion from the main issue.

So, we now know that Federal largesse has gone to make a limited number of contract counter parties whole, one of which is Goldman, Sachs, whose former official Henry Paulson pressed for this aid package in the first place. To use the poker term, the Fed and the Treasury are now "all in" on AIG, with diminishing hope of taxpayer recoveries and increasing risk. We as taxpayers cannot and should not shoulder all the counterparty risk in the AIG portfolio. I don't understand what we are trying to do at this point, and the market doesn't either.

The Federal government has become a significant "owner" of AIG, yet it has chosen not to act like an owner, but like a silent partner. Owners take ownership, participate in business and oversight decisions, and demand accountability. Since the Feds has to do none of these, it's not at all surprising that management were untrammelled in paying themselves for being irresponsible. It's probably too late to go back and place a Federal director on the board who reports directly to Congress or the executive branch. It is a shame.

The bonus issues are hard to understand, because bonuses are typically paid on mixture of corporate and personal objectives. What kind of objectives could have led to some the reported payouts? A corporate objective of maintaining a non-zero share price? A corporate objective of taking more Federal money? Unfortunately too, the proxies will come out long after our Twitter attention spans have forgotten about these issues. Perhaps the companies receiving the handouts should have to 8-K their real time, current compensation plans on their websites. Now, that would be transparent. When someone like Dick Kovacevich refers publicly to Fed and Treasury stress tests as "asinine," you know that there is trouble in Dodge.

Saturday, March 7, 2009

Bill Gross Made the Call on GE in 2002

GE's equity value has fallen by about 80% over the past three years, compared to a 40% decline in the Dow Jones Industrial Average. The legendary Jack Welch talked about GE growing its earnings at 15% per year for "several decades." Logically, this makes no sense, as this would mean that earnings would double every five years. And this would occur in a company largely made up of businesses with long selling cycles (nuclear reactors, jet engines) and that are cyclical in nature (appliances, and media susceptible to advertising and new program cycles). So, the dealer had to have one or two cards up his sleeve.

Indeed, acquisitions and GE Capital were the two cards. As an equity analyst for many years, I loved to read the work of credit market analysts and portfolio managers, who did rigorous modeling work and who had much more conservative and skeptical natures than did the lap dog cheerleaders in the equity market. Bill Gross, who is must reading for me wrote in 2002, "It (GE) grows earnings not so much by the brilliance of management or the diversity of their operations, as Welch and Immelt claim, but through the acquisition of companies....using high-powered, high multiple GE stock or cheap near-Treasury Bill yielding commercial paper." (March 21,2002 on So, as Thorton O'Glove would have said, their "quality of earnings" was very low.

At the heart of things, the business model was flawed. The portfolio of businesses was simply not geared for generating earnings growth of 15% per year. So, earnings were managed consistently in an era of liquidity and declining interest rates. GE disclosures were so uninformative, and yet no analysts ever complained or even asked uncomfortable questions. The financial press wrote about Six Sigma, the GE culture, and about the Croton management training academy that taught the "Tao of GE."

Unfortunately, it's hard to believe that management didn't realize earlier than today that the dealer would have to fold soon. Now all credibility has been lost, and once it's lost, it's very difficult for the same team to get it back. Wall Street loves to pile on, and that's what is happening now.

Some lessons to be learned:
1. Beware of the cult of personality and the association of a company's value with the personal charisma of any one individual, even Jack Welch;
2. No large-scale, public business can predictably grow at 15% per year "for decades," without caveats galore.
3. Earnings quality matters.
4. Disclosure and communications are not for flaks and PR agencies. Informative disclosure is the lifeblood of the marketplace and professional investors. As Bill Gross wrote in 2002, "I would like GE and other companies to be more candid in terms of disclosing exactly how they do these things....If they grow earnings, then let's hear about it and find out how much comes from these types of maneuvers (acquisitions, low cost financing, and other financial engineering)"
5. Credibility, as much as a credit rating, has to be maintained. A market decline can be retraced, but a loss of credibility is very difficult to recover. Again, Bill Gross noted, "The fact is that GE is a conglomerate financed by a money machine...but unlike Berkshire Hathaway, its foundation is vulnerable because its survival depends upon the confidence of outside investors..."
6. The GE brand in the consumer market place was heavily associated with the appliance business, which GE has long said it wanted to exit. With the current lack of buyers at the right price, this has significantly damaged the consumer brand equity. Increasingly, this puts the future with the industrial businesses. Green is nice, but it's a long way out before it can move the needle on this behemoth. Cyclicality and economic sensitivity will increase in the future, as earnings flexibility disppears under the weight of the GE Capital anchor.
7. Six Sigma godan black belts don't help make the quarter. Nice for magazine articles but little else.

Thursday, March 5, 2009

The Mortgage Plan: A Passed Ball

When the Obama Mortgage Plan was announced, we opined that it was another passed ball, without the benefit of many details. Now, in today's New York Times, a well written piece by John D. Geonokopolos of Yale and Susan Koniak of Boston University, contains a run of the numbers.

The writers note that the plan gives an interest rate reduction for five years, but, as we surmised, the principal reduction for five years is not meaningful, capped at $5,000. The point to note is that the plan does nothing to stem foreclosures on a significant scale and does nothing to change the incentives for homeowners with no equity in their home to walk away from the mortgage and the home.

Servicers are shown as standing in the way of a path that would, according to the authors' calculations yield bondholders significantly more cash than the foreclosure path. The piddling incentives to servicers are inadequate to negate their incentive to move to foreclosure.

The fundamentals of the declining residential real estate market and the cascading effect on asset prices and foreclosures remain unaddressed, and yet this plan carries another hefty price tag.