Thursday, June 25, 2009

That Won't Fly

Communications represent one of the three key areas of my consulting business, and I've learned from decades of experience that the whole issue is inextricably intertwined with the operation of a business. It's also too important to be left to spinmeisters and PR flaks. Today's Wall Street Journal carries a story about the latest delays impacting Boeing's Dreamliner, a "bet the ranch" project for the company that was first announced in 2003.

The WSJ reports that Boeing management committed in 2003 to be unusually open about the project. In 2007, the President of Boeing's Commercial Airplane unit stated that "the whole issue of transparency is key" to maintaining the confidence of customers and investors. Unfortunately, the most recent project delay, which is the sixth in six years, took the company's share price down 12% in two days.

Having been a sell-side analyst myself for many years, I remember that "knot in the stomach" feeling coming into the office to read the press release and then trying, often unsuccessfully, to reach company management, which by this time were reading off an approved script of platitudes. In Boeing's case, the two key executives were not available to the WSJ for comment. Not a good idea. Portfolio managers, in the meantime, knowing the script, usually sold a portion of their holdings. "And so it goes. "

The J.P. Morgan aerospace analyst wrote, "We believe that had management been more upfront about this situation, perhaps the modest level of credibility on this topic that it had started to re-establish over the past several months could have been sustained." It's a simple lesson, but one that's ignored by companies of every size capitalization. Don't try to fool Mother Nature, and certainly don't try to fool, ignore, or spin the capital markets.

The story suggests, rather lamely, that the growing web of suppliers, many overseas, makes up-to-date project communications difficult, and that might account for the negative surprise. That excuse most certainly doesn't fly in our book. Aerospace companies use industry-leading project management tools, as they have done for decades. If their vendors are not compliant, they need to be held accountable, and the chain of accountability has to move up right to the head of the unit if effective project oversight isn't maintained. However, this is very hard to believe that communication which hadn't broken down for four years of the project, has broken down up to six times without remediation.

Now the challenge will be for Boeing with its customers; there are suggestions that it will lose market share to AirBus. I have a hard time following that argument. The recent unfortunate disaster with AirBus planes has shown, among other things, the limits of design and implementation by committee. In particular, the apparent difficulties that AirBus's Spanish shareholder consortium are having delivering on-time projects should give any fleet buyer pause. The market share game should turn on industry fundamentals, such as fuel price outlooks and long-haul market dynamics, rather than on a daily press release. Boeing has a chance to make things better. Let's hope they take their lesson and make it so.

Tuesday, June 23, 2009

Is It Over Yet, Mom?

A few years ago when we were in the basement of our Minnesota home hunkering down against an oncoming tornado, our son uttered these words; unfortunately, the storm hadn't hit yet. (In this case, it did some damage, but was not devastating)

Simon Johnson, of MIT and the Peterson Institute for International Economics gave an interesting presentation on the current crisis to an East Asian audience. He notes that confidence, in some sense, is returning to the markets, as evidenced by the earlier runup in stock indices, which have retraced. Johnson notes that Jamie Dimon, the CEO of JP Morgan Chase described their past year as "our best year ever." How can that be if things aren't getting better? Getting better today depends on where you sit.

Being an economist by training, Johnson notes that the costs of higher unemployment, lost output and wealth have not been truly felt yet. In his opinion, we face "greater danger" from what he cleverly describes as the "Super Sized" U.S. financial sector. We've talked about this phenomenon before, notably yesterday. According to Federal Reserve data in Johnson's slides, the financial sector's share of U.S. domestic profits was more than 42% in 2002 and now hovers at around 28%. Tail wagging the dog?

The current U.S. regulatory strategy, in his words, is to put large, unconditional subsidies into the banking system in order to support financial intermediation, and this is justified by the need to lower the risk of bank runs and a loss in confidence. Incidentally, he notes that it helps stock prices in the near term, and provides job security for banking industry insiders.

Like us, he berates the "false" financial innovation trumpeted by U.S. market apologists which results in consumers overpaying for what should be commodity financial products.

He uses a very interesting terminology for the surviving entities in the current U.S. financial system, calling them "oligarchs," which is the term used for those hand-picked individuals to whom were transferred all the tangible assets of the former Soviet Union as it was collapsing under the inept leadership of Yeltsin. Johnson notes, for example, that the top 3 U.S. banks currently hold 30% of all deposits, up from 20% pre-crisis. When in doubt, fly to safety, which means fly to those banks who have shaken hands with the government, which describes all the Super Sized banks.

It's not a pretty picture, but it reflects our political system's inability to drive any real change beyond a Most Favored Nation approach of anointing a select group of actors and calling it a day. There are potential coalitions of unlikely bedfellows that could object to the current scenario, and Johnson identifies some of the players.

A parallel discussion has been going at the Peterson Institute, led by my former tutor in international economics Professor John H. Williamson. He introduced me long ago to his concept of Fundamental Equilibrium Exchange Rates (FEERs). It has proven to be a very useful policy tool for international banking and foreign exchange management. Bottom line from this discussion is that the dollar exchange rate vis-a-vis most currencies is overvalued, driven mostly by fear and a flight to what people think is safety. The fundamental outlook might not sustain this current situation.

Finally, investment gurus are advising investors to diversify away from U.S. markets and to overweight towards emerging markets. In theory, and in a vacuum, this sounds sensible. In fact, it would seem to follow from a lot what I've written myself. However, I just read about Satyam, the poster child for corrupt and incompetent Indian public company management, being renamed Mahindra Satyam and moving forward. Unfortunately for risk averse investors, besides the new name and new executives, what has changed? Why should risk averse investors have confidence in Indian securities regulation and in Indian affiliates of U.S. accounting firms? Why should anyone believe in the tone at the top, the controls, and integrity of financial statements under a new, unknown regime? Hard to figure, but it makes good copy.

Monday, June 22, 2009

A Nobel Laureate Takes on Financial Reform

This Wednesday, the United Nations Conference on the World Financial and Economic Crisis and Its Impact on Development" opens in New York City. We have been following the run up to the conference and Joe Stiglitz, the Nobel Laureate in Economics, has written a very interesting working paper on a new global financial architecture for the post-crisis world.

The Obama Administration's empty box of a plan for regulatory reform contrasts sharply with a number of good ideas presented in the Stiglitz paper. I took a graduate seminar from Professor Stiglitz when he visited Johns Hopkins from Yale. Although he takes on a whole host of issues in the working paper, he raises lots of good points and has a number of sharp observations.

For starters, Stiglitz points out financial markets are not an "end in themselves but a means---they enable the economy to be more productive." If this is true, which I believe it is, then the financial sector cannot and should not be the foundation for employment and income for the United States. As such, it follows that our financial sector, post crisis, should be smaller than it is now.

He points out the toxic combination of rolling back Glass-Stegall and the adoption of Basle II, based on a system of self-regulation that Stiglitz rightly calls "an oxymoron." Other market observers like Professor John Coffee of Columbia Law School have pointed out the folly and the unfortuitous timing of both these regulatory changes in their writings.

Many hundreds of puff pieces were written about the need to preserve the United States' lead in "financial innovation." However, as Stiglitz points out financial innovation meant nothing more than confusing, opaque products that created rather than managed risks and did little other than generate huge fees to investment banks, law firms, and rating agencies. Also, if financial markets are servants of the economic system rather than its master, financial innovation is not equivalent to fundamental scientific innovation, which has positive social externalities. He expresses his frustration and a blind wish when he writes, "Wall Street has polluted our economy with toxic mortgages. It should now pay for the clean up." Nice idea, but unlikely to happen for many reasons.

We will be following the progress of the conference through some of our old friends in the international community, and we hope that some useful principles will be adopted by the international group, although we're not optimistic because of the traditional split between the political interests of the developed countries and what was called the G-77.

Thursday, June 18, 2009

No Fear

For those who were worried about a draconian new environment for financial regulation, "no fear," nothing of any value has been proposed, no risks were taken and there's nothing substantive for a loyal opposition to sink their teeth into. Professor John Coffee of Columbia University Law School has characterized our system of financial regulation as "fragmented and almost Balkanized." All that happened with the Obama program is that additional Balkan republics were created. Lines of responsibility between Treasury and the Federal Reserve continue to be blurred.

The plan proposes "giving the Federal Reserve broad new powers to oversee large firms, such as insurance companies, that it does not regulate directly." It would have been a bold stroke to propose national regulation of insurance companies, taking them out of the patchwork quilt of state charters, but this was probably politically unpalatable. However, to think of the Fed having the resources and staff to regulate or oversee in the current setup is just unrealistic.

The Fed failed in its primary charter to monitor, oversee and regulate bank lending within the twelve districts. Its army of bank examiners failed to note anything about the rising lending portfolio risks of any member banks as the systemic risk mounted and accelerated after 2006. More attention should have been paid to making sure that it fulfills its primary charter before giving it busy work, in which it will surely be ineffective. There should have been a Sarbanes-Oxley review of the Fed's own policies and procedures that led to this massive breakdown in its core function.

Instead, the current program of proposed regulatory reform fits neither the "super regulator" model favored by the Europeans, nor the "Twin Peaks" model (banking and securities markets) favored by some observers. Very disappointing indeed, but there is a great sigh of relief in the board rooms of large bank holding companies.

Tuesday, June 16, 2009

(Eco) Imagine That!

GE CEO Jeff Immelt recently lamented our national obsession with financial services , and he gave a plug for prosaic activities like manufacturing. He's put his finger on something that's very important for the future in which our children will live and work. Not everyone will be able, or want to, get a job with Goldman Sachs or a hedge fund.

In the simple two by two (two countries and two classes of goods) models of international trade theory, it was pretty unreasonable to get a "corner solution" where one country completely specialized in producing one tradeable good. Indeed, it's just not healthy for a society to be totally specialized. We shouldn't all be "knowledge workers," whatever that means.

GM factories converted to the WWII effort were able to go from producing cars to airplanes because the workforce had the skills to bend metal and to join parts together. If General Electric is to benefit from its eco imagination strategy, it will need a large supply of mechanical, industrial, electrical and chemical engineers, as well as a dedicated and savvy technical workforce to manufacture products for the smart grids of the future in high tech assembly modules. Some of the kids interested in these careers may not go to college to study business and accounting, but they may need technical associate degrees. Hopefully, our society will also value art, music, theater as professions, so that our culture serves our humanity as well as our commerce.

Our financial services sector needs to get smaller, and much of what it sells are commodities, like white bread. We don't need the best and the brightest to develop new forms of life insurance. Financial innovation, with all the blowhard rhetoric aside, is not like scientific innovation. All of our decades of financial innovation brought us not a cure for cancer, but a financial nuclear winter. Enough already!

Thursday, June 11, 2009

It Beats The Talking Heads

I don't listen to any cable talking heads about the equity or credit markets. I prefer to keep up with active, market participants who've proven their approach over many market cycles. The folks who run the Dodge & Cox Income Fund recently issued their first quarter report, and it makes for instructive reading.

I'm not writing this note as any form of investment advice, and I am a shareholder in this fund, so please note these caveats. I used to provide sell side research to the equity side of Dodge & Cox many years back, and I've always been impressed by their sobriety, structure, and the fact that all the key personnel are heavily invested in their own funds.

DODIX outperformed its benchmark, the Barclay's Capital Aggregate Bond Index (BCAG) by 14 basis points in the first quarter, but the sources of the outperformance were interesting. This fund has a long-standing bet on corporate bonds from quality institutional issuers; the fund is 46.7% weighted in corporate bonds versus 17.4% for BCAG.

The fund overweighted relative to BCAG in Financials, and this dragged their performance down, as Citigroup, Bank of America, and GMAC were particularly weak. The bond performance, together with the ongoing news from Citigroup, probably signals that the company is a true basket case and will be a continuing ward of the state. Dabbling in the equities of financials, which some value investors are doing will probably be limited to a relatively few names, of which Wells Fargo is most often heard, with even Warren Buffett talking his book.

Mortgage backed securities, measured by the Barclay's Capital US MBS Index, returned 2.2% in the first quarter. Asset backed securities measured by the BC ABS Index returned 7.6% in the quarter. So, Bill Gross's long avowed strategy of "shaking hands with the government" seems to working for this fund too.

The corporate index yield premium to Treasuries was near its all-time high at the end of the first quarter. For us, a significant downward movement in this spread has to proceed a meaningful, sustained movement in the broad equity market, and this is not what was seen. The first quarter spread was 543 basis points versus 97 basis points in the first quarter of 2007. Liquidity is still so poor in the high quality, corporate aftermarket that the fund was able to increase its weighting solely through buying new issues. This is not a sign of a healthy credit market either.

Talking to corporate treasurers and CFOs we know indicates that banks are content to enjoy record margins and garner fee income where they can. Lending terms and coverages are significantly tighter than six months ago, even for firms with cash and strong collateral. Again, it's hard to understand what equity markets would be excited about if the fundamentals of the credit markets are still bifurcated and illiquid.