Thursday, September 24, 2009

The FSA Gets It Right

Lord Adair Turner, Chair of the Financial Services Authority (FSA) of Great Britain, is a former non-executive Director of Standard Chartered Bank, former vice-Chair of Merrill Lynch Europe, and a former senior executive at McKinsey & Company. Near to my heart, he studied History and Economics at Gonville & Caius College, Cambridge University. As my musician son would say, "He's got the chops."

As our Financial Crisis Inquiry Commission held its first meeting on September 17th and grinds along, I believe that the March 2009 "Turner Review" from the FSA is an excellent, informative, clearly written one-stop resource on the origins of the crisis and on the market and policy changes needed for the future. It has some very striking charts that bring home the points in sharp relief.

The opening chapter, "What Went Wrong?" should be read and actively discussed in classes and in the board rooms of financial services companies. Lord Turner has become a bit of a controversial figure, which to my mind means that he is getting to the right issues on wholesale financial services.

Summarizing the benefits of securitization, the Review correctly notes that it should: (1) reduce banking system risks; (2) cut the total costs of financial intermediation; (3) pass credit risks on to end investors, thereby freeing banks from holding unnecessary and expensive regulatory capital.

Markets in securitization-related products ballooned during a period of extraordinarily low real interest rates as everyone hunted for yields. So, for example, the credit default swap market stood at $5 trillion in 2H 2004 and soared to almost $60 trillion by 1H 2008. As the markets expanded, relatively little of the securitization production went to end investors, and much of it went to the proprietary trading desks of other banks (see Lehman Brothers et al). The retained tranches were themselves hedged via CDS. Some of the product was repackaged into CDOs and CDO-squareds. Finally, some of the product was used as collateral for short-term bank liquidity. So, the basic premise that created the securitization industry was completely turned upside down.

Repeal of Glass-Steagall again seems like a horrendously bad political and regulatory decision. What it allowed was for trading books at banks to have capital requirements much lower than the capital requirements for the banking books of the parent company. As commercial banks became extensively involved in proprietary trading, when asset prices started collapsing that directly affected parent bank profitability, creating a crisis in confidence and in short-term bank liquidity. Historically, that crisis in confidence could have only occurred from a run on deposits. Now it occurred due to trading activities that were remote from the fundamental commercial bank mission of "maturity transformation."

Think Wall Street knows how to manage risk? Here are two pithy quotes, "At the individual bank level, the classification of these (Structured Investment Vehicles) as off-balance sheet proved inaccurate as a reflection of true economic risk, with liquidity provision commitments and reputational concerns requiring many banks to take the assets on balance sheet as the crisis grew..." There is a breathtaking chart showing the historical leverage ratios of the larger banks, and the charts for UBS and Morgan Stanley are poster children for irresponsible risk management.

Financial innovations (lower tranches of CDOs and CDO-squareds) had "very high and imperfectly understood leverage..." The complete failure of the VAR models have been well-documented by Roubini and others.

According to the Review, "...the development of securitized credit has ended up producing the worst financial crisis for a century." The introductory chapter talks about poor regulation and inadequate capital standards, a message that was recently reiterated by Secretary Geithner in a speech that was not attended by a single money center bank CEO. Again, it must mean he was on to the right issues.

Some basic economic points are well made. Market efficiency does not mean market rationality. Even market efficiency is not something we should take for granted on Wall Street. For example, a chart on bank CDS spreads shows that the market did not anticipate the credit problems ahead. At best, the spreads ranked the relative risks of certain banks (such as Northern Rock in Britain) accurately, but the spreads were a useless leading or even coincident indicator. Neither were the share prices of the banks themselves, and yet stock prices are a big component of US leading economic indicators.

Individual rationality does not sum up to collective rationality. Economic behavior of individuals is not dominated by the "rational maximizer" model that we study in economics and finance.

Finally, Lord Turner starts to stake out some meaningful and controversial ground when the report says that the increases in market efficiency from the creation of complex financial products is essentially trivial. This is a powerful quote that forms the basis for the recent speech Lord Turner gave at Mansion House: "Wholesale financial services, and in particular that element devoted to securitized credit intermediation and the trading of securitized credit instruments, grew to a size unjustified by the value of its services to the real economy." How did this happen? The margins in financial services, and in particular on proprietary trading of these products are opaque. There is substantial knowledge and information asymmetry in the markets. Finally, there are the principal/agent relationships between investors and banks, and between banks and the employees running the trading desks.
This leads to a fundamental economic process called "rent extraction." Trying to regulate compensation does not get at rent extraction fundamentally.

Just a word to the Financial Crisis Inquiry Commission, there's no need to reinvent the wheel. The origins and mechanisms of the crisis have been very well laid out. Let's get right to better regulating markets and the products for the future.

Wednesday, September 23, 2009

What Sunk the Ship?

Andy Kessler in today's Wall Street Journal makes the same basic point that we made in our last post about the futility of focusing on executive pay at banks. There is one philosophical difference that probably originates in the fact that Kessler is a former hedge fund manager. He says it wasn't excessive compensation schemes or excessive risk-taking that almost sunk the global financial system. Rather, he says it was the excessive use of leverage. He claims that Wall Street is good at managing their day-to-day risks. I have a hard time following this one.

Leverage is a decision variable that magnifies risk and returns, and so it is part and parcel of risk taking. So when Bear, Stearns or Lehman Brothers leveraged their portfolios at 35x, these were the accumulation of conscious decisions taken on their trading desks. It is the produce and distribute model for products that are as economically useful as carnival elixirs that needs to be changed and regulated. Unfortunately, there is no appetite to do this any more, as everyone is worn out by the minute-by-minute crisis watch over the past three quarters.

Just like SOX was a victory for accountants, consultants and lawyers with little impact on long-term shareholder value, so too will be the pursuit of executive compensation in banking. It's become so ridiculous that a local paper featured a story about a school board that rescinded performance pay bonuses for senior district administrators. Their performance measures, which included increasing enrollment in special programs, increases in minority performance and the like, were set a year ago; they seem clear, reasonable and measurable. The bonus amounts were a reasonable percentage of the base compensation. Now the administrators were told to give back their bonuses as contributions into special programs, "for the kids." It's not the fault of school administrators that Wall Street got the entire country into the crisis of the century!

Misguided populism is raising its head because the Administration and its Congressional lackeys don't have the guts or understanding to attack the problem at its roots because they are all running for their next campaigns. What a shame.

Monday, September 21, 2009

Executive Pay in Banking Is A Symptom

The Fed and other politicians are now grabbing headlines by vetoing pay packages for banking executives. Look, there is no doubt at all that pay packages for public company CEO's in US public companies was, and is, out of hand. However, it wasn't the level of the payouts that got us into the financial meltdown.

The financial system, and especially the shadow financial system, originated and distributed products such as MBS, CDO's, and CLO's that shifted risks off the balance sheets of the originators and offered investors high returns with what they thought were AAA credits. The creation of credit default swaps, where a buyer or seller need not have any actual interest in the underlying interest caused this market to explode. Proprietary trading in these same toxic instruments was and will always be a very profitable business, because it is dominated by a few large traders and it is not transparent.

Regulation needs to address (1) bringing the shadow system into the regulatory light; (2) forcing originators to retain a substantial portion of the securitization on balance sheet; (3) reforming the rating agencies that gave the AAA tranches their unjustified ratings; (4) perhaps requiring that traders in credit default swaps have some demonstrable interest in the underlying instrument; (5) meaningful SEC regulatory review of financial product creation process-- a firm can't just decide to package pay day loans into a new class of securities without going through some meaningful examination.

Corporate boards of large financial services company were ill equipped to deal with these issues. Jay Lorsch et al. quote a director of a giant financial services company, "[Two banks]--I think they crashed and burned. Neither one of them had anybody that I could detect on the board that's had any serious financial skills. And doesn't look to me like these boards demanded to know what was going on off balance sheet." Another director at the same company questioned management's financial acumen as well. "The bank boards and the bank CEOs and leadership, obviously, with the exception of maybe one or two, did not understand the risks they were managing." Again, it's not a problem of risk management process, it is a lack of care and competence.

Executive pay in these sectors was a symptom of the overreaching, overly coddled CEOs controlling passive boards, which the board members themselves admit, as above. Focusing on pay without focusing on regulating the creation, distribution, marketing, trading and accounting for toxic ("innovative") financial products is a futile exercise.

Saturday, September 19, 2009

Catching Up With Afghanistan

With the turmoil surrounding the Afghani elections, I've had a chance to catch up with friends from Central Asia, and it strikes me that we have now lost our way in Afghanistan. There was such hope last Fall. The reasons are fairly straightforward. The Taliban control the global poppy trade from the fields to consumers in Europe. Many communities rely on Talib leaders for security and for funds to build minimal infrastructure. President Karzai wisely prefers life to death and has allowed rampant corruption to go unchecked among his own supporters. He can then appear on CNN in his multicolor robes and say, "It's not my fault."

The second reason is the deafening silence from Pakistan. What is going on there? Where is our engagement? Without some sort of understanding about our common interests with Pakistan, their instability only contributes to the instability in Afghanistan. Academics had suggested a "divide and conquer" approach to Afghan power groups. That might have worked last year, but not now. Our troops need relief and they need a mission.

Meanwhile, here's a link to a publication from the Central Asia Institute, where you can see how some real progress is occurring on the ground in a small way, namely educating young women.

Market Dances

For the 52 weeks ended Friday, the S&P 500 was down 12%, with every sector down, excepting a slightly different from zero performance from IT. Yet, looking at bellwether Oracle's earnings report, there was very little to cheer about. Positive equity earnings report continue to be built on cost cutting, which is reactionary and backward-looking.

For the same 52 week period, the FINRA-Bloomberg Investment Grade Corporate Bond Index was up 19%. Investors piled into corporate bond funds, to the point where PIMCO's Total Return Fund became the largest bond investor, period. So, up to this point being senior in the capital structure, tilting towards size and quality issuers has proved far, far superior to being in equities.

Now it has always been a classic technical indicator that when retail investors start piling in, it's usually a market top. Perhaps it is so for investment grade corporates, but it's still hard to understand what fundamentals that are going to drive consistent outperformance in equities.

Firms need to be reporting top line revenue growth for things to be fundamentally better. There will be no help from pricing, so the gains will have to be volume driven. So, for example, the Street has been recommending consumer stalwarts like P&G and Colgate--we all to brush our teeth and shampoo our hair after all. Whatever domestic volume gains that we see will be largely at lower margins and will represent temporary shifts in market share. All of these fundamentals seem fairly priced into the market, which is why the market seems so directionless.

China's economy is booming, and most of it seems to be inwardly directed. Again, this doesn't appear to hold a lot of promise for US and European industrial multinationals. There is still a lot of liquidity sloshing around the global markets. Since this appears to be a trader's market, I would guess that there will be more activity in commodities and in distressed financial assets.

Monday, September 7, 2009

A Colossal Failure of Common Sense

I couldn't get Lawrence McDonald's book about the demise of Lehman Brothers out of my mind, so I went back and re-read some parts. McDonald cites the starting point of "America's living in a false economy" as the Greenspan Fed's "free money" that was issued in "defiance of the natural laws of the universe." This is not from a metaphysicist, but from a hugely successful Wall Street trader. As he notes in June 2003, Greenspan pushed rates down to 1%, and this was the beginning of the bubble's rapid inflation.

McDonald writes vividly about the Stockton, California market, east of San Francisco. This area was a market that originated the NINJA ("No Income, No Job") mortgage. "Body builders," working with the home builders generated annual incomes of $300-$600,000 selling mortgages to financially unsophisticated and sometimes illiterate customers. Some of the mortgages were for 110% of the inflated, appraised value, and so the buyer was actually "paid" to take on the mortgage. These instruments went to more traditional, middle class buyers and their workout stories are now turning up in California newspapers. As buyers flocked to Stockton, its population increased by 5,000 per year from 2000-2005, all driven by real estate speculation.

New Century Financial was the largest sub-prime mortgage lender in the United States by 2007. Between 2003-2004, it was one of the fastest growing companies in the United States and listed on the New York Stock Exchange. By 2006, it was clear that the residential mortgage market was turning sour. Congress called for hearings. At one of the hearings, the hapless, inept head of the SEC, Christopher Cox (Harvard MBA and Harvard Law), assured Congress that all was well with corporate governance, financial reporting, and corporate disclosures. How could the head of the most powerful securities regulation body in the world be so clueless? How did he neuter all the internal analytical capabilities and any dissent in his own organization?

Meanwhile, Lehman's distressed debt trading desk, and with the foundation provided by analysts like Christine Daley, aggressively shorted paper issued by players like New Century and made tens of millions. They did it by just looking at public documents, and by asking the penetrating questions! Ironically, in the post-mortem on the New Century bankruptcy, the Delaware Court special examiner wrote, "(New Century's auditor) contributed to these accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitated the company's departure from applicable accounting standards."

The culture and internal safeguards of a Big 4 auditing firm had failed once again, just as it had when Arthur Andersen was blessing the voodoo accounting at Enron. In fact, the failures during this crisis have been across the board. Start at the top with the Federal Reserve and its abandonment of rational monetary policy and its failure to supervise bank lending and capitalization. Move down to the boards, analysts, auditors, attorneys, rating agencies, appraisers, real estate agents and no one said "No, I am not going to approve this document or this way of doing business." As Charles Prince said, "As long as the music's playing, I've got to dance." The problem started when the music stopped, and we are all living with the aftermath, for which no one is accountable.

The problem now is that there is no natural constituency for meaningful, fundamental reform. If there were, the first step would have been to hold people accountable. CPA's who blessed the bogus statements of players like Countrywide and New Century are still practicing their craft. The armies that put together and sold the securitizations that went radioactive are probably looking into securitizing payday loans. The body builder salesmen are probably back in the gym, which they probably own. We are now off tackling the window dressing issues, like "say on pay."

Unfortunately, our markets are built to have these kinds of cataclysmic events and now that the surviving global financial investment banking industry is more concentrated and needs to generate bigger profits to feed the machine, we have to see which market will produce the next bubble.

Tuesday, September 1, 2009

August Vehicle Sales

The market gets excited for a while about August vehicle sales of 14.1 million at a SAAR, the highest level since May 2008. It doesn't take much sleuthing to find that the "Cash for Clunkers" program accounted for this strength, and the corollary is that the sales were probably borrowed from the normal September/October uptick. I talked to my neighbor who cashed in a Subaru that was a clunker only in Government terms, and wound up netting a Chevy Cobalt for about 1/3 off the lowest possible price imaginable under the convoluted pricing system. He's an engineer and worked the pencil furiously, as did thousands of others.

Nissan dealers were notified that some "hot" 2010 models are not being delivered in September/October, but in January. What does Nissan know? They know that there's no benefit in pushing deliveries of a decent value sports sedan and having it languish in lots and then have to throw money at their dealers. It's better to wait, take the temperature of the market, and produce JIT the right number of cars for the market when better data is available. Watch what the smart companies are doing, and Nissan is smarter than the average metal-bending automotive company.

Incidentally, looking over my neighbor's Cobalt, which I badly wanted to like and which seemed like a good value, I couldn't help but notice the poor fit and finish. It is irritating and inexcusable to see this after decades of Japanese leadership in quality. The trunk appears to be offset to one side, and the left hinge is causing one side to be slightly higher than the other. The buyer will get it taken care of because GM is being very solicitous, but there's no excuse for this kind of poor performance.