Friday, March 30, 2012

Sovereign Wealth Funds: Norway's Example

Larry Elliot of the Guardian writes in his blog  decrying Britain's squandering of its North Sea oil resource.  This once vast and rich production area reached peak output in 1999 and continues its decline.  The offshore oil industry really honed its technological, logistical and geophysical capabilities in this hostile exploration and production environment.  It has been a remarkable testament to the industry's ability to extract oil safely in such large quantities from such a nonconventional source.

When I teach my MBA Investments class, I like to break up the dry but necessary mathematical development of the capital asset pricing model and the efficient frontier, by using incorporating some practical material. For this, I incorporated a lecture Professor Robert Shiller gave to his financial economics class at Yale as additional reading material. The link above is to a YouTube video of the class and to a transcript of the lecture.

The subject of the lecture is portfolio diversification, the introduction of the riskless asset, and the optimum portfolio's location at the tangency point to the efficient frontier.  Shiller and his colleague Ronit Walny went to the Norwegian government in 2006 to encourage them to change their portfolio mix dramatically.  Shiller notes that the State pension fund was about 2 trillion Krone at that time, and the national endowment of North Sea oil was worth about 3.5 trillion krone, so 64% of the wealth that could be used to support the State pension fund was "black gold," or depleting oil.  Shiller's argument for changing the portfolio mix was heard by the State pension fund, by the government and the central bank.  Although they moved slowly, the Norwegian achievement has been remarkable, especially when compared to the British experience. 

Professor Shiller's introduction of the CAPM paradigm, the adoption of a different political approach to national involvement in oil production, together with a significant portfolio realignment has led to a $550 billion State pension fund, one of the largest in the world to support a small population of 5 million Norwegians.  In USD, the State pension fund grew from about $300 billion in 2006 to the current level of $550 billion. On top of this, the diversification has served to extend the life of Norway's North Sea oil resources to an additional 60 years, despite intensive production for the past forty years.

Shiller tells this story in a low key manner, but it's a dramatic example of how a fresh application of a rational, financial economics theory can really benefit all citizens.  Were our government only so politically and economically astute.  Alas...

Tuesday, March 27, 2012

EPA Acts on Coal Fired Power Plants

The EPA has proposed regulations mandating new coal-fired power plants to use carbon capture technology, and only this option, to meet stringent new air quality guidelines.  This should hopefully move the industry towards gas fired plant construction, as we advocated in a recent post.  Carbon capture has been studied and prototyped by MIT and other high powered academic engineering groups, but it is unproven on an industrial scale and costs will probably exceed early estimates. 

It is a good thing that the Administration has finally put something on the table for public comment.

Monday, March 26, 2012

Germany Blinks on a Bigger Bailout

Ambrose Evans-Pritchard in the Telegraph reports, "China is unlikely to come to the rescue. Jin Liqun, head of China Investment Corporation, told an Economist forum that Beijing is worried about the "unravelling of the situation" in Europe. "China cannot be expected to buy into high risk in the eurozone without a clear picture of debt workouts. Sorry if I have ruffled feathers," he said.

Stefan Homburg, head of Germany's Institute for Public Finance, said the EMU crisis had already gone beyond the point of no return. "The euro is nearing its ugly end. A collapse of monetary union now appears unavoidable. The Chancellor should have no illusions about this," he said. "

We've posted about the untenable position created for German Chancellor Merkel.  Today, she has deftly taken the postion that she hasn't authorized a bigger ESM facility, but merely accepted the need for keeping the EFSF to run longer so that the ESM can borrow to its full capacity.  No additional German cash has been committed.  Nicely done, but it would seem that investors like Jin Liqun and others will see through this and not like it. 

We have to acknowledge from our previous posting that Stefan Homburg might be a sharp,hedge fund-like investor when he said this, "I myself have invested a considerable sum in Greek bonds. They will mature in one year's time and, if all goes well, produce a 25 percent return on investment. I sleep very soundly at night because I believe in the boundless stupidity of the German government. They will pay up."

Natural Gas versus Coal for Power Generation

Here's information, somewhat dated, on the subject from an EPA website:
"At the power plant, the burning of natural gas produces nitrogen oxides and carbon dioxide, but in lower quantities than burning coal or oil. Methane, a primary component of natural gas and a greenhouse gas, can also be emitted into the air when natural gas is not burned completely. Similarly, methane can be emitted as the result of leaks and losses during transportation. Emissions of sulfur dioxide and mercury compounds from burning natural gas are negligible.

The average emissions rates in the United States from natural gas-fired generation are: 1135 lbs/MWh of carbon dioxide, 0.1 lbs/MWh of sulfur dioxide, and 1.7 lbs/MWh of nitrogen oxides.1 Compared to the average air emissions from coal-fired generation, natural gas produces half as much carbon dioxide, less than a third as much nitrogen oxides, and one percent as much sulfur oxides at the power plant."

With interest rates at historical lows, construction costs cyclically lower and generationally low gas prices, one wonders why the power generation industry doesn't convert significant portion of its fleet of older, coal fired electricity plants into gas fired capacity.  While there has been progress made in burning coal differently and better, this switchover isn't progressing quickly either. According to the Union of Concerned Scientists, we still have 600 coal-fired plants producing 54% of our electricity.  If hydraulic fracturing raises environmental concerns, carbon capture/sequestration is probably even more complex. 

Since electric utilities are so heavily regulated, I'd argue that we have a regulatory failure here.  What kind of regulatory regime do we need to incentivize utilities to rapidly switch more power generation capacity to widely available, cheaper and more environmentally friendly fuels?  Lack of clarity in  the government's regulatory stance may be what's holding back  investment in conversion.

And, while we're at that, what about a Marshall Plan for building the next generation power grid? 

Thursday, March 22, 2012

Bond Outperformance May Be History

In USA Today, John Waggoner reports, "...for the last 30 years, bonds have beaten stocks, according to Ibbotson Associates, a highly respected Chicago research company. "It's hard to say that something that happens over 30 years is a fluke," says Francisco Torralba, economist at Morningstar Investment Management."  It is probably reasonable to say that the strong bond outperformance won't repeat itself over the next 30 year period.

Bond investing is going to get more challenging in the years ahead, particularly for those investors and institutions who favor Investment Grade Corporates.  Post-global meltdown, the supply of investment grade issues is smaller than in the past.  According to Moody's, bonds rated single 'A' or lower accounted for 58% of the corporate market in September 1990, whereas this below investment grade sector accounted for 73% of the corporate market in September 2010. 

Put the other way, investment grade corporates accounted for 42% of the market in September 1990, declining to 27% of the market in September 2010.  As Moody's points out, the cumulative defaults in the investment grade sector for the twenty year period ending September 2010 compared to cumulative defaults in the twenty year period ending September 1990 increased by 156 times

So, in the early stages of future market up cycles, investors can get equity-like returns in a larger below investment grade sector, recognizing that the sector has expanded because of the influx of fallen angels.

 It's also logical to expect that when the fire alarms go off in the equity casino and there are "flights to quality," that U.S. Treasuries will continue to benefit due to the immense size size, depth and liquidity of the market, especially compared to investment grade corporates. 

Those issuers remaining in the investment grade category today generally have the strongest balance sheets in recent corporate history, which is why intermediate bond funds have tilted their allocations to this sector beginning last year or before.

Saturday, March 17, 2012

Fed Goes Oops on Stress Tests

The New York Times reports this morning that the Fed's stress test contained errors in the classification of losses in  Table 4, on page 32  of the report.  This is the table that I discussed in the previous post, and it's certainly disappointing that a high-powered organization like the Fed can't get these calculations right the first time.

It's also interesting to note that JP Morgan jumped on its positive stress tests to front-run the Fed by issuing its own press release.  This made sense, since JPM looked proactive and focused in defending its reputation.  By contrast, I looked around on the Citi website a few minutes ago, expecting to find prominent, flashing red lights pointing to a press release.  This release would have affirmed management's view that the initial test results were below expectations of the management and those of it its expert consultants.  It turns out Citi  had a point, but I couldn't find a press release. Disappointing.

There's another interesting line in  the table which purports to quantify the "Trading and Counterparty Losses" to the 19 bank holding companies from the use of derivatives for hedging risks.  In the original bailout, one of the justifications was that total global losses from a cascade of counterparty claims were incalculable and would bring the system down.  Now, in the case of a somewhat drastic economic scenario, these losses seem to be quite measurable, and they definitely do not bring down a system driven by these 19 systemically important financial institutions.  The Trading and Counterparty Losses shown range from $21 billion to $27 billion, affecting Bank of America, JP Morgan Chase, Goldman Sachs, and to a lesser extent Morgan Stanley.  I wonder what has changed in the world of derivatives that the formerly unknown has become known and manageable.

Tuesday, March 13, 2012

Fed Stress Tests 19 Banks: A Quick Road Test

The Fed's announcement of stress test results for 19 bank holding companies has provided balm for equity and debt holders, with the exception of four banks, which failed to maintain their core Tier 1 capital ratios at five percent of risk weighted assets at the end of the projection period, Q4 2013.  Although Met Life, Ally Financial, and Sun Trust failed the core Tier I test, the big news was that Citgroup also failed. 

There's no doubt that the economic scenario painted in the Fed's required simulation was extremely dire, and so the exercise is conservative in this respect.  Looking at the footnotes for Table 4 in the company projections, I suspect that the actual magnitudes for projected losses, revenue and net income could come in higher, lower and lower than projected, which would balance out the conservatism on the scenario choice.

Taking a quick look at a company like Keycorp which is included in the 19 company sample for the stress test, one still wonders how National City Bank was the only bank holding company in the Top 25 which failed to get Federal aid.  It got pushed into the arms of PNC for a song, further punishing shareholders.  It's still not clear to me how that happened, but enough on that aside.

Many of the ratios on the tables are rounded, so keep that in mind if some things don't add up.  Remember that the horizon we're looking at is 4Q 2011-4Q 2013. Beginning with Pre-Provision Net Revenue (PPNR), the format adds other revenue and subtracts Provisions, Realized Gains and Losses on Securities, Trading and Counterparty Losses, Other Losses and comes to Net Income Before Taxes.  A quick number that gives the flavor is to take the total swing PPNR to NIBT. In one sense, this is the total magnitude of the scenario's impact over the forecast period for a number that matters to investors.  For all 19 companies, this swing amount is $520.5 billion.  Here's the leader board for the swing from net revenue to loss:
  1. Bank of America: $91.4 billion (17.6% of the sample total)
  2. Citigroup: $91.4 billion (17.6% of the sample total)
  3. JP Morgan Chase: $82.2 billion (15.8% of the sample total)
  4. Wells Fargo: $72.9 billion (14.0% of the sample total)
These four bank holding companies, which are universally regarded as TBTF ("too big to fail") or Systemically Important, account for 65% of the total holding company sample's swing from PPNR to NIBT, which is negative in most cases, except for American Express, Bank of New York Mellon, and State Street which all would show positve NIBT in 4Q 2013. 

For the four leaders above, Bank of America, Citigroup and JP Morgan Chase all show significant Trading and Counterparty Losses during the simulation period: $21.1 billion, $20.9 billion, and $27.7 billion respectively.  It would be nice to understand how confident the Fed is in the computation of these losses.

If one goes back to a data set I like, the V-Lab from NYU's Stern School, it shows the top companies in "systemic risk %" being Bank of America, JP Morgan Chase, and Citigroup.  So, with different models and different simulations, we've identified the same characters, which is probably a good thing.  Let's focus the rest of the commentary on these Four Horsemen.

For the simulation period, the Total Loan Loss Table reads:
  1. Bank of America--$70.1 billion
  2. Citigroup--$67 billion
  3. Wells Fargo--$58.3 billion
  4. JP Morgan Chase--$55.8 billion
The Fed presentation shows loan losses by loan categories: First Lien Mortgages, Junior Mortgages and HELOC, C&I Loans, Commercial Real Estate Loans, Credit Cards, Other Consumer Loans, and Other Loans. 

Looking at Loan Losses as a Percent of Average Balances, Citigroup shows the highest aggregate percentage loan losses among the Four Horsemen above at 11.2%.  It shows the highest loss rates for First Lien, Junior and HELOC, and C&I Loans, the bread and butter of bank lending.

A reader can back into the average balances in each loan category, and in terms of dollars, Bank of America is the leader in aggregate loans with average balances of $845 billion, with $264 billion in first lien mortgages, $107 billion in junior mortgages and HELOC, and $160 billion in C&I loans. 

The largest card portfolio in terms of average balances is Citigroup at $146 billion, on which it is projected to generate $27 billion in losses under the simulation scenario.  JP Morgan Chase shows a credit card portfolio of $118 billion, which generates losses of $21 billion.  In the kind of severe economic and market downturn in the simulation, unsecured credit card lending bites back at bad underwriting and balance management. 

The group of four bifurcates into Wells and JPMC which passed their Tier 1 core capital tests and which have a a balance of businesses, the associated revenues and the ability to raise capital.  Bank of America, for all its good work in limiting liability for the mortgage debacle, still has challenges in the traditional product portfolio, and revenue growth will be a challenge; Merrill Lynch will probably be sold at some point, since its performance was relatively flat in 2011 compared to 2010, even though markets were heady.  Citigroup still seems like a directionless story, despite the successful financial engineering work to keep the ship from sinking. Revenue growth and value creation remain a mystery for the Citi That Never Sleeps.

What's Driving Oil Prices?

If the Hormuz Strait hasn't been closed yet, then we must be looking at an Iranian conflict to justify current market prices, at which point high U.S. gasoline prices will be the least of our worries. However, just checking some recent reports from the Energy Information Administration still suggests that there are few fundamental economic reasons for crude oil prices being where they are today.

The first thing EIA notes is the unusually large spread between WTI and Brent, with West Texas Intermediate currently priced at around $106 per barrel, verus Brent at $125.  It turns out that there are technical reasons for this spread.  The Buzzard Field in the North Sea has been having technical production problems for the past ten months, according to EIA, and though its production is small, its output is a key part of the Forties crude blend, which is key to driving the quote for Brent. 

U.S. 50 State liquid fuels production for Jan-Feb 2012 compared to the same period in the prior year, is up 7.3%, driven as the papers remind us, by the tight oil boom, and in response to some technical issues of scheduled maintenance at Canadian tar sands facilities in February. 

Now, looking at U.S. 50 State consumption of liquid fuels for the same two month period, it is 18.3 million barrels per day (mbd) compared to 19.0 mbd in the same period a year-ago, a decline of 3.7%.  Chinese consumption, according to the preliminary February numbers is up 4.2%, while world consumption, according to the EIA figures is up only 1%. 

We don't know if there are technical factors affecting the uptick in Chinese consumption, but the overall profile of world demand doesn't support sustained uptrends in crude prices.  In fact, at the beginning of February, WTI was about $5 a barrel cheaper, but this was the beginning of the drumbeats about Iran closing the Strait of Hormuz.

In Western economies, particularly in the U.S. there is a dominant trend of energy efficiency as measured by energy consumption to GDP.  There's no reason to believe that this won't continue. There is an argument that the level of swing, or excess capacity, in world oil output is at a historical low, but as a factor in driving prices upward, it shouldn't be a big determinant when global demand is soft overall.

German Economist Homburg on Euro Bailout

Der Spiegel has a refreshing and enlightening interview with Stefan Homburg, Director of the Institute of Public Finance at Leibniz University in Hanover.  Here are a few bullet points from Homburg's interview:

  • "The government bailout initiatives create misdirected incentives that continuously exacerbate the problems on the financial markets.
  • The alleged risk of contagion is a myth that doesn't stand up to closer scrutiny. If you share my conviction that all this talk of Greece being too big to fail is simply nonsense, then there is no reason for bailouts
  • Last year, if we had adhered to the Lisbon Treaty, which prohibits assistance payments, Greece would have restructured its debt, just as Uruguay, Argentina, Russia and other countries have done over the past 15 years...
  •  ...they (banks and hedge funds) take governments for a ride with this nonsense that a default would have devastating consequences. In a zero-sum game, there are not only losers, like us taxpayers, but also winners (the hedge funds)
  • I myself have invested a considerable sum in Greek bonds. They will mature in one year's time and, if all goes well, produce a 25 percent return on investment. I sleep very soundly at night because I believe in the boundless stupidity of the German government. They will pay up."
The EU's long run prognosis is not good in our opinion, and Homburg's interview provides another take why the future is not sustainable for the union. 

Saturday, March 10, 2012

Chancellor Merkel In a Lose-Lose Position

                Johannes Eisele/Agence France-Presse - Getty Images

The New York Times this morning carried a front page puff piece about the "friendship" between German Chancellor Angela Merkel and IMF Managing Director Christine Largarde.  It is full of references to synchronized swimming , and to  high end Fragonard French candles being given  as gifts to Merkel as symbols of "hope." Constrasts are drawn to  the differences between the analytical physicist Merkel and the smooth talking lawyer Lagarde, who was an intern on the U.S. Capitol Hill.  Well, as you can see from the picture, Chancellor Merkel has probably realized that she has been hoodwinked into a lose-lose position by an IMF Managing Director who couldn't have been appointed to that position without German support.

What's the big deal?  France is in the throes of Presidential elections, and there isn't any doubt that the timing of Lagarde's very public volte-face about European policies handling the EU crisis is intended to help incumbent President Sarkozy and to hamstring German influence on future multinational political decisions.  In financial crises past, the IMF has uniformly taken the position of "tough love" and taking the bitter medicine of austerity.  Now, the IMF is all about growth and stimulus, putting Chancellor Merkel's position about profligate EU members having to put their houses in order first, in danger of seeming backward looking and intransigent.

If Chancellor Merkel sticks to her guns, which would be absolutely appropriate, she opens the doors to her own internal opposition and to resentment against austerity morphing into a broader, anti-German sentiment.  If she were to throw in the towel and throw her support to the a gigantic bailout fund under the control of the IMF and Eurocrats then the future of the German economy would be be impaired and her own political career finished. 
Recent U.S. trade statistics show a dramatic drop in exports to Germany, reflecting the already marked slowdown in German economic growth, which makes Chancellor Merkel's position even more difficult.  Let's hope that German politicians of all parties can rally around the broader European and German self-interest, which is not served by the burgeoning bailout funds. 

Friday, March 9, 2012

EU Intransigence May Turn Airbus into Airbust

From today's Wall Street Journal:

"BRUSSELS—China's ambassador to the European Union said it "makes sense" for Chinese airlines to shun Europe's Airbus planes in favor of competing American models from Boeing Co. in response to the EU's new levies on aviation greenhouse emissions.

Wu Hailong's comments are among the first by a senior Chinese official linking Beijing's displeasure with the EU's emissions trading system, or ETS, to jetliner sales by the Airbus unit of European Aeronautic Defence & Space Co.

EADS chief executive Louis Gallois on Thursday said that the Chinese government is withholding final approval on contracts for 45 Airbus jetliners with a catalog value of $12 billion because of ETS.

Mr. Wu said that when the EU includes a Chinese airline in the ETS, "it makes sense for them to go to Boeing."

Under the EU program, any airline operating at an EU airport must hold special credits to offset its carbon dioxide emissions since the start of this year. Airlines have said their inclusion in the ETS, which already covered many EU industries, will cost them billions of dollars annually.

Airbus warned last spring of the risk of foreign backlash against the EU plan, as China and others had threatened action if their airlines were forced to comply.

Governments outside the EU, including China, the U.S., Russia and India, have accused the 27-country bloc of exerting extraterritorial authority by levying fees on emissions that occur outside EU airspace."

The final arrogance of the EU is their unilateral imposition of these wacky standards without any consultation, as the Chinese have rightly pointed out.

If international flights aren't allowed to even fly over European airspace, this will be much more disruptive to global economies than any realistic possibilities attached to the Strait of Hormuz blockade.  Someone is going to have to blink on this one, and let's hope that the Eurocrats come to their senses, but it's not guaranteed. 

Thursday, March 8, 2012

Brussels Won't Be Capital of Europe

As the European debt crisis lumbers along, if it wasn't obvious before it is now: ceding national sovereignty to fiscal integration and political union in Europe will be a nightmare.  Bureaucrats in Brussels, we are told in the New York Times, can impose austerity on poor Greek citizens, but they can't make their own travel arrangements, must fly business class, and have to take private jets in order to visit with Russian officials. 

The CEO of Ryanair, a no-frills European airline, says, "The European Union spends most of its time either suing me, torturing me (a bit much, but he's a CEO), criticizing me or condemning me for lowering the cost of air travel all over Europe."  Efficiency can't stand in the way of comfort and ease for the Eurocrats in Brussels.

Even more outlandish was the requirement that international airlines flying over European airspace buy carbon offset credits for polluting once national, but now European airspace.  The Chinese government has rightly said that they will not play along with this ridiculous ploy to generate revenue for the failing Euro cap and trade system.  Their claims were rejected, but today the Chinese government has declared that one of their large orders for the Airbus 380 is being placed on hold because of EU intransigence over the carbon credit issue.  Can rationality prevail in Brussels?

The Greek government is seeing the effects of the Brussels-imposed austerity, and Spain and Portugal will have to wonder when the cudgels will be wielded on their sovereign economic policies by the Eurocrats.  A European customs union makes sense, a currency union makes a bit less sense, but political union is a non-starter.

Monday, March 5, 2012

Brian Clough and Bill Belichick on the Financial Crisis

Years ago, while scrimmaging during a soccer coaching clinic for one of my first licenses, I heard the English coach scream, "Most goals come from two men trying to do one man's job!"  He had just witnessed a play where my team had unfortunately been scored upon. I was a culprit, as I was in a bad position when the ball was fired into the goal.  I didn't really understand what he meant, but his passion was evident in many ways, including the large vein standing out, throbbing in his neck. 

Some time after that, I was reading an interview with  Brian Clough, the legendary English coach who was the only manager to lift the old First Division trophy with two different clubs, Derby County and Nottingham Forest. It became evident to me that the origin of what I had heard in my clinic was from Clough's philosophy.  Over many years of playing and coaching to today, I now know and understand that he was right! 

Fast forward to the recent Super Bowl, and Bill Belichick's famous rant, "Just Do Your Job!"  Believe it or not, this is basically  the same insight Brian Clough had.  I recall a Giant running play when Amed Bradshaw ran off right tackle and was stuffed at the line by the nose tackle and his partner, both doing their jobs.  The running back bounced out, looking to go right, and the Patriot linebacker was lining up the tackle, as Bradshaw continued to drift, looking for an option. On the outside, the contain man, whose job it was simply to ensure that Bradshaw didn't turn the corner, instead chose to bite and tried to make a tackle for a loss.  That was NOT his job.

Instead, Bradshaw used a stiff arm, ran over the DB and burst outside.  Because of one man not doing his job, the linebacker was now out of position and had to chase, not down the line, but from behind. Down field, Bradshaw was able to get blocks from receivers who wound up in great positions to block the surprised corners. Two men tried to do the linebacker's job: make the tackle at or behind the line. The second man didn't do his job, which was to contain, but he looked for a moment of glory and caused a collective failure. Sounds simple, but it's not a simple insight, by any means. Cloughie was a smart guy, as is Belichick!

Whenever I've run my Finance departments, I've always emphasized keeping it simple and just doing your job to the best of your ability, asking for help if it's needed. If you've hired good people, trained them well, and they buy into the concept and the team comes together with mutual accountability, it's a good recipe for success.

How does this relate to the financial crisis?  Simple: nobody did their jobs during the crisis. If Belichick had been  in Henry Paulson's place, he would have pulled up his hoodie and gone apoplectic.  I'm going to quickly use two of the most egregious bad actors in the subprime mortgage lending business as examples.  I've attached links to some useful documents for readers who want to go through some of the gory details.

By year-end 2006, New Century Financial was the third largest originator of residential subprime mortgages in the nation, originating $52 billion in that year alone. On February 7, 2007, New Century announced restatements of results for the first three quarters of 2006, due to errors in accounting for the effects of mortgage repurchase obligations from securitizations which were unraveling. On April 2,2007, New Century filed for bankruptcy protection with $26 billion in assets.  The most informative document on New Century is the hard hitting report of the Special Master Michael J. Missal, done for the Delaware Bankruptcy Court.

From its humble beginnings as a REIT, IndyMac Bank became the 9th largest originator of residential mortgage loans nationwide, hitting a peak annual origination volume of $90 billion in 2006.  From 2001-2006, indexing 2001=100, by 2006 IndyMac's stock index value was 222 compared to 158 for the Russell 1000 Financial Services Index.  Executive compensation, indexed to EPS and ROE skyrocketed based on the value of option awards and performance bonuses. The stock price collapsed less than one year later, and by the spring of 2008, IndyMac was shown to be a house of cards. The best reading on this case is the report of the Inspector General of the FDIC

Who didn't do their jobs at New Century and at IndyMac?
  • Executive management and the board of directors allowed a toxic "tone at the top" to flourish which celebrated outlaw production of mortgages by uncontrolled brokers, who overrode IT, internal audit and underwriting controls with impunity.
  • SOX 404 certifications and auditor reviews of internal controls clearly failed with no weaknesses uncovered until 2007. 
  • Audit committees replete with CPA's and financial experts signed off on implausible financial results. The 2006 loan loss provision for IndyMac was $20 million, the same absolute amount as in 2003: originations in 2006 were $90 billion compared to $23 billion in 2003!  And, since 2004 management and the board had clear indications of deteriorating performance in the securitization trusts and in originations.
  • External auditors never challenged any of the reporting practices, including the use of gains on sales, which often accounted for a significant proportion of reported earnings, which drove management compensation.  Mark-to-market accounting may or may not have been a major culprit in the total crisis, but it was clearly misapplied across the subprime industry's worst actors.
  • Internal audit and underwriting processes failed because although their monthly work clearly showed the problems, they could not establish a direct communication to the audit committee, and so were squelched by the loan production groups who reigned supreme.
  • SEC counsel and corporate counsel failed to require adequate disclosures of risk, current financial condition and forward looking statements.
  • Federal regulators, particularly the Office of Thrift Supervision, failed in their routine, periodic audits of IndyMac Bank.  This failure caused material loss to the FDIC and was clearly called out in the report of the Inspector General of the FDIC.  The OTS was folded into the OCC as a result. 
  • Equity analysts, credit analysts and credit rating agencies all failed to do their jobs to help investors.  Instead, they served as cheerleaders, driving their own revenue models.  
 We clearly don't need another regulatory nightmare like Dodd-Frank on top of what was already in place.  Any or all of these mechanisms above should have served to surface the strategic, business and financial risks of subprime lending and the mechanisms in place should have forced adequate disclosure and proper valuation of revenue, reserves, income and balance sheet items.  Listen up!  Do your job!

Thursday, March 1, 2012

Are Cell Phone Carriers Stopping A Race to the Bottom?

ATT announced today that it was effectively eliminating unlimited data plans for its customers, and it said that it would allow customers to use a set amount of data services per month before adding penalties.  More downloads at the highest speeds will now hit a limit, generate a text warning, and then slow data download  speeds and generate higher user fees. It remains to be seen if other carriers will seek to obfuscate the issue to take share, but we applaud ATT for trying to introduce some rationality into the pricing of mobile data services.  Ultimately, the current situation is the interest of Apple and its devices, but not in the long-run interest of the carriers or of the broad consumer user base. 

In the investment research literature, behavioral economists and others have identified all kinds of irrational behavior by individual investors, leading to patterns of buying high and selling low, for example. Corporations are not supposed to behave this way.

Sprint and others started a race to the bottom by giving away phones and unlimited data plans.  Sprint further made a huge bet on iPhones and will be limited to operating on life support as a result. Carriers were subsequently forced into a network upgrade arms race and a pursuit of buying spectrum at ridiculous prices.

Water and power utilities have long ago proven the economic value of tiered pricing, with higher prices for those users who force the utility to build for peak loads which are excessively above average demand levels.  Perhaps rationality is coming to the cell phone carriers.  Let's hope so.