The Chrysler UAW Bailout

The auto industry bailouts during the financial crisis completely overturned our traditional legal statutes governing how creditors are treated during bankruptcies. With today's announcement that Fiat is buying out the 41.5% of Chrysler which it does not already own, these issues are as evident as ever.

A 2012 Backgrounder from the Heritage Foundation gives good information and references which are very consistent with the most recent October 2013 report from the SIGTARP Inspector General.

Chrysler has been mismanaged for many decades, and it has had several turnarounds.  None of them ever really addressed their operational and product development mismanagement, or their labor costs which were among the highest in the American automobile market.  Pre-bankruptcy labor costs at Chrysler were $76 per hour in May 2012, higher than both GM and Ford at the time and significantly higher than costs at Honda, Toyota and Nissan.

Pre-bankruptcy, Chrysler has $6.9 billion of senior secured liabilities and $2.9 billion of junior secured liabilities, according to the figures in the report.  $5 billion was owed to unsecured trade creditors.  Chrysler owed $8 billion to the VEBA (Voluntary Employee Beneficiary Association) formed in 2007 to assume the liabilities of the employee retirement plans.

Bankruptcy allows the corporation to restructure its contracts, subject to two heretofore inviolable principles. Secured creditors stand first in line for recoveries, including the ability to seize encumbered assets if necessary.  Unsecured creditors are considered the great unwashed, and they are traditionally wiped out or in unusual circumstances get pennies on the dollar as recoveries.

Because of Chrysler's long, troubled financial history its bonds were secured debt, which wasn't typically the case.  Senior secured creditors of Chrysler who were owed $6.9 billion recovered $2 billion, or $0.29 on the dollar.  The junior secured creditors somehow recovered $0.0 on $2 billion owed.

In this kind of structure,  which is very unusual, the unsecured creditors, including the UAW/VEBA, should have expected nothing except to be wiped out. Instead, the Obama administration converted the $8 billion into a 41.5% stake in the reorganized Chrysler, along with a 9% note.  The total 2012 PV of the Chrysler bailout, which only benefited the UAW and its membership, was estimated at $9.2 billion in the report cited.

Labor agreements and labor costs are traditionally renounced and reset in bankruptcy agreements.  While labor costs were adjusted to close the nominal gap to Honda/Toyota/Nissan to around $56 per hour, Chrysler workers will still earn substantially more than the average U.S. manufacturing sector worker, with no ties to productivity or work rule flexibility.

The exercise of Federal control and intervention in financial markets and in matters like executive compensation of corporations in which it has bought a stake at gunpoint will surely be regarded as a weakening of our economic system whose virtues we trumpet so loudly.  The government's facilitating of rent seeking by its favored political constituencies, like auto unions, is also an unprecedented manipulation of the bankruptcy process in which the role of the judges and administrative apparatus have also been marginalized. "If there's money up for grabs, I might as well be the one grabbing," a client once told me. He was a greenmailer, but his motto is still relevant today.

Bon Chance, Justice Chandler!

Craig Mellow, in this quarter's Board Member, has written a thoughtful piece on the retirement of Chief Judge William Chandler of the Delaware Court of Chancery. When I was an equity securities analyst, I read many of the cases coming out of the Delaware Court, since most of the companies I followed were Delaware corporations. Subsequently, as a public company Director, I read some of the rulings like the Disney case on the Michael Ovitz severance package, through a different lens.

I have to admit that I bristled at the Disney opinion, in which the board was adjudged to have followed a reasonable process, been given sufficient information, and to have exercised reasonable business judgment in awarding Ovitz a totally outlandish severance which raided the corporate coffers and diminished the corporation's reputation. However, reading through the decision, it followed the standards of the business judgment rule as I understood it. As much as I viscerally disagreed with the equity of the ruling, it wasn't at all unreasonable.

Some of the madcap polemics now about shareholder rights does strike me as unreasonable, though. In our fractious and uninformed style of public debate, these issues are being framed as either "anti" or "pro" something. Shareholders cannot and should not be protected from bad business decisions by judicial fiat. They are at the bottom of the capital structure by design, and they accept this arrangement by choosing to buy common shares. If things go well, they can enjoy outsize rewards. Should bondholders sue in the name of fairness? "What about us?" could they say? No, they chose an instrument that put their claims at the top, and for this seniorty of claim, our system measures out for them a fixed return.

If shareholders aren't paying attention, or have misjudged the risks or misjudged the character of management, well, that's why capital losses can be offset against capital gains.

Chancellor Chandler has the qualities one would hope to find were we to appear in front of a jurist: intellectual acuity, technical knowledge, an ability to listen, thoughtfulness, a sober demeanor, the ability to integrate information from a variety of sources into a logical framework, respect for legal continuity and tradition, and abiding humility in the face of the jurist's own power over those appearing at the bench. I haven't come across this combination often, but U.S. corporations and their shareholders should be grateful.

Being an Audit Committee Chair

A new blog entry by Keith Higgins of Ropes & Gray LLP cites the case of Vasant Raval, the audit committee chair of infoGroup, Inc. who consented to an injunction and agreed to pay a $50,000 fine for not stopping $10 million of payments for illegal perks to the CEO along with $9 million in related party transactions. Having been a public company audit committee member and chair myself, it seems rather odd for the SEC to have made an example of the directors and officers of this company, when the folks at Lehman Brothers Holdings (board, officers and auditors) seem to have not suffered even an Excedrin headache for their contributing to the destruction of billions of dollars in value while also cashing out hundreds of millions in stock sales ahead of the collapse. "Bad facts make bad law," according to Mr. Higgins.

Why Did They Do It?

I attended an interesting workshop at the University of St. Thomas Law School, sponsored by the Holloran Center for Ethical Leadership entitled, "Crime, Punishment & Redemption: Three Unique Reunions." Three panels discussed three cases of white collar crime. Each panel was composed of the perpetrators, the judge who sentenced them, and the U.S. Attorney who brought the case. Additional comments were made by very senior Federal judges. I am not a lawyer, but the human side of it all was very hard to listen to without some emotion.

The first panel concerned Stephen Rondestvedt, who came from a middle class background with a record of high achievement in his undergraduate studies and then in law school. Steve started a solo practice in the area of workman's compensation and disability claims. He said that his clients were not well-to-do generally. He got caught up in the pressure to upgrade his home, and his wife wanted to badly close on the new home before the old one was sold. So he had to come up with a $28,000 down payment, which he did not have because the business was sucking up his liquid resources. Under the emotional pressure to satisfy their aspirations, and with an inability to say "No, we can't do this now," he tapped the trust fund of claims money held for his clients. He firmly believed that he would pay it back so rapidly that it wouldn't matter, though as an attorney he fully realized the ethical and fiduciary violations the withdrawal represented. From there, the sense of entitlement got worse and eventually morphed into a fraud of $789,000. He served 20 out of a 46 month sentence in the Federal Penitentiary in Yankton, South Dakota. He was clear and candid about his weaknesses and his bad judgment. He has rehabilitated himself and is now Executive Director of Axis Medical Center in Minneapolis, which provides services to the primarily Somali community in Minneapolis. Why? Financial pressures to upgrade the lifestyle and an inability to postpone satisfaction led to a bad judgment in a moment of weakness. There was a perception that the act would not linger around long enough to constitute theft and betrayal of trust; it did much more and morphed into fraud. It ultimately cost him his marriage. Tough stuff.

The second case was David Logan, who while a City Administrator in Pipestone, took bribes from companies looking for city business over a long period of time. What started out as a legitimate desire to cut red tape and generate development, turned into a career of working with his hand out. Again, there was a sense of entitlement--after all, he was working harder than his peers and he was actually bringing development revenues to the city of Pipestone. From there, in a desire to flee the history, he became CEO of an industrial hog farm, where he got involved in generating fraudulent loans that were tied to hog prices as part of the terms. Ironically, while perpetrating these fraudulent loans, the history at Pipestone was being uncovered and he received the notice of Federal Court proceedings relating to his city career while he was in his new CEO job. In the end, the U.S. Attorney recommended a sentence in the lower range of 34-71 months, as part of the plea agreement. Here's where it got interesting.

Michael Davis is the Chief Judge of the U.S. District Court in Minnesota. While on the dais with Logan and the U.S. Attorney, Judge Davis who had not seen Logan since the sentencing, proceeded to tease out a much less sympathetic portrait of Logan, whom he sentenced to 71 months in Federal prison, the maximum term according to sentencing guidelines. Logan made the statement that the bank loans were eventually repaid, with the implication that no one was harmed. Judge Davis noted that this happened only because Logan "had made the right bets," that is hog prices rose dramatically during the loan period assuring repayment. It seemed to me that Logan, of the three cases, had not really acknowledged to himself the real extent of his crime.

Judge Davis then gently, but forcefully excoriated the system for focusing almost entirely on punishment of offenders as opposed to rehabilitation and for treating white collar crime, dealing with large amounts, as somehow more benign than a black kid sticking up a store for $100. He raised a lot of interesting questions, most of which I first ran into when I read the "Autobiography of Malcom X," in high school. We cannot incarcerate large segments of our population for longer and longer terms with no plans for what these individuals might do when they are released. No easy answers, obviously, but Judge Davis' quiet indictment of the process was worth listening to. The program was recorded by Twin Cities Public Television, and the Holloran Center will publish a transcript.

The third case was a couple where the husband was a senior HR executive for a large company, who told his wife to start a personnel consulting company in her maiden name. Nick Ryberg then hired his wife's company to provide "research support" for HR recruitment programs, for which no work was done. The false invoicing scheme billed more than $1 million! What was the motive here? Nick said it was "corporate ego," the feeling that he was smart enough to manipulate the system, that he was entitled because he was a corporate hitter and that he could deflect any questions and explain everything away. Corporate ego. Hubris. A sense of entitlement....

The person's background was not predictive of whether or not they would be lured into fraud and white collar crime. In the case of Steve, for example, his background, early family life, and parental values were all exemplary. Moments of weakness where the person loses their bearings seems to be the common descriptor. They all also seem not to have had confidantes who might have pushed back on their decisions. As the frauds grew, so did the sense of isolation and even desolation. Alcohol was the "drug of choice" to make the pain go away. The frauds were clearly toxic to relationships both with spouses and with children, who are often the forgotten victims.

The Supremes

I find it really disheartening to see the level of attention we lavish on these rituals for elevating someone to the Supreme Court. Judge Sotomayor seems like a nice person, but is she the best candidate we can come up with nationwide? Now, we all understand that she is going to be confirmed. Yet we have to go through this mind-numbing ritual. And, in grand political style, the candidate has to skate delicately away from some of her nonsensical and injudicious remarks. The Congressional staffers helping her out have all the stock phrases: "I was quoted out of context;" "That was then, this is now;" "I'm a different person now;" "I would be a Supreme for all the people." Pick one and rework--we're done.

I've written before about my meeting with Chancellor William Chandler III of the Delaware Chancery Court some time back. Sitting at a table of lawyers, the questions came rapid fire for the Chancellor. He had several qualities I admired. The first is that his pace did not rise to match the rapid breathing, high heart rate of his questioners. He sat back, Zen-like and listened intently. He also thought about his response before he spoke. On television, the producer would have been crying about "dead air."

When he responded, at first, it didn't seem as if he were answering the question. However, if you listened carefully, it was exactly what he was doing, and the response was not, "I think, I think..." He gave a short, very precise response to what the salient point was, or should have been. It was very impressive.

The good news is that since most public companies are still Delaware corporations, that bench will still have lots of influence on corporate law and governance. The Harvard Law School governance blog carried a nice piece about the work that the Chancery court is doing.

If only the Supremes would aspire to be these qualities.

It's Still A Bad Plan

In a post dated February 13th, we made two key points. First, we felt that forcing financial firms into some form of bankruptcy was superior to substantial direct investment by the government. Second, we believed that the plan-without-details for buying toxic assets through private-public partnerships was an extremely bad idea.

Now with the passage of time and some more details, we feel even more strongly about these positions. In a paper by Kenneth Ayotte and David A. Skeel, Jr., "Bankruptcy or Bailouts?", the authors note that it has been a guiding principle of Fed Chair Bernanke and former Secretary Paulson to "..avoid bankruptcy filings by the distressed firms...based on the belief that if a troubled firm files for bankruptcy, the consequences would be severe." The risks are categorized as firm-specific, including the rapid dissipation in value of the firm's assets, and systemic, such as the continued erosion in confidence. They note that three days after filing for Chapter 11 protection, Lehman Brothers had garnered court approval for the sale of its North American investment banking operation to Barclays, which provided $450 million debtor-in-possession financing. Two weeks after filing, Lehman had sold its European, Middle East and Asia operations to Nomura and its investment management business to two private equity firms. Through this example they show that the concerns about bankruptcy being slow and increasing firm specific risk, are not as significant as interventionists say they are. The authors are, respectively, law professors at Northwestern and the University of Pennsylvania.

Nobel Laureate Joe Stiglitz, writing in the New York Times ("Obama's Ersatz Capitalism," March 31, 2009) exposes the Geithner plan to purchase troubled assets via public-private partnerships. His characterization, drawn through two scenarios, shows that the plan socializes the potential losses, while offering private investors, pre-crisis returns of more than three times their equity investment. Professor Stiglitz sums it up best when he says, "The Geithner plans works only if and when the taxpayer loses big time." Yet, this plan cannot die at this point, for political reasons.

Today it is being tweaked again, not for its fundamental construction, but for issues of access by smaller firms to the candy being handed out by the Fed and Treasury. As several observers have noted, the ongoing financial crisis is not fundamentally about liquidity, but about confidence in the financial system. Despite all the press conferences and releases, very little of substance has been accomplished to restore confidence in the efficiency, transparency, fairness, and governance of the financial system.

Medtronic Business and Law Roundtable (Pt. II)

Continuing from a previous post covering Professor John Coffee's presentation, the next presenter was Lizanne Thomas,Chair of the Global Corporate Governance Team for Jones Day, the largest law firm in the world. Lizanne is an outside director for Krispy Kreme doughnuts. Krispy Kreme launched its IPO, I recall, at a price of about $10 per share, reached well above $45 per share, and settled down below $2. It is a classic case for how not to run a business, and how not to deal with public disclosure.

She talked about the business judgment rule, which requires directors to show loyalty and care in all their deliberations and decisions regarding the company for which the shareholders elect them as fiduciaries. Lizanne noted that some boards take this rule and force themselves into a process-oriented oversight, rather than digging into the substance of business decisions and the risks that they entail. No matter how smart regulators think they are, they cannot, in her opinion, "legislate trustworthiness into general corporate behavior."

She advised all corporate directors to "remember, relish, and assert their independent roles." Lizanne always advises her board clients to never succumb to management pressures and approve what they don't fully understand. This seems like a simple point, but the interpersonal dynamics governing this situation go unnoticed. If the board of a financial services company is listening to a long, PowerPoint presentation, full of charts, graphs, and mathematical model outputs covering risks in a derivative portfolio, I can assure you that most directors remain silent. The ones who have already bought into management's strategy are nodding their heads and going "Uh huh." It is very difficult for a peer who is a director to say something like, "Look, I've been a CEO of an S&P 500 company, but I confess that I don't intuitively understand this strategy and its risks. Can you make it simple for me?" Everyone drinks the Kool Aid; it's much more collegial and face-saving that way.

She thinks that a lot of board decisions that seem overtly foolish came about not from a motive of pure greed, but from a lack of understanding. Incidentally, that doesn't make it any less shameful or regrettable, but I thought that was an interesting comment from someone who is a leader in the legal practice of advising boards of large, public companies. No proposal should go forward through a board approval, she suggested, without every one agreeing on the three biggest risks to the project and deeming these risks acceptable.

On executive compensation, Lizanne Thomas said this had to be reformed and that pay should be for "sustainable performance." She cited the work of Frederic W. Cook in this regard.

She also noted that corporations are devoid of an internal moral code. Lizanne also chided her colleagues in the legal profession for punting when they need to confront a board or management that are paying them hefty fees by taking the pass, "Ultimately, it's a business decision."

William Chandler III is Chancellor of the Delaware Court of Chancery. Delaware is looked to as the bellwether for corporate matters, trust and estates,and other fiduciary matters. Their goal, the Chancellor said, was not to instill public trust in corporations or business, but rather to earn the trust of the public in the integrity of the Chancery Court's process.

In general, he said, corporations are expected to behave in a way that is equitable and fair. Delaware corporations are expected to obey the statutes, and this means that they should hold a duly called annual shareholder meeting, and they should approve all significant transactions after reviewing them with due care and with loyalty to both the corporation and to the interests of stakeholders.

Boards also exert fiduciary duties that should also be based on equitable principles. Chancellor Chandler used words like "duty," "obligation," "fidelity, "faithfulness," and "loyalty." For someone like myself, steeped in quantitative and financial rubrics, it was very interesting to hear these kinds of words being cited as being the bedrock supporting corporate governance.

The opinions of the Chancery Court were referred to as "moral stories," and I have to say that they make interesting reading just as do Warren Buffet's letters. The opinions are offered as road maps and a way forward for directors and officers of public companies.

Rakesh Khurana is Professor of Leadership Development at the Harvard Business School, and he gave a very long presentation that was time compressed; my summary doesn't do it justice. In 1950 he noted that business schools turned out about 3,000 MBA's per year, whereas today the industry produces about 120,000 per year. He cites the work Maureen Tkacik . Maureen's work is full of dark humor and the satirist's truth. Rakesh mentioned that MBA students today run their lives like "little corporations," and he rues their failure to view the modern corporate organization in a high minded or holistic way. This tied back in my mind to the spirit of William Chandler's remarks.

Whereas in 1955, there were 138 accredited institutions issuing the MBA degree, in 2000 there were 995 institutions,many of which are not accredited. Early theories of the firm, which I learned about in Milton Friedman's book on price theory, talked about the firm's objective function being to maximize profit. Michael Jensen of the Harvard Business School eventually changed that into the notion of maximizing shareholder value in a seminal 1997 paper.

Now, a confluence of events conspired to set the stage for decades of debacles. The large stock of MBA's fanned out into the S & P 500, where about two-thirds of the CEO's have MBA's, with Harvard holding the number one ranking among this group. Warrent Buffet describes the transformation as one from "owner capitalism" to "managerial capitalism." The MBA mindset taught these executives that they were nothing but agents of the shareholders. Their self-styled technical and quantitative expertise put them beyond their boards and led them to drive strategy, tactics, and financial management towards short-term earnings goals and quick hits in their share prices. These managers also put into place outsized variable compensation schemes that guaranteed huge rewards for themselves with no regard for sustainability and long-term value creation.

As institutional ownership became the dominant model for large, public companies, "earnings visibility" became a code word for "just deliver the quarter and talk up your stock's P/E." This exclusive focus on shareholder value was enshrined in a 1997 Business Roundtable proclamation. Today, we have the Aspen Principles--quite a difference.

He also noted the irony that directors, faced with technical doublespeak from both management and institutions, chose to outsource a lot of their basic oversight functions to corporate governance consultants, investment bankers, valuation consultants, and executive comp consultants. Directors, he said, fell prey to a "culture of politeness and power asymmetries."

Professor Lyman Johnson in his concluding remarks emphasized that there is no law that says directors are to maximize shareholder value as a primary or exclusive governing principle. Chancellor Chandler noted that regulatory law had completely failed in the current crisis. Professor Coffee noted that securitizations started becoming more toxic when the issuers were no longer required to retain the lowest tranches on their books.

Again, I hope that this summary stimulates thoughts and questions for the readers of this blog.

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.

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!

Learn From The Best

I've always believed that you should always learn from the best teachers, and that goes from physics to the martial arts. In the investment business Warren Buffett and Charlie Munger have always been in my personal pantheon of great teachers and practitioners. Their 2008 Annual Report was published today, and it is, as usual , full of study material, quotable quotes, refreshing candor and introspection. I'm going to reflect on a particular issue in an upcoming newsletter, but here are some notable points from a first reading.

Buffett, a world-class poker player, acknowledges that in the current credit crisis, the Fed and Treasury are "all in." Our own limited perspective gives us considerable heartburn, although Buffett does talk about having to take an aspirin. However, his overarching conclusion is that "America's best days lie ahead." I retain this point as a take-away. The financial websites seize on the comment that the economy is in a shambles and may stay that way. However, reading the letter closely and thinking about financial theory, Buffett concludes that neither he nor Charlie Munger can forecast the performance of financial markets during the same period. If indeed they lead at economic turning points, they may very well outstrip the shambolic economic performance. Who knows? I take comfort in the comment, because it's based on an economic and financial mindset, and not on wishful thinking. I'm happy for my children.

Buffett talks about the first principles underlying their management of Berkshire Hathaway. This should be obvious from a history of reading the letters, but human short-term memory makes a restatement useful. Whatever the economic backdrop and stage of the cycle, they strive to:

1. Maintain a "Gibraltar like" financial position, meaning excess liquidity, modest short-term obligations, and lots of sources of earnings and cash;
2. Widen the economic moats of existing businesses in the portfolio;
3. Acquire and develop new earnings streams;
4. Nurture and expand their stable of business managers who have led to the substantial value creation within Berkshire Hathaway.

If you own a position in a public company, take this list and ask yourself, "Is this what my executive leadership team is doing?" Now, there will have to be some adjustments to a literal interpretation, but if there is a wide divergence, you probably don't have a long-term investment on your hands, but a trade at best.

On the last point, this is something that is almost completely missing from the leadership philosophy of most public companies. Despite the windy rhetoric, apart from the CEO, most members of the leadership team at public companies are considered to be interchangeable cogs. The same philosophy holds for the senior staff of the executive leaders. The Berkshire letters are always rife with genuine praise for the integrity, philosophy, and business acumen of the leaders of their portfolio companies from Sees Candies up to the biggest insurance and utilities businesses. This is, in my opinion, a very important factor in decomposing their performance advantage over the S&P 500.

If you're approached by a brilliant financial engineering mind with a model that supports buying a securitized or structured product, think about this quote: "Beware of geeks bearing formulas."

On a set of related points, Buffett opines that improved transparency will not cure the problems that derivatives pose. He is not aware of any reporting mechanism that can effectively describe or measure risk from derivatives. Remember who's saying this. Insurance and re-insurance are their core business. His stable of managers in this business includes Ajit Jain and others whom he sees as among the most brilliant minds. Yet, he makes this comment. Furthermore, he correctly states that, "auditors cannot audit these contracts." So, we can't rely on their puerile efforts.

Then think about the fact that a lot of legislative and regulatory energy will be devoted to enacting measures around the clarion cry of transparency. So, our teacher is telling us that there will be no measurable benefit to the buy side of the market from all this make work.

Although Buffett has too much knowledge to try and forecast the market, he makes this substantive comment, "The investment world has gone from underpricing risk to overpricing it." He opines that looking back on this period, writers will talk of a bubble in Treasury securities, and this certainly seems to be the case.

For portfolio re-allocators, he offers this bromide, "Beware the investment activity that produces applause; the great moves are usually greeted by yawns." "Cash is king" is on the tongues of all the television talking heads, to lots of applause. High quality corporates and municipal bonds have been the yawning-inducing strategies pursued by some institutional investors. Interesting stuff as always.

Finally, we know that on Wall Street no one is responsible for the current, near-death crisis. No one has admitted to any errors of omission or commission. Yet Warren Buffet does so in his 2008 letter. Berkshire invested $7 billion in the common equity of ConocoPhillips a the peak of oil prices; as of the measurement date, the investment is worth $4.3 billion. Buffett laments his timing, although he believes that the fundamentals point to higher oil prices than current levels of $40-50 per barrel. I'm sure that he's right about oil for a variety of reasons. This candor and self-reflection is refreshing. But, using his own philosophy that no one can time a market, this hardly seems like a big deal. For someone who holds himself to a high standard, though, it's irritating.

Lots of good education for a Saturday.