Neil Barofsky Speaks Out

When Neal Barofsky, a Democrat named by the Obama White House as Special Inspector General for the TARP Program resigned his position in March 2011, Bloomberg News describes the White House as being "privately relieved."  The New York Times lauds his book as a "must-read," but I may pass it up, since I have followed his official and unofficial body of work as the Special Inspector General.

When Barofsky seeks counsel from other special inspectors general about how to conduct himself in the role, he describes the following advice,

“The agency should perceive you as a constructive but independent partner, helping to make things better for the agency, so everyone is better off.” He also learned, he  says, that success as an inspector general meant that investigations come second. Don’t second-guess the Treasury. Instead, “focus on process.”

There we have it from his handlers, focusing on process ensures that the agency and its constituents (the big banks) are better off and nothing of substance changes. 

TARP and HAMP, programs of the Obama White House and its Treasury Department, were abject failures which threw billions at policies that benefited precious few homeowners. First and foremost, these programs were hare-brained in their design and therefore doomed to fail from the start. We've written before about the unregulated mortgage servicing industry and it being a stone wall to any rational, large scale mortgage resolution effort.  Commentators like Joe Stiglitz described the public-private partnership idea for purchasing troubled mortgage assets as "ersatz capitalism." To let TARP and HAMP go forward without a legal plan and funding to bring the mortgage servicers into line with the government's objective was simply dim witted or cynical.

Barofsky to his credit was the most visible public official taking the Treasury to task for its conflicts of interest in applying the programs and for its abandoning Main Street for Wall Street. It was unfortunate that no Senate Democrats stepped up to give him cover.

The title of Barofsky's book is, "Bailout."  Which one?  We should not forget Lehman Brothers and AIG.  Anton Valukas' report on the biggest bankruptcy in history deserves to be read also. From Secretary Paulson's gift to the big banks through TARP and HAMP to current proposals to reward investment banks for bailing out California homeowners with public money, economic policy in the Obama White House, driven by its big bank-friendly Treasury Department has been one unending bailout.

Mr. Barofsky's passion about these issues is admirable, and policy makers on both sides of the aisle should try to come to a consensus about making some badly needed changes.  Unfortunately, this won't happen in an election year, and Mr. Barofsky is on the outside now. This probably makes it easier to hijack and distort his message for political ends.

CalPERS Investments Return 1 Percent.

CalPERS announced a one percent  return on investments for the twelve months ended June 30, 2012.  Fixed income and real estate investments led the way with good performance, with the rest of the asset classes showing dismal performance. Maybe CalPERS should stop focusing on "non-core" activities like hectoring public companies about their governance, political speech and executive compensation and look at their own operation of a $233 billion fund

The Wall Street Journal points out this could be bad news for California cities, "Calpers' 1% return for the fiscal year ended June 30 could force the state of California and its cities to contribute more to the $233 billion retirement system to make up for the investment shortfall."

Which gets us back to an earlier post about Californis municipal bankruptcies.  Wall Street municipal bond advisers sniffed about reading too much into Stockton's recent announcements, suggesting that problem cities would account for 1 percent of total municipal issuance.  No need to get alarmed, three problem cities do not make a trend.

The problem is that municipal bond issuers and buyers live in a world about as real as that of the Truman Show. None of the pension liabilities of municipalities are visible to a local bond investor.  Since these obligations are generally pushed up to the state plan, everybody can make believe skies are sunny in the land of Oz. 

Into the tulip-filled hillside steps, of all entities, Moody's Investor Services which reckons that U.S. states and localities have $2 trillion in unfunded pension liabilities.  The overall municipal bond market is $3.7 trillion.  Here's something that troubles me. If virtually all of these plans have contribution and benefit levels which cannot be reduced per legislative mandate, and the funds are backed by the full taxing powers of the states, then aren't these in fact riskless investments like U.S. Treasuries?  So, should we use a discount rate of 2.56%, say for the 30 year Treasury bond?  So Moody's liability estimate might be much higher. This is an aside, but a serious one.

Since Moody's can't afford to become a pariah in the credit ratings market, the ultimate effect of these announcements will be softened.  However, kudos to Moody's for taking this stand and for putting these issues squarely on the table.

Logically, Moody's notes the following potential effects of their new system,

"...because some liabilities in state pension plans that also cover localities will be allocated to the specific local governments. Currently, some of those liabilities might not be broken out by the individual city, town or school that is part of a state plan. The liabilities of all public pension funds, for both states and localities, could leap, as Moody's will also consider a revision of the rate used to calculate them"

Local voters should vote not just on current salaries and expenditures for municipal workers, but on the true employment costs which are dominated by health care and pension benefits, none of which are visible in the present system. 

Then, when municipal bond investors look at state  bond issues, they too can have a truer picture of the state's future obligations. States  need to have their balance sheets look like real statements of financial condition, not the current fantasy fostered by the GASB. 

So while government unions press corporations about their political speech, perhaps they should allow the antiseptic of sunshine to enter into their world of public pension liabilities.  Transparency and accountability are always for the "other guy," though.

Two Senators Torpedo Law of the Sea Treaty

Republican Senators Bob Portman (R-Ohio) and Kelly Ayotte (R-NH) torpedoed any chances of the Law of the Sea Treaty being ratified this year by sending a rambling and somewhat incoherent letter to Senate Majority Leader Harry Reid.

The Treaty is criticized for being long, cited as being 320 articles and 200 pages long.  The treaty's principles and articles are intended to cover all economic uses of the oceans beyond national jurisdiction: a pretty tall order. The Dodd-Frank bill was over 3,200 pages long, and it didn't even contain the actual rules and regulations, whereas the LOS Treaty describes the regulatory framework of the International Seabed Authority.  By comparison then, the Law of the Sea Treaty is like a Cliff's Notes for the oceans! 

The Senators want assurances that the treaty will be "enforced impartially and in a manner consistent with U.S. interests."  This is an example of incoherence.. The requirement that all disputes be resolved in a manner consistent with U.S. interests wouldn't be acceptable even if the treaty were signed only by the U.S. and the six biggest naval powers in the world.  Provisions of the dispute resolution process have been negotiated by multiple Administrations over decades. Like any treaty, they represent trade-offs our representatives felt acceptable because we gained what we wanted in other areas, such as international shipping and access to deep ocean resources for U.S. companies.

The authors make a big deal out of this Article: "Article 207 decrees that “[s]tates shall adopt laws and regulations to prevent, reduce and control pollution of the marine environment from land-based sources … taking into account internationally agreed rules.”

Realistically, I'm not sure that there are any internationally agreed rules governing ocean pollution from land based sources, so Article 207 could be disputed longer than patent claims between Microsoft and Apple. Also, the U.S. is active in UNEP and GESAMP (Group of Experts on the Scientific Aspects of Marine Pollution).  Both these bodies would have something to say in the actual implementation of Article 207, if and when it came to that point. A fear about this article is not reasonable in the prevailing institutional practice.

To take the other side of this argument,decades long overfishing of deep ocean stocks by former Taiwanese and Korean industrial trawlers and the subsequent pollution  from processing-at-sea was something that all nations, including the U.S, wanted stopped.  Without enforceable treaties, this economic abuse couldn't be addressed at all.

The two Senators make an unfounded claim that usual and customary practice in international law and bilateral negotiations are sufficient to maintain peace and defend our national interests.  The evolution of usual and customary practice relating to the 200 mile limit was made possible by the same multinational, consultative approach with they now decry. In fact, I believe that Chile and Peru were first to claim sovereignty over that limit, and U.S. declarations followed theirs as international law evolved.   What happens when Exclusive Economic Zones overlap?  If resolutions are always bilateral, what if the dispute, let's say, is between a nation like China and a nation like Vietnam?  Isn't it worthwhile to have an internationally accepted framework which governs the delineation of zones and disputes? 

We are headed to more and more of these situations. as pictured below:

Xinhua News Agency (China)

The picture, released to the Associated Press, shows a Japanese coast guard vessel (left) encountering a Chinese patrol boat near disputed islands in the East China Sea.  

I'm not saying by any means that having a treaty in place would create an oceanic Eden.  The current patchwork quilt of customary practice, bilateral treaties, military pacts, and aggressive assertions by Russia and China is inherently unstable. Our military leaders recognize this. 

In fact, as the Journal writes,

"One of the enduring mysteries of the treaty is how it has failed to even come up for a ratification vote given the breadth of support it enjoys from widely disparate groups. Former secretaries of State, both Republicans and Democrats, top civilian and uniformed Pentagon officials, the U.S. Chamber of Commerce, environmentalists, and former presidents George W. Bush and Bill Clinton have all been vocal supporters"

It's always better to throw some papers around in an international court disputing a boundary than it is to be firing rounds from a naval vessel in a far off sea.

Goldman Walks Over a Client

Reading the Sunday New York Times is usually a pleasant, innocuous experience, since I generally skip the news and editorials, and go straight to Sports, Business and the Book Review. Reporter Loren Feldman has written a story about how two "two computer speech revolutionaries," Dr. Jim and Dr. Janet Baker hired Goldman Sachs to sell their company, Dragon Systems and its path breaking speech recognition technology to one of the many suitors who were peppering the couple with offers. 

Goldman came to the conclusion that Belgium's Lernout and Hauspie, a publicly traded company, was the best fit and offered $580 million.  I had to search the memory banks for this one, because couldn't find a Wall Street Journal story by a  reporter who actually went to one of Lernout's foreign sales offices; the reporter found a brass plate downstairs, and upstairs a receptionist sitting in an empty office filled with cardboard boxes.  At this point in time, the stock was an institutional darling and rated "strong buy" by a number of brokerage companies. 

At the same time, several financial analysts, not on the Wall Street buy or sell sides, were openly contemptuous of Lernout's accounting practices.  Most prominent among these was David Rocker, of Rocker Partners, which became Copper River Management. Rocker was short the stock and not shy talking about it. I have been a long time reader and admirer of Howard Schilit and his early book, "Financial Shenanigans."  Here is a chapter from one of Schilit's publications in which he talks about Lernout's accounting. Wall Street's sell side remained blindly committed to "the story."

In November 2000, the auditor for Lernout and Hauspie withdrew their clean opinion on the company's 1998 and 1999 financials, which it had previously blessed.  This, however, came about only after the company itself admitted prior accounting errors.  Meanwhile, based on the Journal reporter's story, Korean companies who had been said to be doing significant business with Lernout stated that they had never deakt with the company.

Lernout's offer for Dragon Systems was originally a half cash and half stock offer, which the Times reports was changed to an all stock offer.  Apparently, Goldman raised no questions about Lernout as a qualified buyer.  This came despite the fact that another arm of Goldman had refused in invest in Lernout after doing its own due diligence.  Goldman did not question the risks and inferiority of an all stock offer for a controversial company.  Bottom line, the Bakers got nothing, and their technology was trasferred in bankruptcy to Nuance Communications and subsequently transferred again. The Bakers and technology experts suggest that their inventions are part of Apple's Siri personal assistant app for their devices.

In 2010, the founders of Lernout and Hauspie were finally convicted in a Ghent court to five years in prison, of which they actually served little time. The Bakers are suing Goldman for about $1 billion.  The objections by Goldman attorneys and spokespeople reported in the Times are arrogant and infuriating.  The excuses are laughable.

Again, for this industry, we have FINRA, the SEC, and all manner of Federal agencies, and we can't get simple justice and fairness for entrepreneurs who were left high and dry by their bankers.  Oh yes, but we now have Dodd Frank.  I'll bet that's comforting to the Bakers.

California Subprime Mortgages: A Bad Dream Won't Go Away

The state that spawned the California Gold Rush and "fool's gold," was the center of the subprime mortgage industry,  Although there was a spike in subprime mortgage issuance beginning in 2004, academic researchers have found that some of the worst mortgage products (option ARMs, 80/20 mortgages, and subprime HELOCs) and the absence of documented underwriting standards combined to account for high volumes of toxic products in 2006. 

In the second quarter of 2006, 8 of the 10 top subprime mortgage originators were located in California.  The top 10 orginators issued a staggering $110 billion of mortgages in the quarter, of which 82% came from the California issuers.  Ironically, Wells Fargo Mortgage was the biggest issuer in Q2 2006, with $27 billion, followed by New Century Financial with $14 billion in the quarter; Countrywide was number four with $11 billion in the quarter.  These data are contained in Bankruptcy Examiner Michael Missal's report, which we have cited before as required reading for any serious student of the mortgage crisis. 

New Century Financial writes in its disclosures, that the company is focused on "lending to individuals whose borrowing needs are generally not fulfilled by traditional lending institutions because they do not satisfy the credit, documentation, or other underwriting standards prescribed by conventional mortgage lenders and loan buyers." 

Separately, Professors Mian and Sufi of the University of Chicago Booth School of Business write, "Homeowners with low credit scores in areas with high house price growth from 2002-2006 have seen mortgage default rates climb from almost 4% to almost 15% from 2006-2008." 

In June of 2006, Missal cites an internal finance department email at New Century Financial stating that their weighted average loan to value ratio in the borrower portfolio (combining mortgage and home equity lines of credit) had reached 87%!  Missal notes that there were three CPA's on the Audit Committee, including the Board Chair. CFO Cathy Dodge was a CPA. New Century had built it's model on a foundation of "originate and distribute."  By 2006, loan quality had clearly been falling apart since 2004, and growing "kickbacks" of bad loans from securitized pools by investors threatened the ability to raise cash by unloading the toxic assets to investors, declaring a gain on sale and pumping up earnings.  All of the normal processes and reporting were in place, and yet neither internal audit, the audit committee, nor the external auditor raised any red flags. Everything was fine until the company was near death: then nobody knew what hit them.

Were the borrowers all innocent victims?  I hardly think so.  Most of the mortgages originated by New Century were stated income loans, in other words the borrower gave an annual income number with no verification and the company's independent broker originators did no due diligence.  In addition, this kind of market with this kind of lending attracts the professional fraudsters, who plague credit card companies, rent-to-own companies and direct marketers like Fingerhut. It is a Faustian bargain, because why should the homeowner turn down free money, and why should brokers turn down cash commissions, and why should the management turn down bonuses for reported EPS which is economically fraudulent? 

Professors Mian, Sufi and Trebbi produced a startling and original scholarly research paper in 2009, "The Political Economy of the Mortgage Crisis."    The 2008 "American Homeowner Relief and Foreclosure Prevention Act" passed under President Bush had a "Hope for Homeowners" program which gave strapped mortgagees access to $300 billion in federal agency insurance.  The authors show that while defaults rose in both Democratic and Republican districts, support for the Act by Democrats were "near unanimous" whatever the default rates were in their districts, where Republicans tended to vote in favor where they represented high default rate districts. Mortgage defaults draw lots of bipartisan legislative sympathy, as opposed to credit card debt or student loans, at least historically.  There are a number of interesting trends in their data which are would take too long to discuss in a post.

Expect the full court press to stay on the Mortgage Resolution Partners California bailout plan for the bad actor homeowners in California.  If the executives at the subprime lenders got a free ride, why not them?  And now we have the massively incompetent (or worse)  managers of San Bernardino adding their two cents,

"We are intrigued," said Gregory Devereaux, chief executive of San Bernardino County, which is east of Los Angeles and has one of the highest unemployment rates in the state. "Our economy in this county can't be turned around until a large proportion of the mortgage crisis has been addressed."

No, Greg, the municapal finance crisis can't be turned around until San Bernardino gets control over its employee salaries and benefits and scales services at a level consistent with an economically sensitive tax base.

Be afraid, as this giveaway is not going away. 

Barclays Downgrades HP

HP closed at $19.35, close to its 52 week low of $19.02.  As we mentioned a while back, the chart looked awful.  Every newspaper reader knows the tech sector is challenged for top line growth.  The market also appears to be entering the summer malaise. 

Given how poor HP's technobabble guidance has been, analysts are realizing that there's absolutely no reward for being heroic about the upcoming third quarter earnings due out August 22nd.  So today, Barclay's analyst Ben Reitzes cut his rating on HPQ to "Equal Weight," whatever that means.  It doesn't mean, "buy," or "accumulate."

Reitzes' 2012 EPS estimate is cut from $4.04 to $3.99, a reduction of 1.2%.  So, since the market appears to want to price HP at 5 times forward earnings, it would suggest a $20 price, which is roughly where the stock is today.  The analysts is derisking his position.

His main reason for the reduction in revenue and earnings is pressure on the printing business.  That's all well and good, a reasonable conclusion which reflects the current realities with retailers, channel pricing, and promotions to fight off ink refills.The fear factor is a interesting tactic. Why is printing under pressure?

"Reitzes also notes that as younger workers join the workforce, they may be doing less printing (and more with mobile apps)."(Street Insider)

This is a demographic shift which is surely not taking place intra-quarter!   What measure would the analyst have for this shift?  I sympathize with him: he wants to cut his number to get closer to consensus and he needs a cover.  It sounds good, forward looking, and it goes with all the ads for people staring at their smart phones. 

This demonstrates again the limited value of Wall Street research and the lack of any real clarity from HP management in where their business is going and what will drive it.  Hopefully, HP has set expectations so low, with so much slop in their guidance, that there won't be an earnings warning between now and August 22nd.

Pershing Square and Regulatory Capture

I had to read the WSJ Pershing Square's taking an "activist" stake in Procter twice, and I'm still confused.  Here's the relevant passage, "Mr. Ackman's move became known via the Federal Trade Commission, which gave Mr. Ackman's hedge fund antitrust clearance to proceed with the investment. Moves by activists are usually made known by filings to the Securities and Exchange Commission. Buying enough stock to require a quick SEC filing—5%—would cost about $8.8 billion." 

So, in order to save Pershing Square time and money, the fund shops for clearance at the FTC?  Isn't this the kind of regulatory capture that we moaned about during the financial crisis?  Is Pershing Square planning on going into the global personal care business?  If not, what's the relevance of an antitrust clearance?  Shouldn't the FTC have said, "Sorry, go and get your blessing from my friends at the SEC?"  Also, with the FTC's blessing, it's not even clear to the Journal how much of a stake has been blessed.  Nice transparency for the equity market.

Incidentally, I really liked the quote from the Procter and Gamble CFO, "We welcome listening and learning from any investor."  Well said.  Let the fun begin.