Tuesday, August 27, 2013

Ray Ozzie on Why Microsoft Needs To Smash Its Own 'Windows'

Here is what Microsoft's short-time executive Ray Ozzie wrote to Microsoft employees in 2010.  It's all here about Windows.  The Windows strategy was developed by a hyperagressive Microsoft team led by Bill Gates in partnership with Intel, and it certainly worked, but it sowed the seeds of its own demise, as many things in nature do.

"Complexity kills. Complexity sucks the life out of users, developers and IT.  Complexity makes products difficult to plan, build, test and use.  Complexity introduces security challenges.  Complexity causes administrator frustration.
And as time goes on and as software products mature – even with the best of intent – complexity is inescapable.
Indeed, many have pointed out that there’s a flip side to complexity:  in our industry, complexity of a successful product also tends to provide some assurance of its longevity.  Complex interdependencies and any product’s inherent ‘quirks’ will virtually guarantee that broadly adopted systems won’t simply vanish overnight.  And so long as a system is well-supported and continues to provide unique and material value to a customer, even many of the most complex and broadly maligned assets will hold their ground.  And why not?  They’re valuable.  They work.
But so long as customer or competitive requirements drive teams to build layers of new function on top of a complex core, ultimately a limit will be reached.  Fragility can grow to constrain agility.  Some deep architectural strengths can become irrelevant – or worse, can become hindrances.
Our PC software has driven the creation of an amazing ecosystem, and is incredibly valuable to a world of customers and partners.  And the PC and its ecosystem is going to keep growing, and growing, for a long time to come.  But today, as I wrote five years ago, ”Just as in the past, we must reflect upon what’s going on around us, and reflect upon our strengths, weaknesses and industry leadership responsibilities, and respond.  As much as ever, it’s clear that if we fail to do so, our business as we know it is at risk.”
And so at this juncture, given all that has transpired in computing and communications, it’s important that all of us do precisely what our competitors and customers will ultimately do: close our eyes and form a realistic picture of what a post-PC world might actually look like, if it were to ever truly occur.  How would customers accomplish the kinds of things they do today?  In what ways would it be better?  In what ways would it be worse, or just different?
Those who can envision a plausible future that’s brighter than today will earn the opportunity to lead."
No matter how much time Microsoft's executive recruiters spend on their search process, whomever they find through the predictable process, no matter how talented, will ultimately be chewed up by the stultifying Microsoft culture before (s)he claims victory and is replaced. The entrenched forces are too numerous and too deeply dug in to believe in another new messiah.
Rick Webb of Quotidian Ventures has a provocative thesis.  He believes that Microsoft will acquire Ray Ozzie's Taiko start-up and name him their new CEO. He recently joined H-P's board, which was a coup for them.  This would be a pretty radical move, but unless it's driven and approved by Bill Gates himself, it won't happen.  If Mr. Ozzie couldn't change Microsoft from inside before, what will have changed by taking the reins now?  Credit for a refreshing idea, Rick. 

Monday, August 26, 2013

Microsoft Needs A Major Reboot to Stay Relevant

Given the CEO Steve Ballmer's recent announcement of his intention to step down in 2014, I had to reprise this from a recent post.

"Here is my first clue that this announcement spells trouble:
                                                                                            credit: Getty Images
This is the CEO who wrote the 2,700 word memo communicating the reasons why Microsoft was going to re-energize itself and its customers with a reorganization that would unleash "One Microsoft."  One small problem: this man looks incredibly tired, bored, and devoid of any energy and enthusiasm for the message he is delivering.  This is not a man who is going to take names; he badly wants to take a nap. He doesn't believe in what he is preaching: a Chinese menu of platitudes and buzz words."

Now, of course, the reason is clear: Mr. Ballmer knew he was a lame duck and was probably exhausted from coming to terms with the end of his tenure on a terrible quarter and on this dolorous announcement. 

Microsoft is a AAA corporate credit with no net debt and $77 billion of cash on its balance sheet.  Its operating income return on average equity for the fiscal year ended June 30, 2013 was 37%.  Yet for investment returns over the trailing ten year period, its performance was marginally different from that of Cisco and Hewlett-Packard.  Since 2000, according to the New York Times, Microsoft's shares are down 33 percent.  Cisco shares are down 54 percent, Oracle's down 30 percent, and Dell is down 70% over the same period, according to the NYT. 

Microsoft is a growth stock selling at 11x forward earnings?  What gives?

The Windows Division is what the company was founded on in 1975, and 65% of the division's total revenues comes from the sale of the Windows operating system to OEM manufacturers who pre-install it on their desktops and notebooks.  It also houses the Windows services and web services products like Outlook.com and SkyDrive.  In the fiscal year ended 6/30/13, the Windows Division recorded $853 million of Surface RT and Surface Pro revenue. Sales of PC accessories like keyboards and pointing devices are also in this group.  The operating margin for Windows Division, adjusted for the $900 million writeoff related to inventory of the Surface product inventory, was an incredible 54% of revenue.  

This wonderful legacy business, which has a quasi-monopolistic stranglehold on corporate and consumer desktops, is also an Achilles Heel.  The New York Times quotes Zach Nelson, CEO of Net-Suite saying, 
"Microsoft had phones, Microsoft had tablets, but they tried to put Windows in them.  They couldn't leave the PC world behind, even though they saw the change coming." 
Do you think that this issue is in the past? Think again.  Read the Microsoft 10-K for the fiscal year ended 6/30/13, where the company talks about its big picture market opportunity.  The company talks about (p.24, Pt. II, item 7) devoting substantial resources to:

  •  "Developing new form factors that have increasingly natural ways to use them, including touch, gesture, and speech. (Surface and successor devices which will mix segment margins down as volume increases.)
  •  Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command.(Ray Ozzie's idea?  AI may be for geeks, but this functionality is probably not  what consumers will want)
  • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals.(Everybody is in this game. The winners could be new and several.)
  • Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.(This means that the legacy though currently very profitable will inhibit real innovation.  Microsoft needs to let go of Windows and its legacy)
  • Delivering new high-value experiences with improvements in how people learn, work, play, and interact with one another." (This sounds like a gaming company, like Nintendo, or a media company, or perhaps a new e-learning company.  It doesn't sound at all like Microsoft.)
Culturally, it has long been the case within Microsoft that the Windows cabal carried the day for resources and rewards within the company.  The degree of this dysfunction may be subsiding but it is real and very problematic for the company and for its next CEO.  As Zach Nelson says later in the NYT article, "You can imagine a world without Windows..."  Microsoft itself needs to do this, but within the current corporate organization, addressing this kind of change is impossible no matter who the next CEO is.

Can Microsoft "increase agility." Former CTO Ray Ozzie didn't see it MSFT's DNA in 2010 when he wrote, "Certain of our competitors’ products and their rapid advancement and refinement of new usage scenarios have been quite noteworthy.  Our early and clear vision notwithstanding, their execution has surpassed our own in mobile experiences, in the seamless fusion of hardware, software and services, and in social networking and myriad new forms of internet-centric social interaction."

Steve Ballmer's announcement of the most recent reorganization was probably something that should have been left for a new CEO.  What if (s)he has a completely different vision?  This reorganization truly does look like rearranging deck chairs and a waste of resources, as we've said before.

Microsoft's board of directors is totally out of step with a company trying to step out and lead the transition to the kinds of market opportunities listed above in the company's own 10-K.  The President of Harvey Mudd College.  The CEO of Seagate, a key legacy device in the legacy PC.  The former Vice Chairman of Bank of America.  An investment banker with roots in the earliest days of the company.  I've been tough on HP and its board, as have others, but this board is unworthy of one leading a company which, along with Intel, created a whole new industry and probably needs to reinvent that industry again.

They have left the succession issue too long, and the timing has been about as bad as it could be.  The final reason for not owning the company now?  Have you heard the names of some of the touted successors to Steve Ballmer?  Carly Fiorina!  Mark Hurd!  Legacy CEOs-- and bad ones at that-- for a company struggling to go beyond its operating system legacy are not what the company needs. The stock should go down significantly on the announcement of either of these two candidates, and if it doesn't, a short position would probably pay off handsomely. Within eighteen months, the company would implode under the leadership of either of these two candidates.

More tech savvy CEOs who are strong operators have been mentioned, but one hire alone cannot overcome the cultural morass that is present-day Microsoft.  The new CEO would get no useful assistance from the current board of directors.  Overall, things are set up for the failure of a real outsider CEO.  You say that Lew Gerstner did a comparable turnaround at IBM?  The big difference is that the IBM board, a pretty decent one at the time, knew exactly what it wanted to do about its cultural issues, and it was willing to throw its intellectual and relationship capital behind their one and only preferred candidate.  The Microsoft board has no comparable capital to offer a young CEO.

What's the real issue?  As we've said before, and as you can see from Microsoft's own avowed market opportunities, there are probably three distinct technology companies within the current Microsoft.  The first is the legacy Windows Division, which would have the enormous but tapering cash flows from OEM/PC Windows to switch over to Web based applications and services, along with tablets and phones for its future.  If it wanted to develop a Windows replacement in parallel, it would have the cash to do so.

The second would be a fairly powerful and attractive Microsoft Business Division which would also include Servers and Tools.  Revenues of this company would be north of $50 billion, and it would have extremely healthy operating margins, along with robust growth prospects compared to weakened competitors like Dell and others.

The third MiniMicrosoft would be an entertainment/gaming company with online services.  This would be the company where, freed from an O/S legacy, some real risk taking and innovation could take place.  It would need funding, but it would probably draw interest from institutional and strategic investors, provided that it had totally new management and a new culture.

This kind of change is unlikely, but it is necessary.  Perhaps a holding company structure, where excess capital were dividended up to the HC and reallocated would be best.  Some analysts talk about improving capital allocation within the new Microsoft.  Highly unlikely.  Microsoft is hugely overcapitalized, which is inefficient for investors in the current structure.

Put it all together, and there's no reason to own the stock now, but it does pay to keep the radio dial tuned to WMSFT-FM.  I'll be listening.

Sunday, August 25, 2013

HP's Separation Anxiety: Take A Deep Breath

A friend of mine who is a globally traveled, senior tech industry executive and problem solver asked me this question, "How did HP do in its most recent quarter?."  The best answer I could give him was. "That depends on what you're looking at."

Overall, the quarter ending 7/31/13 was greeted by Wall Street sending the stock down 12% on the day: a pretty strong reaction.  But, putting it in perspective this left the stock's YTD run up at over 66% versus the prior day's number of 78%. This is still an extraordinarily robust gain, no matter how an investor looks at it.

GAAP revenue was down 8%, and down 7% on a constant currency basis.  Clearly this was a disappointment to the CEO, and a brave face couldn't disguise that it took some air out of her best positive face.

Total Personal Systems sales were down 11%, but really this shouldn't have been a surprise in direction, but perhaps in degree; industry reports on PC shipments and other anecdotal information intra-quarter would have suggested that it was going to be a tough quarter.  Notebook sales were down 16% in dollars, 14% in units and 2% in price.  Desktops were down 10% in sales, 9% in units and 1% in price.  Given the bad timing for the release of Windows 8.1, the notebook retail channel is probably congested with stale product. Pricing didn't collapse, but the fourth quarter might not be pretty either. Again, none of this is new.

Total Printing sales were down 4% y/y, with consumer hardware sales flat.  Overall, not a real negative surprise.

The real stinkers in the quarter from the revenue perspective were the Enterprise Group and Enterprise Services.  Again, the CEO made reference to the Enterprise Group's go-to-market issues which were clearly not something she expected with a mature product offering and long-serving executives.  ISS revenues were down 11%, but again this shouldn't have been much of a surprise since Dell's quarter showed a phenomenon, namely that industry standard servers are commodity products whose scale, cost, energy performance and computing power per rack will make them dinosaurs in an industry transition.  Overall, Enterprise Group revenue of $6.786 billion were down 9% y/y, with the higher margin Technology Services business declining 7% also. The Enterprise Group's operating margin had compressed sharply in the fiscal first quarter, and with continuing sales declines, this business needs to get its act together, but it's not exactly rocket science to determine what needs to be done.

The Enterprise Services Group, a business which we don't think is critical to HP's future in the current configuration, declined 9% y/y with the fading BPO business declining 7% and the Application and Services Business declining 11%.  This business carries a 3.3% operating margin which is comparable to that of the PC business, and yet this ESG gets no discussion on the investor calls.. We've said it before: HP can't be Accenture or IBM in this business, and it doesn't need to be in order to succeed.

So, to this point, the answer to my friend's question would be "It was a lousy quarter."  GAAP diluted EPS was $0.71 versus ($4.49), but clearly this isn't a useful comparison and it meant nothing to a trader reading the headline.  Adding back $0.15 per share for amortization of purchased intangibles, restructuring charges and acquisition-related charges, third quarter Non-GAAP diluted EPS was $0.86 versus $1.00 in the prior year period, on a comparable basis; the prior year period had $5.57 per share in charges for the same categories. Without the promised and delivered cost cutting, the comparison would have been much worse because of the revenue shortfalls discussed above.  The non-GAAP operating margin in the quarter was 8%, a 100 bp decline over the prior year period margin, despite an 8% decline in net revenue.

Cash flow from operations surprised most analysts to the upside with $2.7 billion in CFO, declining 6% y/y; total cash returned to shareholders is something we liked because of the $253 million returned in the fiscal third quarter, only $3 million came from share repurchases and $250 from dividends.  Altogether, looking at Non-GAAP EPS, CFO, funds returned to shareholders and paydown of debt it was really a solid quarter of financial performance.

Here are some bullet points from the Wall Street Journal's discordant story, "H-P's Separation Anxiety"

  • Meg Whitman is shuffling deck chairs;
  • Her strategy could "still sink Hewlett-Packard;"
  • Ceding market share in order to maximize profitability "seems misguided."  
  • The company seems as "strategically moribund and unmanageable as ever."
  • Lenovo could be a strategic bidder.
  • Dell is "cutting price on its gear so that it can grab customers who then sign higher-margin service contracts."  
  • Bernstein analyst says the company is worth 50% more than its "current" price being sold for parts.
Let's start from the most trivial points first.  The same analyst who called the stock more undervalued than any stock he'd ever seen at $12 and stayed neutral as it ran away, and in January 2013 his sum-of-parts guesstimate was $29 per share.  Well, it's $22.40 today, with about $0.26 per share also having been returned to shareholders in the interim period.  This is beating the bushes for a deal and just self-serving. 

Dell: well there's certainly an industry leader worth emulating.  If they were cutting prices to grab customers, then that explained their most recent, horrendous quarter on all counts.  The CEO himself, in a totally disingenuous way, has said that he can't take the measures he needs to take to fix his business while all the financial dirty laundry is public.  Is there any evidence that Dell landed major service contracts from giving away gear?  That's a one-time only deal anyway, if it were true.  Trivial point two is laughable.

Lenovo a bidder?  Not likely, unless the Chinese government were to write the checks.  Even in that case, the announcement would crater the HP credit rating, hit the IGC bond holders--who are, in some cases, also equity holders--, and it would rile the U.S. Government and CIOs around the world.  Talk about uncertainty: if you thought the Dell process was a mess, this one would be a value destroying debacle. 

Picking up on the last point, the CEO in her opening plenary statement to Discover 2012 in front of 15,000 participants and 120 Chief Information Officers, said "You want us to win."  We've made this point before, namely that the CIOs want to have at least one or two viable global players who can sell and service platform agnostic solutions, as opposed to shilling appliances and applications separately. 

Remember when G.E. was the global darling of the financial press in Jack Welch's hey day?  Their corporate slogan was "We want to be #1 or #2 in every business we're in, otherwise G.E. will get out of that business." Well, according to Meg Whitman at Discover 2012, HP is #1 or #2 in every business in which it competes.  Now this clearly can't line up with the reporting segments, but I think that you get the idea.  HP has global distribution, presence, and scale that mimics the customers who will need to served in an IT industry that is going to shed many of the go-to-market practices of the past thirty years.  

So, what are the questions and some of the substantive issues at this point in the incipient turnaround?
First, the current strategy has been vetted and belongs to the board; it is not Meg Whitman's strategy any longer.  This is certainly more than can be said for those of Mark Hurd and Leo Apotheker, who did things that the board learned about by reading the newspaper.  It's a nuts and bolts, fundamental strategy of sizing the cost structure to the future business, and as such it's a marathon not a sprint. 

The CEO made a telling comment at Discover 2012, "It's hard to kill founder's DNA."  She was trying to portray the DNA of the founders as being in customer service.  I don't think that's what the business historians would say was the legacy of the founders. One element of their culture was clearly innovation.

CEO Whitman makes proud reference to the work of HP Labs, which is their equivalent of the iconic Bell Labs of the old ATT.  In an environment where the IT customer can't keep up with the future evolution of the industry, credible global players have to do this for the customers.  The CEO has refreshed HP Labs, but she has also said that they need to speed up the transition from a lab idea to a commercial product.  I would guess that the HP Moosnhot server platform is probably one such innovation, but there have to be more and they must be produced on a faster cycle.

The structure and culture of the company has become sprawling and ossified.  The CEO clearly has been giving unprecedented access to employees deep within the senior ranks through different communications media, and this takes time but it has impacted morale for the better.  To switch again would be deadly.  

The one valuable discussion that took place on the third quarter conference call was one about the to-date almost exclusive reliance on HP veterans to lead all the businesses, with the exception of Software.  This seemed to catch the CEO a bit by surprise, and she thoughtfully stated that she had looked to insiders for their knowledge and presence with customers, but that it was something to consider.  I do think that this is something to consider, and what looks like shuffling of deck chairs could be a prelude to more fundamental leadership changes, from which the company's strategy would benefit. 

The issue of Autonomy should be addressed once and for all. If the U.K. Office of Serious Fraud has yet to opine on Autonomy's numbers, it suggests that perhaps there was nothing there.  In her 2012 remarks to Discover, the CEO says that the company is "100 percent committed to Autonomy and Vertica" for products, technology and innovation.  She made specific references to Autonomy capabilities in new products.  If this is so, it's time to tell shareholders that a lot of remarks were made in the heat of the moment, perhaps driven by board members trying to save face and that the company has moved on.  

The final point: the new board members are promising, but an entire board that reflects the cloud, mobility and big data--the essence of the future HP---would be a boon to the CEO and for shareholders.

P.S. Another company in Redmond, WA announced earnings and an executive change.  Now this one should be drawing a lot more attention than it has.  More later.

Thursday, August 22, 2013

A Preview from Jackson Hole

The Kansas City Fed's Jackson Hole Conference kicks off its working sessions tomorrow with this item,
 “The Natural Rate of Interest, Financial Crises and the Zero Lower Bound,” presented by Robert E. Hall, Stanford University
Discussant: Hyun Song Shin, professor, Princeton University (my economist 
Professor Hall has presented on these issues before.  Here's a link to a 2011 paper, "The Long Slump," in which he starts thinking about the interest rate as a key mediating factor. Professor Hall has extended this framework to the ZLB in some recent slide presentations.

Tuesday, August 20, 2013

Do Regulators Want To Run Their Supervised Banks?

A big story this week has been the Fed's current hobby horse, "Comprehensive Capital Analysis and Review ("CCAR") for the 18 largest Bank Holding Companies ("BHC") with assets of over $50 billion.  The Fed's March 2013 publication set the stage by redoing the stress tests done by each of the BHCs with an "interdisciplinary team" of Fed staffers who sound just like most corporate staffs, with the exception of not having bank auditors on the corporate teams.

In August, the Fed published "Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice."  The large bank holding companies, as we've said before, have become too complex to manage, especially if we are looking to eliminate any possibility of a failure like the system wide crises of confidence and then liquidity which brought the global system into paralysis.

This document reads like a rehash of many reports on risk management, internal control, and corporate governance.  Have a look at the Report of the Committee of Sponsoring Organizations of the Treadway Commission from 2009, and the reader will see language, themes and recommendations which are reprised in the Fed's August volume.

Basically, the agenda seems to come down to this: the Fed doesn't want banks to consider returning capital to shareholders through dividends and buybacks without redoing their stress tests and then changing their return of capital plans to add a second significant digit (after the decimal) improvement to some capital ratios.

Here's a stirring sentence from the report's conclusion,
"The fundamental insight governing the Federal Reserve’s
expectations about capital planning is the importance
of having a forward-looking perspective on the risks
to a BHC’s capital resources under severely stressful
We also learn, "These elements represent substantial conceptual and operational improvements in capital planning that go well beyond simple consideration of current and expected future capital ratios."  It's never clear at all what lies at the end of having gone "beyond."  A new set of indicators?  A digital dashboard of minute-by-minute risk indicators for every business, financial product, trading desk, currency, and country?  What would it all mean anyway?

We've often made reference to Andy Haldane's speech at the Kansas City Fed's Jackson Hole Meeting, "The Dog and The Frisbee."  In it he notes,
"It is close to impossible to determine with complete precision the size of the parameter space for a large  international bank’s banking book. That, by itself, is revealing. But a rough guess would put it at thousands, perhaps tens of thousands, of estimated and calibrated parameters. That is three, perhaps four, orders of magnitude greater than Basel I.   
If that sounds large, the parameter set for the trading book is almost certainly larger still. To give some  sense of scale, consider model-based estimates of portfolio Value at Risk (VaR), a commonly-used  technique for measuring risk and regulatory capital in the trading book. A large firm would typically have  several thousand risk factors in its VaR model. Estimating the covariance matrix for all of the risk factors means estimating several million individual risk parameters. Multiple pricing models are then typically used to map from these risk factors to the valuation of individual instruments, each with several estimated pricing parameters."
We haven't yet implemented Basel III, and now we are layering Dodd-Frank's evolving regulatory creosote on top of other complex, costly and ineffective frameworks.

The stories about traders dealing with marks on their trading books should tell a dispassionate observer the reality about how global international banks work, as opposed to the bureaucratic schema envisioned in the schemes of European, American, and other regulators. There is no single, infallible, scientifically correct number for the marked to market value of a trading book full of instruments with few buyers and sellers that trade by appointment.

So, some traders walked away from the midpoint of a spread convention.  A regulator would have acted differently.  So what?

Let's also not forget about the boards of directors of the largest bank holding companies. With all due respect, the membership of these corporate boards would never be willing or able to, for example, challenge management on the specifics of their scenario designs or on their methodologies for estimating credit loan losses.  Yet, the Fed report talks about these issues in bureaucratic abstraction as if their schemes can be actually implemented. They can't and they won't.  And, even if it were possible, there would probably be no net marginal benefit to shareholders.

By quoting Haldane's example, I am certainly not advocating the continuing or exclusive use of VaR models, but at least everyone has had some experience with these, for good and ill.

People who are really fluent with complex financial modelling, like Emanuel Derman know their limitations too. He writes,
"Derman, a professor at Columbia University and former head quant for Goldman Sachs, is outspoken on the limitations of modeling and the need for risk managers, along with CEOs, CFOs, financial engineers and traders, to keep their enthusiasm for modeling in check. “There isn’t a short cut or mechanical formula that will help you figure out the right price for a financial product,” said Derman in an interview, adding that, “these financial models are only trying to capture human emotions and instinctual feelings that we use to help us determine prices in financial markets. They are not absolute things like the distance from here to there or here to the sun, where everyone agrees on the distance.”
The managements of many of the largest bank holding companies have failed to exercise a degree of care, diligence and commitment over their sprawling organizations, and JP Morgan has been one recent example, among many.  Their businesses, which each have distinct portfolios with different risk profiles, have been stitched together by acquisition and by evolution.  Trading desks have cowboy cultures that are polar opposite to consistently profitable, high net worth wealth management businesses. Their compensation metrics, conventions and attitudes towards regulation and oversight are polar opposites: yet, they exist under one corporate roof, as in JP Morgan, Bank of America and Wells Fargo, for example.

When things have gone wrong, they have gone wrong in trading businesses, often by the action of rogue individuals who are allowed to buck the oversight.  These are not complex, multidisciplinary, quant issues.  The heads of profit centers, their supervisors, everybody in the C-suites, the board, internal and external auditors, analysts, shareholders, creditors, rating agencies, bank regulators, securities regulators and the courts all have responsibility for making sure that the inevitable issues that arise in complex businesses don't become systemic issues.  We already have plenty of infrastructure aimed at the problems, and we don't need more regulatory complexity.

Which Economist Am I Most Like?

Greg Mankiw sent along a probing survey of over 100 questions, which was clearly well designed by academic economists.  Although I despise the usual corporate or non-profit surveys, I took the bait on this one.  The outcome of the survey determined which "famous economist" I was most like. Professor Mankiw's answers made him most similar to Yale's Professor Ray Fair, whose econometric forecasting model of the U.S. economy I used for as background for some corporate consulting projects.

My views are most like those of Professor Hyun Song Shin of Princeton University, who is also a member of Chicago Booth School of Business IGM Forum. I don't know Professor Shin's papers or views at all, which is interesting given how widely I read.

I am buoyed by having a highly regarded companion in economic thinking, and I look forward to reading his published work. Take the survey yourself, if you want to put your economic policy thinking cap on and get a little surprise at the end!

Thursday, August 15, 2013

Redrafting Goldman's Business Principle #1

As we noted in a previous post, the first business principle of Goldman Sachs per its own disclosure is.

"Our clients’ interests always come first. 
Our experience shows that if we 
serve our clients well, our own 
success will follow."
I thought I would take a shot at redrafting this platitude into something meaningful: here goes.  

The interests of every client always come first.
Our clients want to acquire or dispose of assets in order to achieve their financial goals.  We stand ready to help them by acting as their agents in the marketplace for real and financial assets.  Where a suitable financial instrument doesn't exist to achieve their goals, we will work with our clients to create a unique financial structure which does achieve their goal, for which we will earn fees and commissions for our expertise and our market relationships. However, we will always be open and transparent about how we earn our money and about how our interests are aligned with those of our clients.  

In a global financial marketplace, conflicts of interest will inevitably arise between those of Goldman Sachs, Inc. and those of our clients.  We will explain and disclose these potential conflicts when we write a client's business. The culture of our firm does not countenance treating bigger clients differently.  It also does not countenance writing a piece of client business and then pro-actively betting against our client's interest for the benefit of our business.  

While this ethical principle may cost us some business in the short run, if our clients achieve their goals and sustain their relationships with us, experience shows us that our firm and its shareholders will be amply rewarded. 

It's longer, but it does go out on a limb and say something. You may have surmised that this kind of required corporate disclosure is probably meaningless for institutions like Goldman Sachs, Deutsche Bank, the old Lehman Brothers and others.  Hence, Goldman's attorneys crafted their initial formulation: it gets the job done by checking the box for disclosure, and it doesn't impact the business. 

Senator Carl Levin's sub-committee produced a 645 page report on "Wall Street and the Financial Crisis."  It's interesting how the Goldman narrative in this doorstop of a report fits the contours of the Tourre prosecution.  A long chapter is entitled, "How Goldman Created and Failed to Manage Conflicts of Interest in its Securitization Activities."

Goldman went out of its way to "assist a favored client (John A. Paulson) make a $1 billion gain, and profit at the direct expense of the clients that invested in the Goldman CDOs." 

As we noted in our earlier post, "Paulson had a very negative view of the mortgage market which was publicly known...." 

Despite this statement, the chapter goes on to say, "Laura Schwartz (of ACA) was "unaware of Paulson's economic interest in the CDO."  So, the entire multi-billion ABACUS CDO subterfuge rests at the feet of Fabrice Tourre.  Don't get a stitch in your side from laughing: I did. Thanks, Senator Levin. 

Sunday, August 11, 2013

Tourre, Goldman Sachs and Corporate Ethics: Nothing Has Changed

So, the financial crisis has past, we've prosecuted the first and only face from the crisis in Farbrice Tourre, and lots more ink is wasted on corporate disclosures.

Have financial markets become more fair, efficient and transparent?  No.

Have additional financial disclosures spread the antiseptic of sunshine into dark corners of corporate behavior so that abuses of the past are precluded for the future?  No.

Have the bad guys been made to pay where it hurts, and are they pariahs in their own country clubs? No.

Fabrice Tourre has been successfully prosecuted for "for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors." No C-suite executives from Goldman, Sachs and Company, which created and sold the product have been prosecuted.  So, who is Fabrice Tourre?

According to the complaint, "Tourre was principally responsible for ABACUS 2007-AC1. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors."

This is absolutely inconceivable in any kind of factual reality.  Were it true, his bonus would have been multiples of the already excessive $1 million or so that he earned.  Goldman had done enough of these deals well before Mr. Tourre's joining so that there was nothing for him to "devise."  When John Paulson approached Goldman to structure the equity tranche of the ABACUS 2007-AC1 CDO for him and offered to pay Goldman $15 million in fees, you can bet that he never spoke to, or heard of, Fabrice Tourre.  So, this part of the accusation is pure prosecutorial fiction, setting up a fall guy.

So, if devising the transaction was a fiction, what did Mr. Tourre actually do?  The closes thing to a tangible accusation is ,"Tourre had primary responsibility for preparing the term sheet and flip book." Note that word, "primary," which is not "sole."  In other words, he constructed a term sheet based on the text and boilerplate provided to him by lawyers and sales traders. Mr. Tourre can read, and he can cut and paste text. Also, he employed the PowerPoint he learned in university to produced a slide presentation in a flip book format.  Since his were the only personal emails from Goldman presented during the trial, all we know is that Mr. Tourre became delusional enough to believe that he was a player rather than a cog in the powerful CDO machine.

Mr. Tourre's legal costs were paid for by his former employer, and his role will soon be forgotten, as were the roles of Howard Rubin, Joe Jett, Jerome Kerviel and other traders in past financial crises. He will rehabilitate himself as a PhD. economist from the University of Chicago; I would guess that his thesis title might be, "Adverse Selection: The Behavioral Economics of Constructing Equity Tranches of Synthetic CDOs."  All will be well.

What was the nature of the misleading statements that Mr. Tourre made about the ABACUS deal? ACA Capital, hired as a "Portfolio Selection Agent," was to select the reference securities for the equity tranche that would produce a security with the appropriate risk-reward profile that Goldman's client John Paulson hired the firm to produce and market. Through a lot of fog and innuendo, Ms. Schwartz thought that Paulson's firm was long the equity tranche and would not have rated the deal had they known that Paulson was short.  In the case of ABACUS, ACA and Laura Schwartz were apparently duped by the earnest neophyte Mr. Tourre who made representations that Paulson's money was long the equity tranche.  This is probably nothing more than Mr. Tourre overreaching, trying to ingratiate himself and revealing his total lack of understanding of the deal's players.

According to the complaint,
"Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing (very much akin to a rating agency) the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1"
This is totally laughable.  Anyone who even scans the business section of a newspaper would know that Mr. Paulson was broadcasting to anyone who would cover his story, his pessimism about the housing market bubble and how it could only end badly.  A person with the experience of Ms. Schwartz and ACA would never accept the contrary thesis on the basis of an email from a minor league player like Mr. Tourre.  With so much money at stake, either Ms. Schwartz or a principal of ACA Capital would surely just have called Mr. Paulson himself.

In the end, the verdict on Mr. Tourre was, in the words of jurors interviewed by the New York Times about "Wall Street greed," which had gone unpunished because no CEOs had gone to jail.  So, Mr. Tourre takes the fall, with an air mattress underneath him.

With all the ballyhooed academic legal writing about improved corporate governance and disclosure, let's read from Goldman's own published principles for running its business.  Here is Principle No. 1,
Our clients’ interests always come first. 
Our experience shows that if we 
serve our clients well, our own 
success will follow.
This isn't a principle, but a platitude.  Let's try and apply this in the case of ABACUS.  John Paulson and his hedge fund must have been such a client, because he came specifically came to Goldman to design an equity CDO tranche in which he could place the kind of bet for he was widely known to anyone with a pulse. Goldman took a $15 million fee and presumably took a fiduciary interest in Paulson's project.

A deal isn't a deal unless it is sold in the market place, and ABACUS couldn't be sold unless it had the "brand equity" of ACA as Selection Agent for the reference securities in the equity tranche.  If ACA Capital took the other side from Paulson, then they shouldn't be bailed out for being stupid.  Being stupid is not a violation of the securities laws, but perhaps it should be.

Goldman itself took some losses from the selling of swaps to Paulson, which is a bit hard to understand, but it appears that the market froze up on them before they could net out their exposure. So, Goldman takes the other side of Paulson's transaction, which is a service and arguably consistent with their principle that the client's interest comes first. Goldman also takes a bath, net of fees paid upfront.

What about the other big suckers in the deal?   German bank IKB Deutsche and Dutch bank ING.  But, they bought into what they thought was a AAA tranche at a time when the housing market fissures were about to explode.  These are sophisticated investors: what additional protections do they need which they themselves cannot demand from the marketplace?

Goldman, which itself came to see the wisdom in the positions of their client John A. Paulson, soon began trading against the very CDO instruments coming out of the other side of the sausage factory. Does this represent putting "clients first?"  Or, is it just legitimate proprietary trading?   But, isn't it based on material non-public information and communications coming from contacts with Mr. Paulson, the client?

The complaint cites this communication from an employee of John Paulson's hedge fund,
“It is true that the market is not pricing the subprime RMBS wipeout scenario.
In my opinion this situation is due to the fact that rating agencies, CDO
managers and underwriters have all the incentives to keep the game going,
while ‘real money’ investors have neither the analytical tools nor the
institutional framework
to take action before the losses that one could
anticipate based [on] the ‘news’ available everywhere are actually realized.” 
This about sums things up.  The second sentence reprises Charles Prince's statement that as long as the music is playing, you have to keep dancing.  Rating agencies (like Moody's and ACA in this case), CDO managers and underwriters (like Goldman and Lehman) have all the incentives to keep the music playing.  Investors like IKB Deutsche and ING are too lazy or not smart enough to tease out the market's truth from publicly available information.

So, Fabrice Tourre is guilty of making misleading statements.  His bosses, who are the managers and underwriters and who hire the rating agencies, escape any prosecution and pay fines with shareholders' money.  Disclosures give no guidance about present or future behavior.  Nothing has changed, save for some intra-system transfer of funds, and life goes on.

Thursday, August 8, 2013

Government's Abuse of Eminent Domain: Richmond, California Grabs Current Residential Mortgages

When we wrote about this issue over a year ago, most observers dismissed governments using eminent domain to seize residential mortgages as a tempest in a teapot. Instead, the whole issue has come to the fore in the summer doldrums, just before the coming September Congressional confrontations about sequesters, the budget and debt limits which will really color the 2014 election cycles.  Naturally, the first front has been opened in California, home to one of the biggest pots of electoral and popular votes.

On August 7th, Bank of New York Mellon filed a motion for Declaratory and Injunctive Relief against the City of Richmond, California.  Here's a link to the complaint.

BNYM calls this "a case about the misuse of public power for private benefit," which in effect "rents out" the City's powers of eminent domain for the private profit of Mortgage Resolution Partners, a for-profit group masquerading as a community action group and funded by well heeled investment banks like Evercore Partners, which was founded by former Clinton administration staffer Roger Altman, who is also a major fundraiser for President Obama.

The "Seizure Program" will purchase mortgages, including current mortgages, at deep discounts to fair market value, refinance the mortgages for the existing homeowners, while generating fees for the City of Richmond and its financiers.  The financing investment banks will receive the Federal guarantees for the new mortgages, which will then be packaged and sold, the big paydays for the investment banks.

The trusts which now own the seized mortgages will take their hit, as will investors in pension plans and mutual funds which own MBS.  So in part, this is a government sponsored transfer of wealth from one set of investors, public and private, to a selected set of private investors.

As the complaint states, "...the Seizure Program actually targets performing loans and does nothing to help homes in foreclosure."  Yet, slide presentations attached as exhibits trumpet the community action nature of the program to save the City of Richmond money by forestalling expensive foreclosures while keeping people in their homes.  Well, if the homeowners are current, they were staying in their homes anyway.  The propaganda would make a Russian blush.

The document says the the city has offered to initially purchase 624 loans, 85% of which are not in any stage of foreclosure.  81% are current or have not received any notice of default.  90% of BNYM's 105 loans in this initial pool are not in any stage of foreclosure.

The relevant language of the Fifth Amendment reads, "...nor shall private property be taken for public use without just compensation."  As Professor Mary Ann Glendon of Harvard Law School points out, what began as a notion of the just compensation being solely for a public use became "silly putty" in the hands of the courts.  Glendon cites retired Supreme Court Justice Sandra Day O'Connor who wrote, "where the exercise of eminent domain power is rationally related to a conceivable public purpose, the Court has never held a compensated taking to be proscribed by the Public Use Clause."

"Keeping people in their homes," saving municipal funds and preserving jobs in the local community are all part of the propaganda for the Seizure Program, so MRP and its government enablers have thought this out well.  From as early as the 1790's however, jurists recognized that use of the eminent domain clause should never be used to generate "taking" schemes which merely transferred wealth from one group to another. Unfortunately, that is exactly what is coming down now as this scheme begins to be implemented.

Major fixed income investors like PIMCO and BlackRock have awakened out of their slumber, intoxicated and flush from the longest bond bull market in history, to protest the scam.

The stench has returned worse than before.


Thursday, August 1, 2013

Met Life Reports And More Thoughts on SIFI

I had been thinking about the FSOC process for designating non-banks as Systemically Important Financial Institutions (SIFI) for some time, and Met Life's potential designation as a SIFI stood out to me, which led to the post.  Since they just happened to have reported their second quarter results, I thought I should go over them quickly to see how they tie to some of the points at issue.

The CEO noted that Met Life is in stage three of the process for being designated a SIFI.  He pointed out that AIG and GE Capital had spent about seven months in stage 3 before being designated as SIFI. Designation as such requires a two-thirds majority of the FSOC, including an affirmative vote from the Chair, who is the Secretary of the Treasury.  Met Life is in favor of prudential regulation of insurance companies, since they have lived under that kind of regime for their 140 year history; he does, however, want any additional layers of prudential or capital adequacy regulation to be suited to Met Life's insurance business model.

Non-GAAP operating income for the quarter was $1.624 billion, up 11%  over the prior-year period. The reported net income figure of $471 million was down dramatically compared to a reported net income of $2.264 billion in the prior-year period.  This was driven by a net derivatives loss in the current quarter of $1.69 billion ($1.1 billion after tax) compared to a net derivatives gain last year of $2.092 billion.

Met Life's derivatives portfolio exists to hedge the risks in their business lines and not as a profit center, as was the CIO at J.P. Morgan or at AIG.   About sixty percent of the derivative losses were attributable to the Americas portfolio, primarily the U.S.  The company's announced base case forecast, used for their stress tests in their 2012 10-K, showed the 10 yr Treasury rate at 2.58% at the second quarter of 2013, and it ended up at 2.6% compared to 1.69% at the end of 2012.   Average spreads on their product portfolio were projected to be 200-250 bp, and they ended the quarter at 244 bp.  Overall, there's nothing in their near-term performance versus outlook which suggests unanticipated risk in the next year or so.

Book value per share, excluding accumulated other comprehensive income and using actual shares outstanding, was $47.20 and $46.77 using the diluted share count. Overall the stock looks fairly valued on its outlook, and to their credit the management suggested that share buybacks were not a high priority in near-term plans for returning capital to shareholders. Most buyback programs, particularly in the tech sectors are sops to Wall Street and destructive of value.  Kudos to the CEO for stating his position clearly.

Overall, all of the business segments performed well, and as planned sales of variable annuity products dropped 40% over the prior-year period to $2.8 billion in the quarter, since this business is not a productive user of capital.

One small item, from the point of view of materiality, was a reference to a winding down of Met Life's business in Poland, as a result of changes in the previously privatized national pension system.  The CEO of AMEA noted changes coming in 2014, as a result of the government having to make emergency contributions to the plan assets.  Opponents of the 1999 privatization charge that the costs of the investment products and fees were exorbitant, where some of it surely has to do with plan design, benefit changes, and with economic trends.

GDP growth in Poland has been less than 1.1%, and the public deficit as a percent of GDP is at 4% versus the EU required target of 3%, which could trigger mandated EU austerity.  The system will likely be renationalized, according to local observers.  Met Life assets under management total around $7 billion, and all deferred acquisition expenses related to Met Life assets have been written off.

This company has been a quiet, perhaps sleepy performer which is in the midst of trying to unify and globalize its brand.  As such, some of their investor include value-oriented mutual fund operators like Dodge and Cox and Mass Financial Services.  From much of the conversation on the call, this process has a solid foundation, but is just beginning.

CIOs Don't Care About Dell's Proxy Battle

This piece from the Wall Street Journal's online publication "CIO Journal," says that corporate chief information officers just want a return to normalcy from Dell as a supplier, and reassurance that Dell will continue to innovate.  The piece concludes that going private won't give customers much reassurance.  What a surprise!