Catching Up With the Financial Press: Nothing Has Changed

U.S. equity markets have had five consecutive record closes. Governments in the U.S. and Europe continue to view financial sector public companies as ATM machines, with a steady stream of announcements of higher reserves for legal settlements.  Everybody's happy.  Where are we now compared to the dark days of 2006-2007?

• Our banking system is more concentrated than ever, with the top 4 banks controlling 47% of domestic banking assets.  Weighed down by an unending stream of regulatory and capital constraints, their business models need revision. 
• Despite all the research on the role of Fannie Mae and its central role in the subprime mortgage debacle, no meaningful diminution of its role has occurred through legislation or regulation. According to Goldman Sachs in "The Mortgage Analyst," May 2014: "Mortgages implicitly or explicitly guaranteed by the government are 90% of all loans originated, compared to two-thirds before the crisis." To cap it off, a new executive has called for Fannie to once again increase home ownership by loosening credit standards!
• QE has been a windfall to some market participants but a policy bust.  Even career Fed watchers can't make sense of pronouncements about the path of interest rates.  We have long said there is no fundamental economic case for raising rates. Minneapolis Fed President Kocherlakota let the cat of the bag first when the noted that the Fed couldn't right size its balance sheet for decades.  
• Europe's Fed-lite and QE-lite have been even worse failures, and their banking system still hasn't done its penance.  What's worse, economic fundamentals remain weak, with capital spending reflecting the negative sentiment of business executives.  
• The marriage of IFRS and GAAP was called off when bride and groom refused to show and the minister went home.  More than a decade worth of meetings, workshops, presentations, interim proposals, and investors have more verbiage and less clarity in disclosures than ever.  
• The IMF, of all players, has opined that a risk heat map for some markets like high yield, leveraged loans, and even corporate bonds show levels comparable to the 2006-2007 peaks!

I'm going to cut the list off at this point, but you get the picture, dear reader.  Words over action, form over substance, special interest politics above all, that's 'market reform' American style. 

Barofsky on Principal Reduction

We wrote in July,

"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."

Today, Reuters reports these quotes from Neil Barofsky.

By late 2009, it was becoming apparent that HAMP would never come close to its stated goals. The program was designed poorly, and Treasury refused to hold the banks accountable for the abuses to which they subjected homeowners in the program. In one meeting I attended, after Secretary Geithner was pressed about the flaws in the HAMP program, he justified Treasury’s actions by explaining that the program would “foam the runway” for the banks by extending out the foreclosure crisis over time. In other words, Treasury was far more concerned with using HAMP to soften the blow of the housing crisis for the banks – just as the FAA once recommended spreading protective foam over a landing strip to prevent a disastrous crash of a malfunctioning airplane – than with helping millions of struggling homeowners. Now, three years later, with a tightening presidential election and a Democratic base disillusioned by the government’s abandonment of its promise to help homeowners (less than 8 percent of the funds originally allocated in TARP for foreclosure relief has actually been spent), Geithner and the administration would like to present themselves as having undergone a conversion.

Let’s be very clear about what is going on here. This is not a conversion – it is a political convenience. Geithner may well be correct when he wrote in a letter to DeMarco that an effective principal reduction program would “help repair the nation’s housing market” and that the refusal to do so is not “in the best interest of the nation,” but it is his own policies that are primarily to blame for where we are today."

Come crunch time in election season, look for a politically convenient, economically bad deal to be done for mortgagee votes in another late innings bailout with more taxpayer money. 

Housing Still Needs A Big Fix

The New York Times this morning quoted 30 year conforming mortgage rates at 4.22%. The ten year Treasury yield fell after today's trading to 2.24%. The 30 year mortgage spread over the ten year Note is then 198 basis points.

A 2009 paper by Glenn Hubbard and Chris Mayer of the Columbia Business School shows that the normalized spread is 160 basis points. Although the spread has come down from the intra-crisis peaks, it is still above the normalized level. In their paper, the excess spread raised the cost of owning versus renting by 10-17%.

We've noted before that banks have gone from drunken sailors to Scrooges, and mortgages are being denied to even a bank's good customers. Appraisers were complicit in the U.S. housing debacle, and in my state of Minnesota, the ability to fog a mirror can get you an appraiser's license. That industry is still out of whack, and it is complicated by the appearance of Web sites like Zillow which purport to show estimates of residential value which are based on their proprietary models. What I've seen of Zillow has been nonsensical though it has been improving. Their database on individual properties has gaps, inconsistencies and errors.

We have not come up with a solution for the tens of thousands of homeowners with negative equity in their homes. The worst ones are in the mill but the homeowners are staying put, not making payments, while it's unclear who holds the mortgage and who can dictate the new terms. The Obama administration seeking ideas to turn these homeowners into renters seems to be a blunt instrument which leaves lots of implementation questions unanswered.

The Government is still insuring more than $6 trillion in mortgages, and we can't expect anything from this sector for a long, long time unless it gets a pretty big fix, which should involve shared pain for the banks, investors, homeowners, and the taxpayers, unfortunately.

Treasury Note Yields At New Lows

It seemed to us in July, that Treasuries would continue to be a safe haven for investors after any downgrade, and today's news confirms this. The Wall Street Journal writes that the two year Note's yield of 0.232% is a record low and below the top end of the Fed's policy band for the rate. The financial press seems to forget that safety and liquidity are very closely intertwined. Perhaps a Swiss government bond somewhere may be perceived as "safer," but Treasuries are the broadest, deepest and most liquid market for FI obligations, and that's important for nervous investors.

S&P, we can all agree, has imprudently overplayed their marketing hand and revealed, through their $2 trillion arithmetic error, that they don't deserve to be taken seriously on the U.S credit rating downgrade.

It was discouraging to read that the Justice Department has concluded its investigation into actions taken by Countrywide Financial and its officers during the run up to the financial crisis. Nobody has gone to jail yet, and it sounds as if that will continue to be the case. The Fairholme Fund's self-interested conference call with Bank of America management might be interesting, although it seems quite bizarre that the BofA management has agreed to this unique format for a 1% shareholder. It's a funny way to do business, in our opinion.

The GSEs and The Financial Crisis

The Financial Crisis Inquiry Commission's proceedings and report are a really sad commentary about the low quality of inquiry and debate in our political and economic system. From the beginning of the mortgage meltdowns in the 2001-2006 Nodoc/Lowdoc mortgages until today, we have effectively been chloroformed into forgetting how we got here.

In his testimony before the Senate Banking Committee, Professor John Coffee of Columbia University expanded upon a presentation I heard in Minneapolis:


"The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications. With an increased supply of mortgage credit, housing prices rose rapidly, as new buyers entered the market. But at the same time, a corresponding increase in mortgage debt relative to income in these communities made these loans precarious. A study by University of Chicago Business School professors has found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults--in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials."


Professor Coffee's testimony is clear, factual and follows the chain of events. To conclude that the Fannie Mae had no part, or was a minor player in the meltdown would require a Soviet-style inquiry process populated by our own government and quasi-government apparatchiks. That's exactly what we got. Wall Street continued to securitize this junk with AAA ratings, given by agencies interested in nothing more than market share. To paraphrase Charles Prince, "As long as the music's playing, you've got to dance." The shadow banking system did so, until the music stopped. Here we are years later: in denial, still searching for the guilty, and still dealing with the wreckage.

Musing About Margins

When the global meltdown began a couple of years ago now, analysts all over the world agreed that the financial sector, particularly in the United States, had simply become too big. Whether measured by percent of GDP or percent of the S&P's capitalization, the lubricant of our economic system had become bigger than its wheels. We then tried to make this into slogans, "Too big to fail," or "To big to save." Reading the news in the current earnings season, the financial sector continues to live large.

Cleveland-based Eaton Corporation (NYSE: ETN) reported outstanding results for a global leader in power management systems, hydraulics, automotive and aerospace. My former colleague, Norm Klopp of Midwestern Investment Management, always liked this stock. Core revenues were up 18% for this global leader, and operating EPS rose 32 percent year-over-year. Segment operating margins increased to 13%. Good company, with good management and a business model leveraged to strong volume increases, and it's as good as it gets.


Now move over to medical devices, a sector with which I'm familiar first hand. This sector offered great demographics, unmet clinical needs, technological innovation, and proprietary technologies. Multiples were in the ozone years back. St. Jude Medical (NYSE: STJ) reported an 11% revenue increase for their fiscal third quarter, and operating EPS up 5% year-over-year. Operating margins increased to 26%. That is a pretty nice margin for a manufacturing business, and it reflects characteristics of the device business. St. Jude is selling at 13x this year's projected operating EPS, reflecting uncertainty about reimbursement and healthcare reform. Remember, STJ's operating margins are twice those of the more industrial Eaton.


So, what made me wring my hands this morning? BlackRock (NYSE: BLK) reported a 74% increase in third quarter earnings, besting all analyst estimates, driven by its acquisition of Barclay's Global Investors, the leader in indexed fund products. Current operating margins were 33.8%, projected by the CEO to move to 40 percent, which will be driven by asset inflows into indexed equity and fixed income funds. I don't mean to single out BlackRock, because the large banks would also be poster children, but it was the absolute value of the operating margin that drew my attention.


In the funds business, there's no metal bending, no R&D, no product development risk, no product liability, no price controls, no FDA regulation, and no accountability for poor performance, since indexed products mimic the market risk. Goldman Sachs is reported to be ready to redeem Berkshire Hathaway's $5 billion convertible because, among other things, it has $1 trillion in excess liquidity with the Federal Reserve Bank. Something is wrong with this picture, and it could be that some numbers, particularly for banks as opposed to asset managers, are illusory.


We've written before about this issue. Simon Johnson takes a stab at guesstimating the unrecorded bank portfolio write downs as being $50-$100 billion, with a ten percent probability of losses being multiples of his estimated range. Really, really big in other words. Even if we careen to this scenario, there will be no reform and no accountability. Former CEO Angelo Mozilo of Countrywide Financial, one of the great enablers of Fannie who poured jet fuel over the early flames of the mortgage crisis, walks away with no life style changes, while the housing sector is beginning yet another episode of cardiac arrest. I took a Rolaids with my coffee.

Termites and Foreclosures

We wrote in a 2008 post:
"The banking industry has never been set up to effectively and humanely handle large volumes of foreclosures, because it is something that they're not good at and something that was never anticipated on a large scale. The participants in the foreclosure business are yet another unregulated, unseemly lot. Unleashing this process on a large scale is like introducing termites into a house."

Now, yet again, Congress and the pundits are focusing on symptoms like documentation and robosigners. The media discussion, which will feature lots of political posturing and horse trading in front of the upcoming elections, will deflect attention from the fact that tranches of MBS's need to be written down which will again raise questions about portfolios where the paper is held.

Even potentially positive events for consumers, like sales of foreclosed homes have been revealed to be poisonous. Auctioneers have transferred homes to reasonably informed buyers with attached first and second mortgages! No one is responsible for even providing this kind of information to bidders. There's no accountability anywhere in this dismal financial chain and we wonder why consumers are not leading the recovery.

Averages and the Housing Market

Economists J.R. Abel and R. Dietz of the New York Fed have an interesting piece in the March issue of "Current Views." Nationwide, home prices rose at 8% per annum from 2000-2006, meaning they would have doubled every nine years! Now, these weren't stock prices, but residential home prices. Fast forward to 2009, as we look at the top 10 metro markets for home price appreciation, and we find markets like Buffalo, Rochester and Syracuse, New York. In fact, Buffalo was the 6th best performing market for price appreciation in 2009.

Now, in a sense, the authors are measuring a truism, the higher up you are, the faster you're going when you hit the ground...or the bigger the bubble, the bigger the mess when it bursts, but there are instructive points in their data.

Upstate New York (USNY) markets saw existing home sales grow by only 15% in the decade from 1995-2005, whereas the broad, national market saw existing home sales rise by 75% over the same period. So, nationwide, things were really frothy, but within that average, we had dispersion. Our national housing bubble like Lehman's portfolio risk was concentrated.

Of the 383 metropolitan markets covered by FHA surveys, 65% (249) of the markets had average annual price appreciation less than the national average.

They have a very instructive chart that maps all of the metropolitan areas into four quadrants:
"No or moderate boom; no bust," "Boom, no bust," "No or moderate boom; bust," and "Boom, bust." 57% of the 383 metro markets were in the "No or moderate boom, no bust" category. These included USNY markets like Binghampton, Buffalo, Elmira, Rochester, Syracuse and Utica.

The worst markets are strongly concentrated in California, Washington, Florida, Arizona, and Las Vegas, NV. Of course, we knew and suspected this, but it's nice to see the data and analysis laid out. It's like looking for the cause of a heart attack. Although the entire organ is at risk, we need to find the culprit lesion in the occluded vessel. Well, we had quite a few lesions, in sunny climes.

There have been a few misinformed apologists who suggested that subprime mortgages were not the key to the financial meltdown. Hopefully, they are in treatment now. The Fed economists bring together data on nonprime mortgages and show that the penetration rate (mortgages per 1000 homes) was 82/1000 in the boom/bust markets versus 50/1000 for the national average. The table showing performance of these mortgages right to foreclosure is sobering.

I suppose the good news is that reasonable employment growth in the non-boom/bust markets could bring some of these housing markets back relatively quickly. However, as other research has shown, this may not be likely because of the limited geographic mobility of job seekers tied down by their homes, and because of job skill mismatches. We need corporations and businesses to start addressing these issues by thinking long-term and looking to expand their capital spending and market development.

What's Underpinning This Market?

From my perspective, the news from the housing and mortgage market isn't good. February new home sales declined 2.2% versus the consensus 2% increase, while the supply of homes for sale continues to increase. The MBA refinance index, according to Ned Davis Research, fell 7.1%, its fifth decline in six weeks. Correlating this data point with what's going on in markets I can observe, it seems as if the "Sold" signs and closings are on entry level homes, because of the first time buyer tax credit. Those who can refinance appear to have already done so. The sales in the middle and upper end appear to be below even the reduced local assessed values, never mind what the seller bought the home for. This is to be expected, but not indicative of a robust market recovery.

Meanwhile, companies I talk to are still dealing with challenges in getting top line sales going on a consistent basis. I was reading a report on Hewlett-Packard, a bellwether stock that is owned in dividend-paying mutual funds, quality growth funds, and value funds. They did a great job when the crisis began by cutting staffing, reducing compensation (in which everyone shared the pain), and by doing unheard of things like substituting video conferencing for routine business travel. Driven by their new CFO, it worked like a charm, both financially and culturally. However, reading their performance by business group, it's fairly lackluster. It seems to me that a disproportionate share of their income still comes from consumables, and that's not healthy. That may be why their relative P/E lags their competitors. Great company, great products, but its performance will be driven by earnings going forward and not by higher valuations. The same seems broadly true for this market.

Where is the engine for our continuing economic, as opposed to stock market, recovery? I'll let you know when I find it, and if you find it first, let me know.

Conscience and Character

What do these have to do with the crisis of the American financial system? Nothing. And, that's exactly the problem. Wall Street fosters an environment where a person's governor or self-regulator, called a conscience is switched to "Off" during office hours. The name of the game is always to go to the edge, and over the edge. If someone calls you on it, pull back, with no consequence and go about your business. Each minute, hour, day, and quarter is serially independent of any other. "Size of the book" is all that matters, and the positive or negative sign means little. Size means you're a player, and a negative sign means that you are "aggressive."

Unfortunately, a variation of this theme applied to bank regulation during the build up to the crisis. That truth is slowly coming out. Here's a self-assessment of the Federal Deposit Insurance Corporation's loan review process reported on the Calculated Risk blog:

"The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed. ...“It’s often we’ll see in our reports that the FDIC detected problems in the bank in a timely fashion, but in some cases forceful corrective action wasn’t required by the FDIC to be taken quickly enough,” Jon Rymer, the FDIC’s inspector general, said in a telephone interview." (Source: Calculated Risk)

So, it's not a matter of inadequate process or regulation. Examiners were in place, and they went out and followed their processes, which pointed out the issues. What is unclear is why the levels of bad loans were allowed to get so high, and why "forceful corrective action" wasn't taken. It's the same issue: a failure of character and faithfulness to one's mission. Of course, having worked for a few agencies of the Federal government, it's easy to construct a scenario where an examiner calling for shutting down lending in a go-go market in a "free market" administration might not think this was a good career move. And that's a shame.

I've never responded negatively to one of my staff giving me bad news or taking a stand on something. Overzealousness shows passion and commitment; it can always be remodulated, if it has to be. Failing to call attention to a problem or being inhibited about bad news is a more complex problem; it's being tepid, which is a bad thing in sports, life and in the world of character and conscience.

Reverend Dr. Martin Luther King, Jr. longed for the day when a man would be judged "not by the color of his skin, but by the content of his character." Perhaps the latter is something that should start going onto performance review forms.

The FSA Gets It Right

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

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

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

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

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

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

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

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

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

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

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

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

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

A Colossal Failure of Common Sense

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

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

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

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

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

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

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

It Beats The Talking Heads

I don't listen to any cable talking heads about the equity or credit markets. I prefer to keep up with active, market participants who've proven their approach over many market cycles. The folks who run the Dodge & Cox Income Fund recently issued their first quarter report, and it makes for instructive reading.

I'm not writing this note as any form of investment advice, and I am a shareholder in this fund, so please note these caveats. I used to provide sell side research to the equity side of Dodge & Cox many years back, and I've always been impressed by their sobriety, structure, and the fact that all the key personnel are heavily invested in their own funds.

DODIX outperformed its benchmark, the Barclay's Capital Aggregate Bond Index (BCAG) by 14 basis points in the first quarter, but the sources of the outperformance were interesting. This fund has a long-standing bet on corporate bonds from quality institutional issuers; the fund is 46.7% weighted in corporate bonds versus 17.4% for BCAG.

The fund overweighted relative to BCAG in Financials, and this dragged their performance down, as Citigroup, Bank of America, and GMAC were particularly weak. The bond performance, together with the ongoing news from Citigroup, probably signals that the company is a true basket case and will be a continuing ward of the state. Dabbling in the equities of financials, which some value investors are doing will probably be limited to a relatively few names, of which Wells Fargo is most often heard, with even Warren Buffett talking his book.

Mortgage backed securities, measured by the Barclay's Capital US MBS Index, returned 2.2% in the first quarter. Asset backed securities measured by the BC ABS Index returned 7.6% in the quarter. So, Bill Gross's long avowed strategy of "shaking hands with the government" seems to working for this fund too.

The corporate index yield premium to Treasuries was near its all-time high at the end of the first quarter. For us, a significant downward movement in this spread has to proceed a meaningful, sustained movement in the broad equity market, and this is not what was seen. The first quarter spread was 543 basis points versus 97 basis points in the first quarter of 2007. Liquidity is still so poor in the high quality, corporate aftermarket that the fund was able to increase its weighting solely through buying new issues. This is not a sign of a healthy credit market either.

Talking to corporate treasurers and CFOs we know indicates that banks are content to enjoy record margins and garner fee income where they can. Lending terms and coverages are significantly tighter than six months ago, even for firms with cash and strong collateral. Again, it's hard to understand what equity markets would be excited about if the fundamentals of the credit markets are still bifurcated and illiquid.

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.

The Executive Pay Distraction

Executive pay is a fundamental, long-term issue for public companies, as well as for mutual fund managers who often lead the chorus for "reforming the other guy's pay." These issues can't be dealt with as part of the banking and credit crisis. Unfortunately, hand wringing about bonuses at AIG comes after the horse has left the barn, and it is a diversion from the main issue.

So, we now know that Federal largesse has gone to make a limited number of contract counter parties whole, one of which is Goldman, Sachs, whose former official Henry Paulson pressed for this aid package in the first place. To use the poker term, the Fed and the Treasury are now "all in" on AIG, with diminishing hope of taxpayer recoveries and increasing risk. We as taxpayers cannot and should not shoulder all the counterparty risk in the AIG portfolio. I don't understand what we are trying to do at this point, and the market doesn't either.

The Federal government has become a significant "owner" of AIG, yet it has chosen not to act like an owner, but like a silent partner. Owners take ownership, participate in business and oversight decisions, and demand accountability. Since the Feds has to do none of these, it's not at all surprising that management were untrammelled in paying themselves for being irresponsible. It's probably too late to go back and place a Federal director on the board who reports directly to Congress or the executive branch. It is a shame.

The bonus issues are hard to understand, because bonuses are typically paid on mixture of corporate and personal objectives. What kind of objectives could have led to some the reported payouts? A corporate objective of maintaining a non-zero share price? A corporate objective of taking more Federal money? Unfortunately too, the proxies will come out long after our Twitter attention spans have forgotten about these issues. Perhaps the companies receiving the handouts should have to 8-K their real time, current compensation plans on their websites. Now, that would be transparent. When someone like Dick Kovacevich refers publicly to Fed and Treasury stress tests as "asinine," you know that there is trouble in Dodge.

Bill Gross Made the Call on GE in 2002

GE's equity value has fallen by about 80% over the past three years, compared to a 40% decline in the Dow Jones Industrial Average. The legendary Jack Welch talked about GE growing its earnings at 15% per year for "several decades." Logically, this makes no sense, as this would mean that earnings would double every five years. And this would occur in a company largely made up of businesses with long selling cycles (nuclear reactors, jet engines) and that are cyclical in nature (appliances, and media susceptible to advertising and new program cycles). So, the dealer had to have one or two cards up his sleeve.

Indeed, acquisitions and GE Capital were the two cards. As an equity analyst for many years, I loved to read the work of credit market analysts and portfolio managers, who did rigorous modeling work and who had much more conservative and skeptical natures than did the lap dog cheerleaders in the equity market. Bill Gross, who is must reading for me wrote in 2002, "It (GE) grows earnings not so much by the brilliance of management or the diversity of their operations, as Welch and Immelt claim, but through the acquisition of companies....using high-powered, high multiple GE stock or cheap near-Treasury Bill yielding commercial paper." (March 21,2002 on CNNMoney.com) So, as Thorton O'Glove would have said, their "quality of earnings" was very low.

At the heart of things, the business model was flawed. The portfolio of businesses was simply not geared for generating earnings growth of 15% per year. So, earnings were managed consistently in an era of liquidity and declining interest rates. GE disclosures were so uninformative, and yet no analysts ever complained or even asked uncomfortable questions. The financial press wrote about Six Sigma, the GE culture, and about the Croton management training academy that taught the "Tao of GE."

Unfortunately, it's hard to believe that management didn't realize earlier than today that the dealer would have to fold soon. Now all credibility has been lost, and once it's lost, it's very difficult for the same team to get it back. Wall Street loves to pile on, and that's what is happening now.

Some lessons to be learned:
1. Beware of the cult of personality and the association of a company's value with the personal charisma of any one individual, even Jack Welch;
2. No large-scale, public business can predictably grow at 15% per year "for decades," without caveats galore.
3. Earnings quality matters.
4. Disclosure and communications are not for flaks and PR agencies. Informative disclosure is the lifeblood of the marketplace and professional investors. As Bill Gross wrote in 2002, "I would like GE and other companies to be more candid in terms of disclosing exactly how they do these things....If they grow earnings, then let's hear about it and find out how much comes from these types of maneuvers (acquisitions, low cost financing, and other financial engineering)"
5. Credibility, as much as a credit rating, has to be maintained. A market decline can be retraced, but a loss of credibility is very difficult to recover. Again, Bill Gross noted, "The fact is that GE is a conglomerate financed by a money machine...but unlike Berkshire Hathaway, its foundation is vulnerable because its survival depends upon the confidence of outside investors..."
6. The GE brand in the consumer market place was heavily associated with the appliance business, which GE has long said it wanted to exit. With the current lack of buyers at the right price, this has significantly damaged the consumer brand equity. Increasingly, this puts the future with the industrial businesses. Green is nice, but it's a long way out before it can move the needle on this behemoth. Cyclicality and economic sensitivity will increase in the future, as earnings flexibility disppears under the weight of the GE Capital anchor.
7. Six Sigma godan black belts don't help make the quarter. Nice for magazine articles but little else.

The Mortgage Plan: A Passed Ball

When the Obama Mortgage Plan was announced, we opined that it was another passed ball, without the benefit of many details. Now, in today's New York Times, a well written piece by John D. Geonokopolos of Yale and Susan Koniak of Boston University, contains a run of the numbers.

The writers note that the plan gives an interest rate reduction for five years, but, as we surmised, the principal reduction for five years is not meaningful, capped at $5,000. The point to note is that the plan does nothing to stem foreclosures on a significant scale and does nothing to change the incentives for homeowners with no equity in their home to walk away from the mortgage and the home.

Servicers are shown as standing in the way of a path that would, according to the authors' calculations yield bondholders significantly more cash than the foreclosure path. The piddling incentives to servicers are inadequate to negate their incentive to move to foreclosure.

The fundamentals of the declining residential real estate market and the cascading effect on asset prices and foreclosures remain unaddressed, and yet this plan carries another hefty price tag.

Black Swans and Black Suits

Nouriel Rabini, writing in the Wall Street Journal today, comes out on our side for nationalizing the banks. Here's a short, cogent excerpt from the interview, "Mr. Roubini tells me that bank nationalization "is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s] -- i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector -- it's clear that it's temporary. No one's in favor of a permanent government takeover of the financial system." (The Wall Street Journal, Online Edition, January 21st, 2009)

He talks about Greenspan's intellectually slavish adoption of Ayn Rand's economic view, and the Bush administration's disastrous idea of turning the Fed into the "lender of only resort." What's needed now is not a discussion about the merits of a free market system--an academic concept--but rather decisive action.

Fail--Nationalize--Renew

After waiting with bated breath for the Treasury's latest rescue plan, it's clear that we're out of ideas and have lost clarity and focus about issues and effective solutions. Today, there is much being written about Japan's "Lost Decade," and the need to learn from it.

Heizo Takenaka, who headed up the Japanese financial reform effort is quoted in the New York Times as telling Japanese banks, "Don't cover up. Don't distort principles. Follow the rules." So, let's learn from this.

Whether by enhanced Comptroller of the Currency audits or not, let's acknowledge that banks holding a large percentage of national deposits are insolvent. Wipe out the shareholders, which unfortunately are the rules of the game for owners of the residual interest. Nationalize the banks, and workout the assets. Let new banks emerge and bid for the assets. Let a new banking industry emerge, and incidentally it should be much smaller. If private equity types want to play in this field and operate banks under much tighter oversight and scrutiny, then that's preferable to the alternative.

A really bad idea that won't go away is to have government buy the distressed and toxic assets in partnership with private equity investors. A basic principle: that partnership's benefits will accrue to one and only one side, namely the private equity players. If really smart bond market investors can't value the assets properly, then certainly the government can't. The pressure to build in a rental, or subsidy, element into the prices will be irresistible on the Hill. A truly bad, bad idea.

In a related area, the legislation to require private equity vehicles to register and be subject to SEC oversight and regulation should be passed. Arthur Levitt, former Chairman of the SEC, correctly identified the 'levelling of the information playing field" to be critical for the efficient functioning of the capital markets and so it is. I wonder if we have the gumption for this, but now with the ineffective former leadership of the SEC out, perhaps we can find the fortitude.

If we believe in capitalism, then don't only focus on capital creation, because capital destruction is an integral part of the cleansing and renewal process. Take the medicine now and be done with it.