Starr CEO Greenberg Wins Against the Lawless and Discriminating Feds

The Federal Claims Court today ruled in favor of Starr International Company, the largest shareholder of AIG, against the Federal government's treatment of AIG during the "Lehman Weekend" and its unprecedented, claimed illegal extraction of equity in exchange for an $85 billion rescue loan.  No damages were awarded, and though that outcome seems inconceivable, Judge Wheeler's logic had some very weak merit.

 It is a clean, well written opinion, in which the text's many pithy sentences speak for themselves:

• "This sizable loan would keep AIG afloat and avoid bankruptcy, but the punitive terms of the loan were unprecedented and triggered this lawsuit." 
• "Operating as a monopolistic lender of last resort, the Board of Governors imposed a 12 percent interest rate on AIG, much higher than the 3.25 to 3.5 percent interest rates offered to other troubled financial institutions such as Citibank and Morgan Stanley. Moreover, the Board of Governors imposed a draconian requirement to take 79.9 percent equity ownership in AIG as a condition of the loan. Although it is common in corporate lending for a borrower to post its assets as collateral for a loan, here, the 79.9 percent equity taking of AIG ownership was much different. More than just collateral, the Government would retain its ownership interest in AIG even after AIG had repaid the loan. 
• The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance. In September 2008, AIG’s international insurance subsidiaries were thriving and profitable, but its Financial Products Division experienced a severe liquidity shortage due to the collapse of the housing market. Other major institutions, such as Morgan Stanley, Goldman Sachs, and Bank of America, encountered similar liquidity shortages. Thus, while the Government publicly singled out AIG as the poster child for causing the September 2008 economic crisis (Paulson, Tr. 1254-55), the evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions.

Though the opinion doesn't recount the discussion, the mere association of an $85 billion loan facility to fund a relatively small Financial Products Division with an 80% stake in a holding company with extremely profitable insurance businesses defies logic; surely other arrangements for collateral pledges could have been made had the Feds decided not to put the gun to AIG's head.  

• The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act. 

The government is cited by Judge Wheeler as carefully orchestrating the taking of equity, installation of management, and overrunning of the company by its favored consultants without requiring a shareholder vote, and to maximize the benefit to AIG Financial Products Division counterparties, the taxpaying public and to the U.S. Treasury.  

On the fundamental issue of illegal extraction of value from AIG shareholders, the court found,

• "Having considered the entire record, the Court finds in Starr’s favor on the illegal exaction claim. With the approval of the Board of Governors, the Federal Reserve Bank of New York had the authority to serve as a lender of last resort under Section 13(3) of the Federal Reserve Act in a time of “unusual and exigent circumstances,” 12 U.S.C. § 343 (2006), and to establish an interest rate “fixed with a view of accommodating commerce and business,” 12 U.S.C. § 357. However, Section 13(3) did not authorize the Federal Reserve Bank to acquire a borrower’s equity as consideration for the loan. Although the Bank may exercise “all powers specifically granted by the provisions of this chapter and such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this chapter,” 12 U.S.C. § 341, this language does not authorize the taking of equity."

Oops.  While the smart folks at the Fed and the Treasury were working hard to save us from a thirties style depression (a red herring), they did manage to violate a fundamental statute of the Federal Reserve Act in the process.  However, when an enemy with unlimited time, funds and access to the court of public opinion comes gunning for you, surrender might be the lesser of two bad alternatives, and so the AIG board capitulated based on that logic. 

• In the end, the Achilles’ heel of Starr’s case is that, if not for the Government’s intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG’s shareholders would most likely have lost 100 percent of their stock value.

The last sentence threw me because I thought surely that the extremely profitable insurance businesses would have provided some real residual value to shareholders. However, state regulators which are charged with protecting policy holders at all costs, would have brought assets which supported those policies into their ambit through existing state insurance regulations, as well as through other protections.  

In some ways, Starr and Mr. Greenberg are to be congratulated for using their slingshot against our own rapacious, selective prosecuting, and plundering financial regulatory Goliath.  Goliath has almost finished plundering the financial services sector for cash, and as it continues to selectively apply its novel legal theories to its enemies, perhaps other victims may stop and say "Basta!"  Let's see how Met Life does.  

Feds Stance on Met Life Shows Irrationality and Will Hurt Shareholders

We've written about Met Life before, first as a well managed company with a strong domestic business, and a growing international insurance business in solid markets like Japan.  It is absurd that is considered to be engaged in non-traditional, non-insurance businesses that could generate systemic risk. In fact, the company's complaint contends that Met Life has been deemed a "non-bank financial company" and therefore falling under Dodd-Frank solely because it has 15% of its assets in foreign subsidiaries.

The Financial Oversight Stability Council's lack of transparency and unwillingness to share its data and methodology for its conclusions with Met Life has pushed the company into either acquiescing to FOSC's banana republic tactics, or fighting the action as the rules allow and incurring the ongoing wrath of the Feds.

The move for summary dismissal of Met Life's protest is again arrogant and ludicrous.  Let Met Life have its day in court.  If the Feds are right, Met Life will have spent its own money, but at least it would have sought to preserve future earnings growth, multiple expansion, which are in the best interests of its shareholders.  This is good governance.

Some so-called analysts have suggested the Met Life management should have agreed to divest its foreign businesses, thereby escaping the classification as a systemically important non-bank financial corporation. That is another irrational suggestion because that would admit that the classification process had validity, and it would sell off future growth engines for revenue, earnings, while increasing the dependence on mature economies for growth.

By the kind of reasoning, Berkshire Hathaway is the ultimate, non-bank financial company, with most of its non-bank businesses being financed by the float from its insurance and reinsurance businesses.  The Feds aren't fools and wouldn't dare take on their friend in Omaha: that battle would end before shots were fired.

As the numbers attest, Met Life operates through highly regulated insurance subsidiaries, both here and abroad, which together generate 95% of corporate revenues, hold 98% of consolidated assets, 96% of consolidated liabilities; these subsidiaries are true operating subsidiaries, selling and servicing insurance policies, while managing the assets which backstop the policies.  What could be simpler? Insurance has long been effectively regulated, as far as risk and policy holder protection, by existing state and federal laws.

Met Life shareholders should be, but are probably not, flooding the mailboxes of their elected representatives to end this folly.  Stay tuned.

Jamie Dimon on Regulation, Treasuries and the Next Crisis

I'm still penciling through some recent bank financial reports, and I keep coming back to JPMorgan Chase CEO Jamie Dimon's shareholder letter.  Around page thirty on, there are plenty of good nuggets.

He notes that banks today, driven by backward-looking regulation, are part of a banking system "that is stronger than it ever has been."  Yet, the bond market, and particularly the Treasury market, could be the venue for an event-driven crisis in any one of three or four hotspots around the world.

Regulation has made market making in bonds less profitable, and although bond market spreads have come down and stayed low, the market depth has actually declined. The letter says, "..the market depth of 10-year Treasuries (defined as the average size of the best three bids and offers) today is $125 million, down from $500 million in 2007."  This despite the fact that today's Treasury market is $12.5 trillion as opposed to $4.4 trillion in 2007.  Dealer inventories are down 75% from their 2007 levels.  There's no need to run a complex stress test to see that this is not a healthy market for the asset of choice in a global crisis.

For all the talk about a "flash crash" in stocks, the October 15th, 2014 one day move of 40 bp in Treasuries was a much more serious "shot across the bow."  As the CEO's letter points out, this was a move of 7-8 standard deviations!

Bond investors like Blackrock and others have been writing about the need to innovate these markets for some time, but the point is now that the time to formulate a new structure, agree among the market participants, issuers and regulators will be years in this political environment. A crisis could come in the fall, as they often do.

The supply of Treasuries available for sale is relatively small, given the large size of the stock and the burgeoning demand. Total Treasuries outstanding are said to be $13 trillion.  At least $6 trillion are tied up in central bank forex holdings, another $2.5 trillion on the Fed balance sheet, and another $0.5 trillion held by big banks as liquid assets.  Take out this $9 trillion, and about $4 trillion are potentially available to be traded.

The Japanese central bank, for currency and other economic reasons, has published aggressive targets for purchasing Treasuries on top of the $1.238 trillion which they already hold.

In the event of a typical run, driven by the next crisis, global investors will look to U.S. Treasuries as they did in the last crisis, when more than $2 trillion in demand was created by the fire sales of risky assets.

On April 6th, Wall Street Journal correspondent Michael Casey's lead sentence was "The bond market is malfunctioning."  In a full-blown flight from risk, this could be an understatement.

China's Slowing Growth Rate

China's economic growth rate is characterized as "slowing," to 7% per annum; but, this means that the giant economy can be extrapolated to double in ten years.  Given recent economic and financial developments, is this really plausible?

The Chinese Economic Miracle was predicated on two key slogans, "Privatization," and the evergreen "Growing Middle Class."  In the intervening decades, we know that privatization meant a selective treatment of some private companies and more the creation of grossly inefficient state-owned enterprises.  Financing of the latter in an environment of low, falling interest rates and growing state surpluses of foreign exchange wasn't an issue as far as the eye could see.

As the Chinese economy grew to the sky, the ruling members embarked on a strategy to corner all the key resources needed to fuel the growth of an industrial economy, from recycled PET to paper, rare earth minerals, copper, and food commodities.

Prices for clean, post-consumer baled PET began a rapid ascent about fifteen years ago, and when I called some of the companies gathering this commodity from municipal waste streams, they all told me that the demand was Chinese and "insatiable."  Chinese consumers also wanted their clear beverage bottles for water and soda.  Today, prices are quite different.

Chinese companies owning copper mines in Chile have seen prices collapse recently.

Again, risk is one thing for a private company with lots of debt and relatively small equity, but it is another thing for the Chinese central banking system.  However, economics ultimately carries the day, especially in an environment when the music appears to be stopping, i.e. rates may be rising.

However, it is also difficult to see what would justify raising rates when Europe, apart from Germany and Switzerland, is a basket case.  Traders are reported to be hoarding oil in a carry trade awaiting normalized, higher prices. Great Britain has an economy where consumers are being offered credit cards on television with 50% A.P.R.s.

Barron's columnist and legendary investor Jim Rogers recently said that he was long Indian equities, which have done extremely well.  However, he said too that he had his doubts about the intentions of the Modi government to really deregulate and reform the Indian economy so as to unleash a real economic miracle consistent with all the press releases.  I think that his skepticism is well warranted.

In the U.S., talk of higher taxes, redistribution and a U.S. National Health threatens the longevity of what has been a slow, lethargic recovery.  As Bill Gross said in a different context, the U.S. may be the "cleanest dirty shirt," among global economic leaders, and it still has the primary reserve currency and liquid markets, so far....

US Postal Service Reform: A Dead Letter in 2014

Throughout 2014, we read warnings about yet another crisis at the US Postal Service.  Aspects of Congressional regulation regarding prefunding of employee healthcare do have the effect of showing paper losses, and the postal union suggests that removing the prefunding requirement by itself would put the USPS in a healthy condition.

Unfortunately, this isn't the case. Meanwhile, as Congressional bills like Carper(D)/Coburn(R) languish without coming to the floor for a vote, it is clear to anyone who uses the Post Office that delivery times from Minneapolis to New York, for example, which used to be 2-3 days for First Class mail are now 5-7 days, while rates have gone up.

There are too many small post offices, too little self service, and the delivery fleet itself is outdated and antiquated.

The Postmaster-General admitted that its commercial bulk rates were not competitive enough to win share from online retailers like Amazon.  The USPS recently cut rates for holiday shipping by large shippers, and it did take share from FedEx and UPS, much to their chagrin.

Delivering groceries with the current expensive workforce, work rules, and antiquated fleet seems ridiculous. Handling returns for online retailers should help fixed cost coverage and make some money.

However, without dramatically reforming employee heath and welfare benefits, this is all the usual posturing with no real reform.  Carper/Coburn makes noises about bringing these programs in line with other Federal agencies and about enrolling some beneficiaries in Medicare, but why should this be done solely for USPS, when Congress itself and the Federal government are all on gold-plated plans?

The bill also suggests that these proposed reforms are all subject to bargaining.  Goodbye to any meaningful reform.  Look for continued decline in the speed and quality of service ordinary consumers enjoy, and look also for more glum faces and surly workers at the post office.

IT Buyers Face More Regulatory Risks For Business Interruptions

In yesterday's post about Cisco, we stated our belief that IT buyers, whatever their justifiable complaints against their traditional suppliers, need them as real partners going forward because of the increasing risks IT leaders face if their systems suffer business interruptions.

In today's Journal, the case of Royal Bank of Scotland made the business pages as RBS paid a fine of $88 million for an IT failure that kept customers from accessing or transacting from their accounts reportedly for weeks.

British regulators opined that there wasn't a underinvestment in IT systems which led to the failure, but rather an absence of adequate software testing systems which led to the outage.  Heaven only knows how regulators who were asleep during the global financial meltdown suddenly have become expert in software implementation and testing.  This is, however, the world in which IT buyers, particularly in financial services, are going to function from now on.

To save pennies on a project, bring in newer,smaller unproven partners, or to piece together hardware, software and services on an a la carte basis would be a risky way to do business and it wouldn't be good for an IT exec's career.

The Four Horsemen of Tech will continue to have an advantage going forward in the new world of IT, if they can change their go to market strategies and become more customer-centric: they don't have any other options.

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. 

Dick Kovacevich On TARP and the Financial Crisis

Dick Kovacevich, the retired Chairman and CEO of Wells Fargo & Company is one of the best chief executives of the hundreds I have met during my career in the capital markets, though I never covered banks.  I heard him tell the story of Norwest Bank for many years, and it was always the same message about the importance of the retail 'stores' and improving the number of relationships per customer. My savvy banking analyst colleague at Roulston and Company held him in the highest regard also, and he didn't hand out plaudits easily. Mr.Kovacevich's  pitch was a model of clarity, simplicity, and focused on a few core metrics. The ROA, with a modest degree of leverage and a portfolio of businesses including asset management, led to a superior ROE: it was beautiful and simple.

When he took on the famous "merger of equals" that was Norwest and Wells Fargo, Kovacevich really stepped on the hornets' nest, but he handled it with brass knuckles in a velvet glove.  Having seen him during a few pickup basketball games, he was unassuming and never drew attention to himself. As a board member at Fingerhut, I know that he was always prepared, engaged and focused on getting the company to do the right thing for all stakeholders; when he couldn't meet his own high standards any more, he left the board. It isn't any coincidence that WFC has been one of Berkshire Hathaway's core equity holdings for many years.  His piece in the current Cato Journal caught my attention, and whenever Dick Kovacevich talks about banking and financial services, it's compulsory listening for me.

In 2009, in the din of drums beating for more special Treasury/Fed/government rescue plans, we stood along side a relatively small minority writing about letting the capitalist mechanism of bank failure under existing mechanisms do its job, as it had done before.  This post, it turns out, is being re-read often today.

CEO Kovacevich was in Washington, D.C. for the 2006 Treasury TARP meeting.  He writes,

"I believed at that time, and I still believe today that forcing all banks to take TARP funds, even if they didn't want of need the funds, was one of the worst economic decisions in the history of the United States."

The Sins of the Few, Not of the Many

At some point, all banking crises have at their root, a crisis of confidence. TARP destroyed confidence in the banking system because the public concluded that all the TARP banks had to be in trouble, otherwise why would they have taken the government's money?   Kovacevich writes that "...isolated liquidity issues turned into a tsunami impacting all banks and industries."

Fewer than twenty financial institutions precipitated the crisis, in his opinion. Dick Kovacevich writes that "The housing crisis got as big as it did...only because of the existence of quasi-public/private entities such as Fannie and Freddie."

Meanwhile, of the twenty institutions he references, half were investment banks and half were commercial banks, roughly. Citi was a commercial bank acting more like an investment bank. Why, he asks, punish 6,000 commercial banks for the sins of a relative few?

Bear, Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and others had liquidity crises. Their funding model where trillions in balance sheet assets were funded by short-term liabilities was toxic, just waiting for the music to stop when short-term funds couldn't be rolled over any more.

Abuse of the Term "Systemically Important."

After more than forty years in the banking business, Kovacevich writes,

"In my opinion, there was not any systemic reason to not let banks fail over this time."

Bear, Stearns which was half the size of Lehman Brothers should have been allowed to fail. Had this happened, he writes that Lehman's assets would have been sold as the BS workout would have provided market guideposts for bidders to price Lehman's assets. Under the secrecy of TARP, there was no transparency, and hence no confidence and hence the Treasury could talk about the lack of  bidders for all of Lehman, which is a red herring and disingenuous.

Regulatory Failure and Incompetence

One quarter after being forced to take TARP funds, Wells Fargo reported record earnings, the highest in the firm's 160 year history.  In less than one year, the TARP funds were paid back, along with $2.5 billion in bank interest cost of funds borrowed, and warrants required as part of the shotgun package for the unused and unwanted funds, were exercised in-the-money. 

When WFC stepped in to rescue Wachovia in the fall of 2008, it took about one week for WFC's auditors and examiners to conclude that expected losses and required litigation reserves would exceed existing reserves by more than $60 billion!  

How, the author writes, could have ongoing examinations by the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have failed to turn up this deficiency earlier?  

SEC oversight over the Financial Accounting Standards Board failed when it allowed FASB to impose mark-to-market requirements when markets had become frozen (i.e. failed) and unable to generate economically rational prices. All the market participants understood the market failure, but their opposition was cast politically as an aversion to regulation and financial discipline.  

The Fed's proprietary risk models overrode those used for the banks' own stress tests, and yet these models weren't shared with the member banks for comparison and testing.  The helter skelter regulatory regime required major banks to put forward profit and capital forecasts for the May-November 2009 in early 2009.  

The Fed's secret, proprietary risk models concluded that WFC's revenues would be 30% lower than WFC's own internal forecasts!  This kind of discrepancy should have set off alarm bells at the Fed, and making the models available for examination would have been the truly 'scientific' thing to do when confronted by an anomalous result like this.  Regulatory chutzpah, arrogance and incompetence fuelled by populist, anti-bank sentiments and by their highly paid outside consultants, ran high. 

Actual results for the forecast period were 2% above WFC's internal forecasts.

The Office of Thrift Supervision failed in its routine examination and regulation of Washington Mutual, Countrywide, IndyMac Bank, New Century, First Franklin, Option One, Fremont Financial and other sub-prime originators.  We have written about WAMU, Countrywide, IndyMac, and New Century in multiple posts.  Various reports by Special Masters/Examiners and others have made the egregious abuses available for anyone to see.

Things were dire at the massively mismanaged OTS, yet nobody was banned from their industry or prosecuted on the regulatory side. OTS was folded into the OCC: the regulatory apparatus wasn't held accountable or downsized, it just got swept under a rug with a new name.

A Simple Idea To Make Banks Stronger

Mr. Kovacevich notes that the total long-term debt of the bank and its bank holding company plus equity and reserves are broadly about 30% of assets, which should be more than sufficient to withstand even a black swan scenario. 

Debt holders, he rightly observes, contribute more capital and can impose more financial discipline than equity holders through either a bridge bank or through the bankruptcy mechanism.  If one felt that this cushion might not be adequate, the author says that an additional 5-10% holdback on uninsured deposits could be imposed; this proposal has been offered by many academic researchers on the banking system, such as Chicago Booth School of Business or the Columbia Business School. 

Dodd Frank Doesn't Make Our Banking System Better or Safer

25,000 pages of new law have not been translated into workable regulation even after more than four years after passage. Regulators have completed only about 52% of the 398 proposed new rules under Dodd Frank, according to the law firm of Davis, Polk. 

More than 100 highly trained and paid regulators office at, or work full time on the specific accounts of the largest banks on a routine basis.  

Fannie and Freddie are still around, not being wound down.  They have once again received the charter, just before the election cycles, to turn on the spigots and make home ownership accessible to all.  Have we learned anything?  No, but that's not the point in politics. 

I'll be posting on a fascinating book by Charles Calomiris (Columbia Business School) and Stephen Haber (Hoover Institution at Stanford University), "Fragile by Design."  It is a must read for any students of money, banking, financial economics and regulation.  

Missing the Mark on Medical Device Marketing

The Wall Street Journal headline says "Medical Devices Lack Safety Evidence" according to a study, not from an academic medical center or high powered clinical research group, but from yet another policy think tank.  It is very disappointing, and it isn't up to their usual journalistic standard.

Safety and risk profiles are reflected in the Class ranking of medical devices: Class I (bandages and surgical gloves, for example), Class II (e.g. infusion pumps and surgical drapes) and Class III(e.g. heart valves, stents, and orthopedic shoulder replacements).

The story reports the following:

"Most devices can get FDA clearance simply by showing that they are roughly equivalent to another product, called a predicate device, that is already on the market. The theory is that if the older device has proved safe and effective, the new one should be also."

"Most devices?"  Yes, a new surgical drape or a guide catheter won't require a full fledged IDE study; that would make no sense, there would be no reason to ever change an old technology, even if materials improved or manufacturing methods allowed miniaturization.  "Roughly equivalent" is the term of a bad journalist.  The FDA guidance says,

 "If FDA agrees the new device is substantially equivalent to a legally marketed device for which premarket approval is not required, the manufacturer may market it immediately."

Were the rule otherwise, the accidental company that came first to market would argue that everybody else required a full fledged IDE study for their improvement or enhancement.  Patients and innovation would suffer for no reason.

Class III medical devices rarely fall under the 510(k) labeling, because of their risk category.  The nature of the clinical study may be different.  All of this falls under the review of FDA staffers, aided by medical consultants, and in the case of companies pushed down the IDE path, a long, expensive, arduous and risky clinical trial path.

The 510(k) substantially equivalent pathway can involve bench data, lab studies, computer simulations, animal studies, or some combination of all.  Reviewers often add more questions and require additional data after the study process has begun.  Having been through it a few times, it is a bit arcane, and having "the public" read a bench study about laminar flows for a company's device adds nothing to the quality, cost or safety of patient care.

Post-market surveillance of cleared devices is definitely one area that needs to be improved, with more burden placed both on the device developer and the medical institutions that use them.  The premarket approval process itself could be made a bit more consistent.

And, a really significant problem is turnover and under staffing at the FDA itself, which I can say from experience, is widely acknowledged but not successfully addressed.

Alibaba: Open Sesame To the Uber Humongous IPO

In a recent post about emerging markets as an asset class for foreign equity investors, we wrote about some things they should look for in selecting their markets and their issuers:

"In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process." 

Despite the fact that the Alibaba IPO will be a record breaker in all investment banker metrics, it seems to lack these basic, critical features and it seems ripe for momentum investors and flippers, aka hedge funds.

A June 2014 staff report of the U.S.-China Economic Security Review Commission goes into the issues clearly and raises the potential legal, investment and governance issues for U.S. investors.  The Chinese government itself makes it a public policy to keep foreign equity investors in disadvantaged positions in their companies.  Yet, Chinese Internet companies have pursued foreign listings with a structure called Variable Interest Entities, which the report says may in fact be illegal under Chinese law.

Templeton's Mark Mobius points out the two-tier equity structure that clearly entrenches management and gives it and the preferred class effective control over corporate assets.  Disputes, he notes, must be settled in Chinese courts, despite the overseas listings.  Good luck with that venue for the poor common equity investor.

The reporter interviewing Mr. Mobius notes that Hong Kong regulators passed on allowing Alibaba to list on their exchange, in part because of the opaque corporate structure.  Asked why U.S. regulators allowed the listing on NYSE, he quietly notes several points, which I may paraphrase a bit:

• U.S. markets have never reformed, post-crisis.
• U.S. regulators serve their customers, namely the broker-dealers and their investment bankers.
• Out equity markets are driven by short-term investors who will flip the shares.

Ironically, some part of Templeton may get a few shares and flip them too.  If they are passing out free candy, why not take it?  But, the comments are sobering coming from one of the oldest companies in the emerging foreign equity investment business. 

Professor Anant Sundaram of Tuck Business School has made comments on the deal from the governance standpoint that worth reading, published in Barron's and the New York Times. 

When Ali Baba opened the door, it was to a wonderful land.  It will remain so until the door closes and investors long to return to the other side.  

Conflict Minerals and Costs to Shareholders

Here is the story from the Wall Street Journal:

"Good morning. Conflict minerals reporting can’t seem to get a break. First, the rule itself, required by Dodd-Frank, was found unconstitutional because it amounted to compelled speech, a ruling that forced the SEC to water it down. As a result, companies don’t have to declare whether conflict minerals are in their supply chains, but instead merely confirm that they’ve looked into it. But now the government has had to admit that it isn’t up to the challenge of figuring out which smelters are financing the violence in the Congo either.
The Commerce Department already missed its January 2013 deadline under Dodd-Frank to list “all known conflict-mineral processing facilities world-wide.” But on Friday, though the department published a list of 400 sites from Australia to Brazil and Canada, it also conceded that it “does not have the ability to distinguish” which are being used to fund militia groups, CFOJ’s Emily Chasan reports.
Companies including Intel Corp. and Apple Inc. said they spent years and millions of dollars investigating their supply chains for evidence of metals from mining operations that are paying for violence. A dozen companies acknowledged their suppliers may have obtained minerals from such mines, but the vast majority said they simply didn’t know. “At the end of the day, the conflict minerals rule creates the worst outcome—it has not helped lessen the conflicts in the Congo and creates economic harm in the U.S.,” said Tom Quaadman, vice president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness."

With all the potential benefits from improving disclosures that could meaningfully help investors assess the value and governance of their companies, our legal, accounting and political elites force the entire market apparatus to focus on things like disclosures on conflict minerals.  Irrationality is said to invade the market psyche in bubbles, but what about our normal regulatory processes? Regulatory capture is not something that happens only from 'big corporations' lobbying for their own narrow interests.

Institutional investors and fund managers have to pick their battles, and they don't choose to fight many. (see our post on the Sequoia Fund) Any institution that came out in opposition to these disclosures would be tarred as being insensitive, hostile to developing nations and poor miners, or worse.  The impact on their marketing and potential loss in net asset value make opposition a bad trade.  Just agree to pay tens of millions as a group, nod your heads in silence, and move on.

Legal firms and accounting firms have no downside to playing along, after all their billings increase from formulating, helping to create 'systems' and monitoring the meaningless disclosures.

Politicians love this, because they can take credit for addressing a real issue, which indeed 'blood diamonds' and 'conflict minerals' have been for many, many decades, without having to break a sweat or taking any interest in the real problems, which are not about disclosures.

The regulatory arena, in which players on all sides act rationally from a financial risk-reward point of view highlights the dead weight losses absorbed by our financial system from an incoherent, growing web of arcane regulations surrounding accounting standards and financial disclosure.

Bank of America, Agency Problems and Selective Blindness in Our Judicial System

We wrote a widely read post about Bank of America's $40 billion mistake in acquiring Countrywide Financial back in 2012, which we link here for context.

The government's 2012 complaint in Federal Court (Southern District) makes interesting reading also for context to the current settlement debates.  According the Feds, Countrywide engaged in a scheme to defraud FNMA and FHLMC, and as a consequence the GSEs suffered more than a billion dollars in unreimbursed losses.

The story picks up, for some reason, in 2007 when Countrywide's originations had fallen from $490 billion in 2005, to $450 billion in 2006 to $408 billion in 2007.  A very superficial discussion of the monthly loan performance monitoring program required of the originators by the GSEs begs a very important question. Surely, delinquent or non-performing loans (here referred to as loans with 'defects') would have been evident from the 2005 vintage long before 2007.  There are mechanisms for dealing with these problems from the GSE perspective, including putting the loans back to the originators.  One would also think that reimbursement or compensation provisions would have been part of normal securitization agreements.  None of this is even mentioned in passing.

As we have said before, agency problems for Countrywide shareholders existed writ large because of the behavior of CEO Angelo Mozillo's outlandish behavior, which has been covered widely in the press. His compensation, bonuses and option grants were conditioned on the volume of originations, even if they were subprime 'stated income,' 'liar loans,' or 'NINJA loans.'

Mozillo, in turn, created compensation opportunities for Franklin Raines, who eventually relinquished $24.7 million of ill-gotten stock options gains from a reported six year earnings manipulation scheme, over which his gains would have surely been greater than $24.7 million. Mr. Raines never felt the heat and wrath of Federal prosecutors, rather his slap on the wrist came from another Federal oversight agency. Why wouldn't the full force of our justice system fall on two kingpins of this mess?  Justice for friends is different from justice for those deep pocketed corporations, who are giving up shareholders' money in the end.

In the government's complaint against Bank of America, there are a few selected quotes from the former CEO and from the current CEO which should arose the ire of BAC shareholders.

"We did extensive due diligence...It was the most extensive due diligence we (Bank of America) have ever done.  So we feel comfortable with the valuation.."  Former CEO Ken Lewis.

"....we will pay for all the things that Countrywide did."  Loose language from current CEO Brian Moynihan.
Fast forward to the recent imposition of fines by U.S. District Judge Jed Rakoff.  As one reads through the 19 page opinion, the judge's conception of gross versus net losses and his infantile examples seem to challenge the usual shibboleth that Federal court judges are more capable of understanding complex financial issues. Recent problems arising in the interpretation of potential sovereign defaults by Argentina raise similar issues.

The total value of 17,611 loans issued by the HSSL loan mechanism of Countrywide amounted to $2, 960,737,608.  But, 57% of these loans were, in the opinion of the government's 'expert' not in fact bad apples.  So the final penalty imposed was 43% of the maximum, or $1,267,491,770.  The wisdom of Solomon!

As Harry Truman said, "The buck stops here."  Well, what about the higher ups who sanctioned all ludicrous, uncontrolled financial malfeasance at their institutions?  According to Judge Rakoff, "....the fact that other, higher-level individuals arguably participated in the fraud but were, for whatever reason, not charged by the government..." doesn't rise to the level of this judge's scrutiny.

Instead, he lays liability at the foot of Rebecca Mairone, a Countrywide executive, who took the actions necessary to perpetuate the fraud described in the complaint.  Was she a lone, rogue agent?  Not hardly. Her crime seems to be having given "implausible testimony."  Judge Rakoff is given to pats on the back and slaps in his opinion. Attorneys on both sides are described as "excellent" (from Wayne's World?) and "superb."  Ms. Mairone apparently wasn't well coached by her excellent attorney to not give implausible testimony.  The jury in fact asked Judge Rakoff why the higher ups weren't being brought up on charges. They got the answer quoted above.

Finally, we are left with Bank of America, which recently reported results. Earnings were a bit better than expected, analysts claim because of expense controls, better than expected trading revenues, and lower provisioning, offset by much higher than expected legal expenses.  Revenues from the core banking businesses were, however, disappointing.  I wonder what will drive 2014 incentive compensation for the executive team?  Based on current expectations, BAC looks fully valued, but longer term its future growth, if it can ever put Countrywide issues behind it, still remains in question.

Productivity Growth and Corporate Underinvestment

Share buybacks have entered the realm of the new corporate orthodoxy.  Much as we have liked, and ourselves implemented, buybacks, they are now being used somewhat mindlessly, especially by mature technology companies, like Cisco and H-P.

When a corporate CFO says that "We see no better investment than our own shares," that statement shouldn't be allowed to pass without some clarification.  Likewise when the target of returning fifty percent of quarterly free cash flow to shareholders in the form of dividends and share repurchases is adopted, a question should be raised about how the math works on this kind of capital utilization.

These statements co-exist with the statements that cloud computing, for example, is the most disruptive technological change since Silicon Valley became a brand.  If this is true, and earnings are under pressure from short-term and long-term trends, then wouldn't it be better to invest in corporate internal projects to position the company for the new future?

Likewise, acquisitions when public market valuations are at local historical highs wouldn't seem to be obvious choices for use of cash.

Where may some of the fallout from these trends be seen?  Productivity, which is measured in many different ways, e.g. output per hour worked, total factor productivity, and capital per worker.  The macroeconomic analysis of productivity has always been a relatively weak area of economic research, but the various time series put out by our BLS do have the advantage of going back a long way.

Looking at one series, real output per hour worked for non-financial corporations, something noteworthy can be seen. The series is indexed to 2009=100, to coincide with the business cycle recovery. The linked chart shows the index at 107.1 in January of 2012, and stuck at 107.7 as of October 2013.

On a broader front, U.S. GDP growth fell to 1.9 percent in 2013, while hours worked rose by 1.1 percent, according to the Conference Board. So output per hour grew by 0.8 percent, and output per hour in manufacturing actually fell.

None of these trends bode well for labor incomes.  Companies like Exxon which are increasing their exploration and capital budgets are largely doing it outside of the U.S. as environmental regulations and energy policy politics make it rational for them to look for opportunities elsewhere.  Tech companies with huge cash hoards held abroad, which are then leveraged for share buybacks and dividends don't serve the long-term interests of shareholders.

Surely, there must be some politicians somewhere who could team up with corporate executives to create a framework for better capital allocation and investment in our businesses rather than in financial engineering. Continuing down this pathway may feed equity markets, but it won't fuel the economic future for the next generation of our labor force.

Our Biggest Banks Are A Mixed Bag

Our March post on the Fed stress tests on our "Four Horsemen" of banking seems like a good background for discussing the first quarter's results for Bank of America, JP Morgan Chase, Wells Fargo and Citigroup.

Bank of America had a lackluster quarter with the biggest surprise being its $6 billion in litigation expense five years into the purported economic recovery.  Analysts concluded that litigation expense was impossible to model, especially given the Catch-22 of the company's not wanting to tip its hand to the plaintiff's bar about how much goodies the legal reserve cookie jar held.  The acquisition of Countrywide Financial continues to plague this company, and no one is in jail.

The return on equity was a paltry 4.6%.  Yet, the P/E is the highest among JPM, BAC, and WFC.  Merrill Lynch may eventually be passed for the most AUM by Morgan Stanley Wealth Management, and it's unclear what synergy the Thundering Herd gets from association with Bank of America.

We've said for a long time that the biggest problem at JP Morgan Chase was not size but complexity.  We characterized this leviathan as "Too Complex To Manage," even for the loquacious, highly numerate, quick witted Jamie Dimon, as the London Whale episode pointed out.  His lieutenants, through all the musical chairs, have not served him well. As time has gone on, our faith in the TCTM thesis is stronger than ever, no matter what any cyclical improvement over trashy quarters might suggest.

The number driven, traditional banker's philosophy that Jamie Dimon brought to Bank One was one of the reasons for its success, plus it was already a well established, high quality name before he became CEO. JP Morgan Chase is a completely different animal, crafted by putting together one of the premier investment banks in the history of American finance with a badly managed Chase Manhattan, a well managed Bank One and many other acquisitions which all together result in the beast that is now a collection of very large fiefdoms.

The management should clean up the portfolio and structure before multiple regulators so something more damaging to shareholders. Average loan balances fell across all market segments, and mortgage originations fell by 68% over the TTM.

Wells Fargo's performance was the best overall in the quarter with its 17th consecutive quarter of earnings growth (+14%) and its dividend increase of 17%, without any surprise in its capital plans with the Fed. It continued with its share repurchases as well.

Deposits grew by 8%, a very healthy number in this environment. Net charge offs were 0.41% of average loans in the quarter and they were down 42% year-over-year.  ROA was a healthy 1.57%, up 76 basis points, and ROE was 14.35%.

The company has quietly moved its institutional and high net worth asset management businesses upstream to customers with significantly higher minimums, and in some areas like stable value the Galliard Capital subsidiary will end the quarter with assets over $100 billion.

The one thing missing from WFC which JPM and C have is significant international exposure.

Which brings us to Citi.  This is still the biggest rabbit warren. It is a structurally messy, grossly under managed managed bank, but the problem didn't originate with Vikram Pandit or even with Charles Prince.  It goes right back to the Sandy Weill-John Reed fractured relationship over decades ago.  Citi, however, has the potentially most valuable future franchises in Asia and Latin America.  It must escape its legacy of Citi Holdings and somehow craft a rational organizational structure and a responsible culture, which it sorely lacks.  It has no Jamie Dimon or John Stumpf.  It could use some activist investors to help whip itself into shape.

Andarko Gets Caught For Kerr-McGee Subterfuge

Kerr-McGee was founded in 1929 as an exploration and production company.  Over time, it diversified into a number of other extractive industries, such as its 1952 entry into uranium mining and milling.  At a time when the Cold War had the U.S. and Russia in an all out nuclear arms race, this probably seemed like a good business to enter. Uranium mining and processing operations were carried out at multiple locations, including on tribal lands of the Navajo nation.

In 1963, Kerr entered into a creosote business for treating lumber, and in 1967 it acquired American Potash and Chemical Company in Henderson, NV which produced perchlorate ("perc") for use in rocket fuel, targeting demand from government space programs and Defense department projects.

Over time, investors grew disenchanted with the conglomerate or portfolio approach to creating public companies. "Focus" became the mantra, partly because it made investor valuation easier and, the story goes, leads to higher multiples without the conglomerate discount.

Lehman Brothers, as Kerr-McGee's banker, encouraged the company to slim itself down into an E+P company, the original business, and a titanium dioxide business, the critical commodity for all manner of residential and industrial paints.   By 2005, Kerr-McGee had reinvented itself, but court documents note that exploration and production produced $1 billion in income in that year, while the Ti02 business generated a little over $100 million in income.

As early as 2002, Andarko Petroleum had taken a hard look at Kerr-McGee but it clearly had no interest in the peripheral businesses, and Andarko wanted to stay away from the large legacy environmental liabilities from businesses like creosote and uranium mining, among others.

So, the bankers came up with the classic, cookie cutter strategy of creating a corporate entity into which to deposit all the legacy liabilities.  In itself, this is neither new nor inherently sinister strategy, provided that the new entity, called Tronox Worldwide, LLC had adequate funding and prospects for financial viability. This structure has been used successfully for asbestos, lead paint, and other long-tailed, costly liabilities.

Andarko acquired Kerr-Mcgee in 2006, a few weeks after the Kerr had divested the legacy environmental liabilities via Tronox becoming an independent company.  When I first read about the liabilities coming back to Andarko, I wondered if regulators had once again overreached arbitrarily into structures that had been used before in the normal course of business.

Reading the court documents, this is clearly not a case of regulatory overreach, although the suit was based on the theory of fraudulent conveyance in the assignment of liabilities to Tronox, including pension obligations. Kerr also raided the cash coffers of the former subsidiaries.  Bondholders of the old KM didn't protest, because they got some special protections, since their indentures specifically prohibited this kind of financial 'three card Monte.'

The executives at the old Kerr-McGee ran an organization whose normal industrial safety and environmental policies were woefully deficient.  They also had the temerity to suggest that the creation of Tronox had nothing to do with offloading the liabilities and weren't motivated by thoughts of a transaction.  Given the record, and common sense, this is laughable.

Prior to cutting Tronox loose as an independent company, the old Kerr-McGee stripped out 83% of the revenue and 113% of corporate income, according to the court documents. Lehman Brothers had looked for other options for Tronox, including spin-off, but they clearly knew that it was a dog, or in the parlance of the financial crisis, a "piece of ***t."

So, the argument of fraudulent conveyance, ex post, proved to be an easy case to make.  Andarko seems to be able to deal with the now, much larger environmental liabilities and associated fallout from the Tronox bankruptcy.

This unfortunately is an example of agency problems with the interests of executive management as agents lying with the creation of Tronox, either in ignorance or of a cynical assessment that the day of reckoning would be down the road after they were all gone.  So it goes.

Fed Paper on Unconventional Monetary Policy

A paper by J. Rogers (FRB), C.Scotti, and J.Wright (Johns Hopkins) was reported in the Wall Street Journal, but it has been out for a while.  We had read it, and it's interesting.  But, it limits its questions to the paths of interest rates, stock prices and exchange rates under the unconventional policies across developed economies.

The paper does not address our question about the broader and much more significant, unintended consequences of the policies, especially for the future. For the question asked, the unconventional policy and its communication to the market performed in line with standard policies, especially as regards bond yields.

The paper indirectly points out the market's acceptance of the Bernanke Fed's communications or forward guidance code, which certainly became as comfortable as an old flannel shirt.  As regards the Yellen Fed, "We aren't in Kansas any more, Toto."

The Yellen Fed Doesn't Sound Like A Central Bank

Too much was made over the choice of successor to former Fed Chairman Bernanke.  Making the choice a political or gender equity issue would not have been a good thing, and it seemed logical that someone who had been a longstanding partner to Bernanke would assure continuity, thereby assuaging nervous markets.

Unfortunately, the early "communications" issues have unsettled even the most experienced Fed watchers I know and respect. John Cochrane, AQR Professor of Finance at Chicago Booth School of Business, has identified the underlying problem as being that central banking globally has morphed into something that it is not, claiming powers that it does not have.

That was made manifest recently, in Fed Chair Yellen's public pronouncement about the Fed focusing its policies on labor markets and unemployment.

Given that macroeconomic models don't incorporate any kind of realistic financial sector, and given our very weak recovery, in its fifth year, had its origins in the financial sector and asset markets, no responsible economist could claim that the Fed has the understanding or tools to address failures and frictions in the labor market.

As we've written about many times, unconventional monetary policies such as quantitative easing and unbounded periods of low interest rates have have essentially done nothing for the economy, as evidenced by the unemployment rates.  Again, as we warned from the outset, these novel constructions would have unintended consequences given our lack of experience with their mechanism of action.

Former BIS Economic Adviser William White's paper, which we've cited before, is still worth reading. Focusing on the shadow banking system, he cites research suggesting the shadow banking system was procyclical in the credit upturn, which seems well agreed upon; he also suggests that it may be procyclical in the credit downturn, which is debated.  In a simple model, he shows that the behavior of this sector and our financial sector as a whole, may be a powerful mechanism for increasing inequality of both income and wealth.

Right now, we have a disconnect between expectations for what central banks can achieve (remember Mario Draghi?) and what they really can do.  Dodd-Frank has made the Fed the de facto Regulator-in-Chief of the financial sector, and the guardian of asset prices, housing prices, and architect of financial stability.  To this we are adding labor markets and unemployment.

We've written before that one of the greatest strategic blunders made by the Bernanke Fed was to effectively become an enabler for fiscal profligacy by his employers in the White House and Senate.  The role of the Fed Chair historically was more 'big picture' focusing on rates, inflation, and the currency.  This is a massive agenda in itself, but the Fed was never to be the engineer of policy.  It provided the backdrop for markets to set the term structure of rates and for the economy to move forward with real economic growth.

When warranted, the Fed Chair would call for fiscal responsibility from the executive and legislative branches, and sometimes the Chair would have to 'lean against the wind,' even if only rhetorically.  That's because the Fed was always independent of elections, politics, and of the noisy public square, including Wall Street.

Today, the Fed no longer makes any call for responsible fiscal policy, and now it is firmly in the camp of perpetuating the current status quo of discretion based, as opposed to rules based policies, which is disquieting to experienced Fed watchers who could always infer a path from Taylor Rules and the like. Now, all bets are off. So, financial markets continue to soar, our inflation rate is minimal, corporate profits are up, and the bubbles continue in corporate assets (companies) fueled by large appetites for investment grade corporate debt.

Meanwhile, the traditional financial sector, namely the six mega-banks are effectively becoming ensconced as the heart of our financial system, with no effective competition.  We still don't know what systemically important means, as we randomly suggest that it applies to insurers like Met Life and to asset managers.

Because of the cynical way in which Dodd-Frank was passed, the regulations that will be at the heart of the future evolution of the system and the source of shocks, are being written away from the eyes of the electorate by anonymous lawyers and policy wonks, all aided and abetted by their favored activists and lobbyists.

The final problem facing central bankers is the IMF's incessant clarion call for national central banks to make their decisions in "a global framework."  This sounds like an innocuous platitude, leading to many meetings at tony locations with lots of papers and meaningless declarations. John Cochrane adds that the real motive may be to pool together all the lenders of last resort and to spread the costs of carrying the weaker players among the stronger players. Our Federal Reserve and the taxpayers certainly doesn't need to take on that burden too.

Central bankers need to be independent of politicians and of Wall Street gunslingers, and their measured, predictable tweaks to the economic engine which enhance growth, moderate cycles and preserve the value of the currency are their most valuable contribution to Main Street.

The Fed's Stress Test Gives Citi Heartburn

We were in the minority when Citicorp removed Vikram Pandit from the CEO position and replaced him with Michael Corbat.  There were loud huzzahs from many quarters, from Sheila Bair to the financial press. Things were going to move much faster now, the chorus said, and shareholders would be rewarded handsomely; the stock did extremely well, but today the Fed took the wind out of Citi's sails by both announcing that it had failed its 2014 Comprehensive Capital Analysis.

Analysts' euphoria has reached such ridiculous heights that the WSJ reports analysts expected Citi to raise its dividend from $0.04 per share to $0.53 a share.  Analysts have been known to access controlled substances from time to time, but it would also seem that they were probably pointed to this kind of increase by  naive management guidance.

The bizarre thing about the CCA, is that Citi passed the quantitative portions of the test.  Consider this,

"Therefore, even if the supervisory test for a given BHC results in a post-stress Tier I common ratio exceeding 5 percent and post-stress regulatory capital ratios above the minimum requirements, the Federal Reserve could object to that BHC's capital plan based on qualitative assessment of the practices supporting its capital planning."

Now the problem is that the Federal Reserve has become another reviewer of Sarbanes-Oxley.  Consider this quote from the 2013 auditor opinion letter on Citi's financial statements on Form 10-K.

"We (KPMG) also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Citigroup’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 3, 2014 expressed an unqualified opinion on the effectiveness of the Company’s internal control over
financial reporting."

But if the Fed, using another set of arbitrary standards, opines that the capital planning process is inadequately supported by reliable practices, then this inadequacy must be reflected in the financial statements.  But, surely the auditors must have gone into more detail than the Federal Reserve?  Something has gone seriously wrong with the CCA process.

Let's be clear that nobody is a hero in this episode.  CEO Corbat deserves a reprimand from the board for allowing his company to be blindsided by its principal regulator. His job was to be far out ahead of this process and to make any changes necessary to achieve the corporate goal of passing both the quantitative and qualitative tests. Former CEO Pandit was said to be "prickly," but CEO Corbat seems inept in dealing with the arbitrary Fed framework. Also, his aggressive plans for capital return to shareholders were premature and unwarranted.

Mr. Corbat, in turn, should probably quite a few changes to his financial organization's senior ranks, and for that matter, to his board.  Why? There is no excuse for not being able to run a stress test, which is not new, to the Fed's specifications.

KPMG should also take some accountability, or they should explain to regulators that they stand behind their assessment of the banks's internal controls, on which they rendered an unqualified opinion.

Remember, finally, in the Fed's recently released FOMC minutes archive the discussion revealing that the Federal Reserve couldn't even figure out that IndyMac was failing even when mortgage brokers and most of the industry knew it months before.

The Federal Reserve didn't adequately audit its member banks in the past, and that is plain even for its staunchest apologists. However, now it seems to have gone too far in setting standards and seemingly not applying them consistently, while also treading upon regulatory oversight of other organizations, like the SEC.

Exxon's Solid 2013 Positions It Well for The Near-Term Future

Mutual fund investors who managed to avoid the global, integrated oil companies in the fourth quarter did well, and those who bought oil field services companies improved their performance relative to benchmarks. But, as prosaic and unloved as these companies (Exxon Mobil, Chevron, Shell, Total, and BP) are, they will be important to global development and to portfolios in the future.

Value oriented investors tended to take positions in Chevron, which has awakened to the importance of returns on capital for growth and portfolio management in the future.  If their returns improve, their stock should do well, since it is relatively cheaper than Exxon.

Exxon's 2013 after-tax earnings from Upstream activities were $26,841 million, down about $3 billion from 2012.  This decline was driven by foreign operations with after-tax earnings of $22,650 million, down $3 billion from 2012.  U.S. operations had a good year. Higher gas realizations ($4.60/kcf vs.$3.90/kcf worldwide) were offset by lower realizations on petroleum liquids; the net increment to earnings was $390 million. Adjusted production was flat.

Upstream activities generated a return on average capital employed of 17.5%, with average capital employed at $152,969 million and capital expenditures of $38,321 million.  The portfolio mix of projects coming on stream around the world (six major projects including the Kearl Athabasca tar sands project in Canada) is well balanced from fuels, geography, and technology viewpoints.

Chemicals had 2013 after-tax earnings of $3,828 million, and a ROACE of 18.5%; the capital base was $20,665 million and capital expenditures were $1,832 million.  The bulk of chemical earnings, $2,755 million, came from U.S. operations, and this is where continuing opportunities for volume growth and profit improvements exist out to 2018 in the current plans.

Exxon is the largest chemical and natural gas producer in the United States.

Downstream operations, including retail gasoline operations, generated after-tax earnings of $3,449 million, with an ROACE of 14.1%.  U.S. operations generated earnings of $2,199 million in 2013. Overall, Exxon's returns on capital continue to be superior to its four peers listed above, no matter what the macroeconomic environment.

Over the next five years, the company expects oil-equivalent production from North America to grow from 32% of production currently to 35%.  Over the same period, LNG production is expected to increase to 55% of production on an oil-equivalent basis from 45% today.  Both of these mix shifts should be positive.

Exxon's $19 billion LNG project in Papua New Guinea is slated to load its first cargo in 2014.  This 6.9 million metric ton per annum project is extremely complex from the engineering, logistical and environmental management standpoints.  PNG is a difficult environment in which to get projects done, as they dithered for years on a seabed mining project, putting it though endless hoops that, along with a global recession, eventually put the project in a deep freeze.

This project's output will be primarily for export,and so it should be a great laboratory for our domestic cries to export LNG from the U.S. Exxon's project, in which it has a 33% operating stake, includes 253 miles of subsea pipelines connecting eight gas fields, with a gas conditioning plant and the liquefaction plant.  One of the real moats that Exxon has around its business is the depth and scale of engineering, procurement and project management expertise that permits it to work in all kinds of challenging physical environments.

Regulatory and compliance expense for all the global majors has been increasing much faster than revenue or profit volumes.  It is good to see the company organizing itself into nine or more cross-organizational teams to deal with global issues like Risk Assessment and Management and Incident Investigation and Analysis. This seems like a way of organizing that makes sense for the business, as opposed to checking a box required by incoherent legislation.

Despite having a robust capital spending plan and returning $25.9 billion to shareholders (the stock has a 2.6% dividend yield even after the run-up), Exxon filed a $5.5 billion shelf for a multi-part debt offering, with a AAA rating from both Moody's and from Standard and Poor's.  Proceeds will be for capital spending, acquisitions, and for refinancing of commercial paper.

A strong balance sheet along with disciplined capital utilization is a good tonic for shareholders.

Justice Department Holds Up Toyota Shareholders for $2 Billion

In 2012, we wrote an entry "Class Action Lawyers Stick Up Toyota for $1.1 Billion."  With the announcement that another billion dollar settlement with the Federal government was in the offing about alleged problems with disclosures to government inquiries, the episode has cost the company well over $2 billion.

The problem is the same as it was in 2012.  The NTSA and NASA studies into the sudden acceleration problem, beyond the acknowledged intermittent issues of pedal entrapment or the pedal sticking, could not be duplicated by the best technical investigative agencies we have.

Most of the first billion dollars went to attorney fees and to research on automobile safety.  It would be nice to know what politically favored organizations are doing that research and what they're coming up with.

The 2011 reports are still available on the NTSA website.

Toyota has paid out billions, suffered economic damage to its reputation, and lost sales for not being forthcoming, or as the WSJ writes about today for bad paperwork.

Toyota, like big banks and other big corporations, knew that it was better to transfer wealth from Toyota shareholders to the supreme beings at the Justice Department than to soldier on about facts, which are irrelevant when corporations are involved.