JP Morgan: Size Alone Is Far From The Problem.

The financial crisis happened, and the response of our journalism machine, politicians, regulatory bureaucrats, academics, and corporate apparatus is put out mountains of reports, testimony, articles and propaganda about what happened.  Nobody reads this material, so the operative narrative is written when the dust has settled and memories have become cloudy. 

The best picture of what happened inside of JP Morgan Chase is provided by their own report on the London Whale trading fiasco. After reading the report in conjunction with mountains of other publications, and having worked inside the bowels of several money center banks, I concluded,

"Institutions like J.P. Morgan are TCTM ("Too Complex to Manage") The talk about the "London Whale" does nothing more than anthropomorphize the huge, systemic risk posed by institutions like J.P. Morgan Chase.  The 2012 CIO losses cannot legitimately be attributed solely to the behavior of one trader, or even to a group of traders."

Today, a spokesperson from the CFA Institute is quoted as saying in the New York Times, 

 “With respect to the big banks, it is not so much a culture problem but a complexity problem,” said Kurt N. Schacht, a managing director at the CFA Institute, an organization that promotes ethics and standards at financial firms. “We think these firms are so large that they are always going to be plagued by rogue operators.”

It's nice to be out ahead of the consensus narrative on complexity versus size, but really to take billions from the shareholders of J.P. Morgan Chase makes little sense from the point of view of simple justice.  

The Madoff fraud was out in the open for anyone to see who was doing their jobs, and this means the SEC in particular. The best due diligence is often very straightforward, and after the fact seems simple, but it's not.  Harry Markopolos did his job when he tried to replicate Madoff's published trading strategies in a real market.  There were others on trading desks who had never heard of Madoff, despite the huge trading volume he would have created if his strategies had been real.  These traders were always under the regulatory umbrellas of FINRA and the SEC, and it would have been easy to interview them and ask them about the Madoff funds.  Harry did the math, and he reported it to the SEC. It went nowhere. The SEC, and its highest officers, should pay the billions to Madoff investors because the evidence was put right in front of their noses and they ignored it 

Besides turf wars between the Boston and New York offices of the SEC (a hallmark of government regulatory and prosecutorial operations), Markopolos "describes poor investigative ability at the SEC." In the newly minted, redacted press narrative, J.P. Morgan Chase pays the bill because they can and because they have little choice.  The people who failed to do their jobs have new leaders, more notoriety and bigger budgets.  Go figure. 

IBM CEO: All Is Not Well With Watson

Well, the big announcement came from IBM, and it wasn't at all surprising.  It also leaves questions unanswered.  The NYT headline reads, "IBM Is Betting That Watson Can Earn Its Keep."

The Watson Business group will have three relevant features that speak to the weakness of the initial concept. 

• Locating it in the East Village far from Armonk speaks to the need to develop a different kind of culture from Big Blue. It is also allows the company to draw from a wider base outside of New York City, since it is easier to get to the Village than it is to Armonk. Princeton and the little tech belt in New Jersey come to mind.
• Experts in industries will be part of the development team. This would presumably address problems the Watson project has had with clients, including WellPoint. 
• The group will have a small venture fund, which clearly says that the basic computing platform needs innovation around its analytical core which can't be done quickly through IBM. 

Henry Morris of IDC says what we've been saying for some time,“Big Data by itself isn't value, it has to deliver recommendations about what to do,"  It can't do that until IBM works directly with its customers to help them understand the dynamics of their own businesses in a way that's helpful to the computer's modes of operation.

Yesterday's comments from WellPoint's Vice President about the IBM Watson experience are a bit puzzling. She said, "...Watson initially took too long to "learn" WellPoint's policies. The task was then to check against treatments for beneficiaries to see if they complied with the policies.  This is not at all a super computing task. IBM's inability to essentially design Google-type searches around the problem seems hard to believe.

The problem, as we said yesterday, is not all about hardware or software--though the latter is a real issue--but it's about being able to work together with the customer and to really understand their needs, as opposed to fobbing off an order for some iron, software and support, which is the traditional IT package. 

On the next conference call, look for analysts to seek revised and specific goals for the Watson Business Group like revenue, net effects on expenses, and earnings contribution to the Road Map.  Get working on those slides now!

Finally, the comparison of the current CEO's early tenure with that of former CEO Sam Palmisano leaves out the luck factor and timing of market and IT cycles.  This is a different time and a different environment, and there needs to be more work done on IBM's sales and customer service paradigms than was evident during headier times.  

IBM: Watson Needs A New Sales Mentality and Model

We believe that super computing is an opportunity for a limited number of global players in the future. Super computing is one of the areas where a tangible connection can be made to the whole ephemeral concept of Big Data.

Particle physics research, running large scale climate simulations, and weather forecasting are examples of a few areas where customers are deploying super computer configurations and buying new iron. These are long cycle, episodic big ticket sales. This is not what IBM is used to doing.

Personalized medicine and supporting patient diagnoses with simulations and statistical analyses have a long way to go, and it's not clear that this will generate the kind of quick fix revenue growth that investors like.

One of our most widely read posts talks about the IBM Road Map and some of its assertions, which might not be consistent.  The problem is, as it is for most of the Tech Giants, revenue growth.  We noted,

 "The Road Map assumes, on average, 11% a year in constant currency growth contribution from IBM's "growth markets," which means non-North America and developed Europe.  It won't be easy."

 Markets outside North America and developed Europe surely won't be driven by super computing sales. And, furthermore they will likely vary too much quarter-to-quarter to move the consolidated revenue number on a consistent basis.

So, back to super computing. Much of the hype surrounding Watson comes from IBM's own PR that attempts to differentiate itself from other super computing players by talking about "machine-based learning." That is, the machine starts working on a complex business or process and quickly learns where it can produce better results and adjusts itself.  Some of the thought behind this is futuristic, but much of it comes by analogy from Deep Blue/Watson's work on chess and Jeopardy! where this process worked well.

The big difference?  In both these cases, the rule books were rather small and rigidly defined.  They were fixed and would not be improved.  Even though chess has lots of combinations from a move, the whole computational matrix had boundaries defined by the board, numbers of pieces, and rules limiting the kinds of moves a piece could make.

A machine learning a business today is hype.  Today's WSJ article essentially has the customers saying so.

"For example, Watson's basic learning process requires IBM engineers to master the technicalities of a customer's business—and translate those requirements into usable software. The process has been arduous."

The first problem is that most customers don't understand their businesses well enough to document the processes in flow charts or decision trees.  Heuristics are in place that work currently, but many of these reside in people or groups.  All of this has to be documented, processed and checked by the IBM engineers and then written into software.  Only then can the machines try their hand at simulating, modeling and back testing the results.  This process, as opposed to the hyped "machine learning" is time and people intensive.

The sales process for this kind of deployment is not the kind that tech salesmen like, viz. find an upgrade area and make the sale on specs, provide financing, and book it just like you've done for years.  Aftermarket support can be done by relatively lower cost resources doing traditional IT fixes.

The kind of post-installation support, including business consulting as opposed to IT consulting, required at a large medical institution is going to totally different from what IBM is used to providing.

"So far, just a handful of customers are using Watson in their daily business. With the supercomputer's help, health insurer WellPoint Inc. determines if doctors' requested treatments meet company guidelines and a patient's insurance policy. Elizabeth Bigham, a WellPoint vice president, said Watson initially took too long to "learn" WellPoint's policies."

So, the IBM CEO felt confident, based on the enthusiasm of her senior sales exec that Watson would have the fastest path to $1 billion of revenue of any venture in the company's history.  IBM really needs to do a lot less of the tiresome "Smarter Planet" brand building, and a lot more rethinking of its sales processes, organizational structure and sales execution before the path to journey's end on the "Road Map" becomes clear to investors.

QE: We Don't Know How It Works

We've never been a fan of the new Fed monetary policy, and here's an excerpt from a 2012 post on the subject:

"First things first.  No QE3.  No Operation Twist and Shout. No more monetary "Shock and Awe."  Lowering rates further or keeping them low indefinitely will NOT raise the "animal spirits" of entrepreneurs and megacap corporate CEOs.  Why?  If there's no reasonable prospect for increased final demand in the foreseeable future, businesses will sit on their cash because the capacity increasing projects still won't be worthwhile even if rates decline by a further 30 bp.  They will instead pursue mega mergers and short-term measures to raise their share prices. Larry Summers makes this point in more colorful language than I can conjure up.
Fiscal policy should be aimed at nudging, cajoling, and jawboning industry to build more pipelines to move North America's increasing energy resources to where consumers need products, building LNG terminals for export, building more refineries, switching coal plants to gas, and building out the power grid and telecom infrastructure, to name a few.  We have to get rid of the budget-busting social initiatives currently in place in order to accommodate a change in the expenditure mix.
Investing in what we need to become productive in the future would be a desirable by-product of this persistent low-rate environment.  Its blind perpetuation would be a continuing transfer of wealth to financiers and speculators."

 Well, it seems that even the architects of quantitative easing don't really know how or why it works.  New York Fed President William Dudley, himself an alumnus of Goldman Sachs, should certainly be among the most qualified to understand the effects of QE on investors and on market behavior.  Instead, we read in the Wall Street Journal that,

• Mr. Dudley and Fed Chairman Bernanke see "clear benefits" from QE
• Mr. Dudley acknowledged that a lot is still unknown about how the bond buying works
• "we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”

One would have thought this statement would have generated some market consternation, but with the continuing euphoria the markets remain strong.  

Unwinding the Fed balance sheet, or removing $2 trillion in deadwood from commercial bank assets at the Fed, will not be simple.  The proposed reverse repo mechanism is fraught with risk and unintended consequences.  I hope to return to this in a future post.

Fed President's Plosser's consistent concerns about the Fed balance sheet have characterized him as a 'hawk,' whatever that is, but now his concerns have been echoed, in different language by a 'dove.'

Separating Symptoms From Disease at Microsoft

The WSJ has a piece on the fact that Microsoft after four months hasn't chosen a successor to CEO Steve Ballmer.  Yes, this is a comparatively long period as corporate searches go, and yes the issues they point out real, if not obvious.  Both co-founder Bill Gates and his hand picked, ineffectively long serving CEO Ballmer are still on the board, which creates problems for a successor who wants to clean sweep the company.  The bizarre presence of Value Act investors on the board means that they are suggesting one of several possible value enhancing strategies which are out of step with incrementalism.

All of these are symptoms of the real underlying problem: Microsoft's current corporate structure is inefficient and ungovernable, if the goals are to use capital efficiently, create incentives for employees, maximize its market opportunities and to create substantial shareholder value.  Looking to one messianic leader to exert magic with the current structure, culture, board and legacy of mediocrity has to have proven extremely difficult. The good news is that in this case, taking time is much better than being rash.

Microsoft needs a major reboot with new leaders, incentives, structures and board.  Technology buyers, especially on the corporate side, have to be hoping that their needs will be addressed by an energized and industry-leading player.  If the board does its job well, perhaps that will be a new Microsoft.

Huawei and Balkanization of IT

The Wall Street Journal reports on the continuing circus at the National Security Agency, where it continues its investigations into the security of IT products.  This is the same issue that we wrote about in 2012, except at that time the discussions were more open in the form of testimony before a Senate committee on Capitol Hill.

Today, Huawei, which is one of several vendors allegedly under investigation by the NSA, calls for avoiding the "balakanization" of IT products by political or national geographies.  Well, it seems that back in 2012, Huawei wasn't forthcoming enough for the standards of the Senate investigators.  Give the customers what they want if the market is important to you.

Of the companies mentioned, Cisco seems to have the most appropriate response in an accessible blog format.  To some extent, they are citing chapter and verse from their own internal controls over IT, and a customer can read the appropriate documents without having to search or call the company.  That itself is a comfort when something like the Der Spiegel article hits.

According to the Journal, HP is waiting for information and documents from Der Spiegel.  That isn't the best public response.

The Chrysler UAW Bailout

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

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

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

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

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

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

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

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

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