US Financial Groups Face Parmalat Backlash

Parmalat spells disaster in Italian much the way that the US can substitute the word Enron. It was an unmitigated fiasco involving 14 billion euros of debt and some very unhappy investors. But the Europeans are obviously learning something from their American cousins, because they're heading to court in a class action suit, according to the Financial Times, and going after the only people left with pockets of any size: the financial institutions and auditors - such as Citibank, Bank of America, Deloitte & Touche, and Grant Thornton - they think must have known about the precarious situation because, hell, it's inconceivable that these savvy organizations could have messed up that badly.

A year ago I might have agreed, but now I can only think of a quote from the movie The Princess Bride. Wallace Shawn's maniacal character Vizzini keeps calling every setback "inconceivable!" Inigo Montoya, played by Mandy Patinkin, eventually says, "You keep using that word. I do not think it means what you think it means."

Given the real estate bubble, it seems all too conceivable that people running money shops of various kinds are quite capable of flushing tens of billions of dollars down the nearest storm sewer while blinking in a confused way. "Inconceivable that we [they] could have screwed up so badly!" Or not.

ExxonMobile Tries Dodging PR Bullet

It's tough when your own business processes and success come back to bite you. That's exactly the picture that the Financial Times has painted for ExxonMobile selling off its 2,200 company-owned service stations. (Here's the link, but it does require a paid subscription.) The problem is having the company name sitting above those big $4+/gallon price signs. The paper does make one point I've been considering - that oil companies may make a whole lot in gross dollars, but the real price setting comes at the well head, not at the pump.

However, let's take a look at the ExxonMobile financials for a moment. When people have criticized it for windfall profits, it has argued that its prices have gone up as well - which is true, as the company buys gas from nations that own their oil. But look at the income statements from the last three years and you see an interesting pattern. If costs had gone up equivalently with profits, then the operating income should have been roughly the same as a percentage of total revenue.

In 2005, operating income as a percentage of revenue was about 16.4 percent, with net income before taxes being 9.7 percent. In 2006, that jumped to about 18.3 percent and 10.6 percent. And in 2007, the numbers were 17.8 percent and 10.0 percent. In other words, yes, the company has managed to raise its net income slightly. But even if you look at operating income, not net income, the jump is under 2 percent. A low price for regular gas in my neck of the woods is about $4.05 a gallon. Cut 2 percent and you get about $3.97 a gallon - a savings of 8 cents a gallon. Sorry to disappoint everyone who wants to raise taxes on "unjust" profits, but all that will do is transfer some of those profits to the government and not lower prices at the pump.

The Follies of Portfolio Theory in Risk Management

As the price of gas starts to approach that of cheap wine, foreclosures hit a record, and companies find themselves unable to get the loans necessary to do business, I think again of portfolio theory in corporate risk management. I mentioned this a while back as a response to an article by Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable. But today I started doing some rough calculations. One of the problems with complex mathematical models is that they have to simplify to make things easy for most people to understand.

However, sometimes there are simple calculations that can show you the potential folly of your ways. Assume for a second that in the financial world, there are, at any given time, 20 things that could go horribly wrong and wreak havoc. Say that the chance of any one of them occuring is only half a percent. Pretty low odds, right? Yes, for each given event, there is only a 0.5 percent chance in a year that it could happen. But remember that there are 20 of them, and because they are independent, they have a multiplicative effect. But 0.5 percent chance of going wrong is the same as 99.5 percent chance of going right. But when you multiple 99.5 percent by itself 20 times, you end up with about 90.5 percent. We've just gone from the psychology of safety in only a half percent chance of disaster to a more sobering 9.5 percent chance. Take that over a decade, and you see numbers that would make you bet the financial world would implode to some degree.

You can quibble with the percentages, or the number of disaster factors, even though I'd say I'm being pretty reasonable. So change some of the percentages, or the number of disaster scenarios. You're still left with the fact that, over time, the world will periodically drive itself into a brick wall at high speed.

I remember interviewing ChevronTexaco CEO David O'Reilly a few years ago. At one point I asked about geopolitical factors, as those are a problem in the oil business. He said that over time, there's always some war or political unrest that affects their business. The company just assumes there will be one at any given time and figure out how to live with it. If more companies should take that attitude, the world might be in far more secure shape.

Coming U.S. Bank Failures?

The Financial Times is reporting that the U.S. comptroller of the currency John Dugan, who oversees about 1,700 national banks, said that banks failures will rise back for virtually none to at least historic rates, and could climb above that.

“That is a natural consequence of the economy going from historically exceptionally benign credit conditions to something that is more normal to something you would get in a downturn.”

Mr Dugan’s comments come as US banks report big spikes in reserves for expected losses on consumer and small business loans, reflecting the spread of the credit crisis from Wall Street to the broader economy.

As companies shove more money onto the shelf for reserves against expected losses, they have less money to invest, less money to pay off obligations, and less money to calm down panicked investors who suddenly want their cash back and who create a run on the bank. Can you say Bear Stearns?

Roiling Financial Regulation

Today's the day that Treasury Secretary Paulson publicly rolls out his plans, as I understand it, to turn the Federal Reserve into a super regulator of all things business and eliminate a number of independent agencies, including the Securities and Exchange Commission. Although I'm all for trying to have one set of regulations for a given industry - for example, have mortgage lenders responsible to one agency - I think that has natural limitations. At issue is two aspects of firms: how they interact with the global financial infrastructure, and how they interact with shareholders.

The two topics are really separate. If you are focused, by your nature, on the greatest efficiency for doing business, you aren't necessarily looking at the need to keep company shareholders informed and making corporate decisions as transparent to the investors as possible. Putting everything under one roof could be a conflict of interests, and one side or the other might be slighted. Even if you wanted to argue for the combination of the two areas, would doing it under the Fed really be that wise? The agency is semi-autonomous and doesn't directly answer to the government, even if it must keep everyone informed of what it does. I'm not sure that I'd want more extensive power over markets and financial activities regulated by such a body.

Did the Feds Topple Bear?

New Jersey Institute of Technology management professor Michael Ehrlich has an interesting premise. A former government arbitrage trader himself, his research and background suggest to him that by announcing that it would make $200 billion available to finance securities from investment banks, the Fed may have unintentionally set off the panic that claimed Bear Stearns.
"I think it's a bad thing for Bear Stearns shareholders, but a brilliant thing for public policy," Ehrlich says. We've established a precedent that they're prepared to bail out firms to protect the little guys ... but that the people responsible bear the costs."

As he says, that means management and the shareholders. I think some of those shareholders often may be little guys, but, realistically, this is capitalism and they continued were holding stock in a company making ever riskier trades because they liked the returns.

The minute the Federal Reserve made the announcement, everyone in the markets started asking whether the Fed knew something that they didn't, which may well have triggered speculation about Bear Stearns - smallest of the investment banks - that turned into "a classic run on the bank," according to Ehrlich.

I keep asking myself the question of whether the Fed's new willingness to lend to investment banks might be handing more money to the very organizations that have proven themselves so tremendously reckless. Ehrlich thinks I'm looking at it the wrong way, and that the effect is to keep the financial system propped up while the shareholders take the brunt of the heat.

But I still feel unconvinced, because I think businesspeople are likely to take this as a tacit guarantee that no matter how stupidly they act, someone will pull their chestnuts out of the fire. All they need to do is keep diversified enough that their estates don't get clobbered like those of the Bear employees.

In any case, Ehrlich also thinks that this is by no view charity on the part of JP Morgan. As he deemed the Fed's move for public policy, so he called the acquisition a "brilliant" move that will probably give the new owner a profit of several billion dollars. Guess I don't see that as something to dissuade behavior in the future - because all the high-powered type A's will assume that they will be the ones coming out on top. We've seen the same behavior in virtually every man-made financial calamity in history, and there's no reason to think that people will act much differently. The only question is how much time it will take them to get back to the usual business.

Cracks in the Financial Fissure

So JP Morgan Chase & Co. is going to buy Bear Stearns. That may seem like a rescue, but it's not. This is yet another crack in the world's money foundation. First the UK government felt it had to take over North Rock, then the Fed was trying to support Bear Stearns through JP Morgan, but it has instead turned into an outright acquisition at $2 a share. Let's get some perspective on this. If you look at a chart, like this one from the Wall Street Journal, notice that the 52-week stock high was $170.23 and the low was $26.85. This isn't a "fire sale" as some in the media portray. This is bankruptcy and selling off the assets without the intervention of a court. And what is the Fed doing? Here's how the WSJ phrases it:

The Federal Reserve announced one of the broadest expansions of its lending authority since the 1930s in an effort to stem a credit crisis that is engulfing the financial system and threatening a deep recession.

For the first time securities dealers, effective today and for at least the next six months, may borrow from the Fed on much the same terms as banks. The Fed also lowered the rate charged on such borrowings from what's known as its discount window by a quarter of a percentage point, to 3.25%, and extended the maximum term to 90 days from 30.

This is a panicked attempt to keep everyone from taking that final plummet that Bears enjoyed. There isn't money because many people are no longer trusting the systems. But to keep things afloat, the Fed has potentially opened the flood gates. After all, it was large investment houses and banks - and the greedy credulity of investors - that landed everyone here in the first place. So now the country is supposed to trust their judgment with even more money? Maybe it's necessary to keep the whole system from freezing up, like an engine without oil, but only at the risk of having so much money out there that they dollar loses a lot more value.

I know there's the theory that some institutions are too large to fail, because you can't afford to have them out of business. But I'm wondering if what we're facing is more like a case of fiscal gangrene, in which you amputate a limb or the patient itself dies. Those who worship at the altar of capitalism must realize that can't adopt a deity and then insist on only the friendly parts. That's like saying you want to be a fundamentalist Christian but believe in only heaven and not hell. and I'm afraid that we're only just beginning to see the literal hell that we'll all be forced to pay.

Light Dawns on This Marblehead - Lenders, Fear, and Liquidity

The title of this post refers to an old Massachusetts put down of someone who suddenly grasps an idea - light dawns over Marblehead, which is a city on the north short of the state. And that's how I felt this morning, when looking at the latest problems with credit prices going higher.

I find that many financial stories, particularly those about the credit crunch, either assume that one understands the dynamics in advance, or assumes that the dynamics don't exist - that is, "And while I wave my hands, the credit markets seize up like an internal combustion engine running without oil." My flash of understanding was on the simple dynamic of what is happening at banks. The underlying driver is fear, as we keep hearing in the stories. But that fear does two things. One, is that the lenders are now afraid that because they've been making bad decisions for so long, any more reasonably drawn decision will be just as risky. So they price risk higher. For example, I received the following in an email from the Financial Times this morning:

Rising credit spreads meant AAA-rated General Electric paid a higher rate on a recent five year bond issue that it did for a comparable bond last May, according to Bloomberg calculations.

Alright, so it's the FT quoting Bloomberg. But consider the substance: GE is having to pay more for credit. It's not that the conglomerate is a worse credit risk. It's that the lenders have frayed nerves, and figure that since stupid decisions went wrong, then all decisions will go wrong.

Compounding that outlet of fear is another. Lenders have been caught having to restate financials to take into account unexpected losses. So they are taking cash and not only paying off the debts that came about from their ill-considered investments in the credit derivative markets, where essentially they create bonds and pay interest based on what they expect to get from payments on underlying assets like mortgages, but they are putting cash in reserves for future screw-ups. That means they lend a lot less of the money they have than they used to, and supply and demand then drives up the cost of interest.

Paulson Adresses Everything But Real Problem

I was driving about on errands with my daughter and was listening to NPR when I heard US Secretary of the Treasury Henry Paulson speak at the National Press Club talk about how the Bush administration was going to fix the credit crisis:

1. Wag a finger at the regulators for not making mortgage lenders explain in plain English to borrowers just what the hell they were in for.


2. Plead with lenders to keep lending, because, after all, if the public isn't borrowing, it's not spending.


3. Actually toughen licensing standards for all those mortgage lenders who can't make loans anyway because no one will front the money because of the mess the mortgage market is in.


4. Have regulators "catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."


5. Cluck at sloppy lending practices.


6. And, of course, let industry self-regulate.

He managed to miss the major issue: when you've got people who are incredibly greedy and who have forgotten their duties to business, the markets, and the public in general, then they will continue to create complex, crackpot schemes to extract cash from the pockets of others and put it into their own. If the financial industries could regulate themselves, don't you think they might have by now? They don't because they don't want to be limited in what they do. The people in charge of all these stupid Ponzi schemes want to continue their quest for unending and unrestrained profits. That's like saying you want so much water from a well that you pump it dry. Now you're left with no water, and no prospect of getting any.

This is a case where self regulation will do nothing. The longer the federal government waits, the more cash it will have to create out of thin air to grease the market's wheels, and the more value of the dollar it will burn off, probably never to return, at least in our lifetimes.

Banks Doing Worse Than Saying

Whatever the banks say publicly about the credit crunch, it appears to be a lot worse. An article in the Financial Times of two days ago mentions how banks have been quietly borrowing a huge amount over the last few weeks - $50 billion - from the Fed under a new mechanism that the U.S. central bank introduced two months ago:

The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.

US officials say the trend shows that financial authorities have become far more adept at channelling liquidity into the banking system to alleviate financial stress, after failing to calm money markets last year.

However, the move has sparked unease among some analysts about the stress developing in opaque corners of the US banking system and the banks’ growing reliance on indirect forms of government support.

It's not just in the US that there are signs of problems. The government of the U.K. decided to preemptively nationalize mortgage lender and bank Northern Rock. And now Credit Suisse has "revealed $2.85bn of losses on structured credit positions caused in part by “pricing errors” by some of the Swiss investment bank’s traders." That will mean re-examining 2007's stated financial results. And so central banks print more money - it has to coem from somewhere - while banks face just how badly they have been managed, as that's all you can describe the need to run for funds and the inability to see a multi-billion dollar loss in advance.

Earnings Are a Corporate Crap Shoot

Results from some new research from strategic consulting firm The Hackett Group just hit my inbox, and my, are the results scary. The consultancy does financial and management studies of a good number of corporations, and they've found that two-thirds of companies are off in their next quarter earnings forecasts by 6 to 30 percent. When it comes to gross sales, more than half of the companies couldn't get even within 5 percent of their next quarter's numbers.

Notice that this is all about next quarter, not next year. And 14 percent of companies describe themselves as being in high risk/high volatility areas - three years ago, the number was only 2 percent. In other words, the number of companies finding the world changing too quickly has been rapidly rising. (My guess would be that conditions changed just enough to let them realize how dangerous their markets were, and not necessarily a drastic change in the markets themselves.) As the release said:

"It’s shocking to see this level of poor performance in such a key area," said Fritz Roemer, who leads Hackett’s Enterprise Performance Management Executive Advisory Program. "We’ve seen companies take severe hits in the past few years after missing forecasts. Analysts suddenly question the competence of senior leadership. Stock prices become unstable and valuations drop dramatically. In some cases, CFOs have had to resign. Yet companies still refuse to make the necessary efforts to get this area under control."

Apparently, two-thirds of companies do year-end forecasts only, not rolling forecasts, which would match changing conditions more closely. Some forecasts should even be done on a monthly basis. In addition, only a fifth of the companies had forecast accuracy targets, which is like saying you're going target shooting, only you'll not look at the score after to see how well you're doing.

Not only is this bad for investors, but it shows that for many corporations, the basics of understanding their business and how things are going is dangerously out of their control. Sure, an unexpected event can come along. But what do you do if you have these events constantly? Then there is something wrong in the business model, management, the board, or some combination of the three.

London Bridge Is Falling Down...

For all the bad financial news coming out of the U.S., Europe is having its own share. A rogue trader costs Société Général $7 billion in France - and the person's superiors might have known what was going on, as management did throughout all the stupid choices of financial institutions here. The euro has dropped, London's FTSE index has dropped, and British bank Northern Rock, which was supposed to get a bailout from private equity group Olivant has just heard that its white night rode right past (because of inflexible conditions given by the government, so Olivant is claiming).

To hope that a financial mess in the U.S. could be contained, with other countries propping prospects for investors, is naive. When the economy becomes global, it by definition becomes interrelated. You can't see one part tumble and expect that everyone else will be left standing. You certainly can't expect that a financial system that decided to go for the high risk "easy" profits can avoid eventually paying for that free lunch.

The Next Corporate Scandal

When writing a recent article on how regulators and prosecutors were going after people farther down the authority line in corporations, a corporate lawyer and former federal prosecutor said that he expected the subprime mess to eventually turn into investigations, at least. Already there is confirmation that it has. According to an organization called the Asymmetric Threats Contingency Alliance (ATCA) - a group of government officials, business people, academics, "original thinkers," and some 250 members of major media - the FBI "has opened criminal investigations into 14 companies relating to improper subprime mortgage loans," while the SEC has started some three dozen civil investigatons.

If you think that the write-downs were bad enough, just wait, as there will be plenty of lost value when companies spend the time, money, and attention to deal with these investigations. And given that we're talking about the subprime debacle, these won't be small companies. I think we can expect them to be among the largest global financial companies. Bear Stearns, Goldman Sachs and Morgan Stanley have all said that government entities are asking about their subprime activities. Reported SEC targets include Swiss bank UBS AG; US investment banks Morgan Stanley, Merrill Lynch, Bear Stearns; and bond insurer MBIA.

Wolfgang Münchau on the Current Financial Crisis

The Financial Times has a good column by Wolfgang Münchau, noting that if the current credit crisis were just about sub prime mortgages, it would already be over. The problem is that there is way more money tied up in other ventures that are find so long as defaults and insolvencies stay at reasonably low levels. Combine that with a recession - and it seems pretty clear that economies are slowing - and the results could be really bad.

Some Financial Companies Get It Right

The Wall Street Journal has an article about some financial companies - Goldman Sachs, Lehman Brothers, and Deutsche Bank - that have managed to largely ride out the credit crunch. What was the common theme? They all knew risk when they saw it and didn't let their desire for easy profits undermine intelligent management. Some of the strategies included shorting the mortgage collateralized debt obligations (CDOs), greatly limiting exposure, and choosing carefully from among opportunities. In other words, this is old fashioned prudence governing recklessness. None seem headed for the massive write-offs some of their competitors are facing.

Market Meltdowns and Oil Spills

When listing to the radio and more news about the San Francisco oil spill, I heard some official wonder how it could all be possible - how, with all the GPS systems and electronics and procedures put into place that a freighter with an experienced pilot at the helm could hit into a bridge, open a 90 foot rip, and pollute the bay. At that moment, I realized this is the equivalent thought that had been going through the mind of every CEO dismissed or pushed out from one of the large banks, of the head of every investment department, of everyone in every board room. How could this have gone wrong? We had all the best computers and software, most highly paid experts and geniuses.

They did, and the mistake was to trust that it's possible to mechanically cheat the law of averages. Technology is fine, when used, but it isn't an omniscient and tireless protector. It can't think and doesn't have the flexibility to react to situations that are beyond programming. Technology only does in an efficient manner what people understand how to perform. Experts and mathematicians and economists can make amazing calculations, but they are still only approximations of reality that work the way they were designed. As conditions move past assumptions, the results fall apart.

We're back to the same word: risk. If you're going to make money, there's a risk you could lose it. The more money you make off your capital, the bigger the chance of loss. That, my friends, is the way of life. According to Hollywood insider Alec Baldwin, we've even seen this attitude in the results of the studios.

People, including those in high positions in business, want something for nothing, and when they can't get it, they want a guarantee that their losses won't be too painful. If all the people who called for letting the market do what it knows best were sincere, they would watch as entire large companies melted down. That is how the market tries to deal with it - through brutal and overwhelming force as punishment, so people will hopefully learn that when you touch a hot stove, you'll be burnt if you're not careful. But businesspeople aren't sincere in what they want. That's why no one will learn anything from the current market turmoils, why things will continue to spin out of control, and why we're all going to pay a potentially huge price, as those who set things into motion refuse to.

Credit Crunch and Trickle Down Economics

We're starting to see the beginning of credit crunch fall-out. From the tech sector, Cisco Systems mentioned that if large banks are having to write down billions of dollars because of bundling debt into securities and getting rating agencies to give a better credit rating than the individual loans could often get, chances are they won't have money to spend on things like new technology. As a Financial Times story quoted:

“If there is a concerted slowdown in financial services you are going to have a big problem,” Richard Parower, managing director at J&W Seligman, said.

Makes sense, and investors agreed by suddenly knocking the NASDAQ composite down. Stocks recovered, more or less, but in a way that doesn't matter. Banks buy less and are wary of deals, which means that law firms don't get all the money they were used to. As things slow, there will be a drop in spending, and in jobs, probably. Tech and finance will affect virtually everything. Energy costs are hitting everyone and everything and food is getting more expensive, so consumers will have less to spend. Borrowing can't cover it, as the dollar is no longer so attractive a deal for those countries like China that are brining in the cash.

Personally, I'm steering more of my own writing business to publications that serve sectors that have some cushioning against recession, like legal, food, and I'm even considering getting a foot into the health care door. Now's the time to take stock of where things will go and to seek out the relative safety you might find.

A Sudden Realization About the Sub-Prime Crisis

I've written a fair amount about this topic, so this will be short. (Having impending deadlines, like other forms of death, concentrates the mind wonderfully.) But when I started thinking about how this debacle came to being, I wrote the following:

By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.

That was the explanation I had read, but something bothered me about it. It didn't quite make sense that some juggling could improve the credit rating that much. After all, to really cover the potential default rates, you'd probably need to add a significant number of "good" mortgages that would be unlikely to default so the return on the investment had a reasonable chance of occurring. But then the default rates shouldn't have had that kind of impact. And yet, it seemed that the derivative securities were largely based on poor credit lending. How did bundling them get better ratings than the individual loans would have?

After paying attention to more reporting on the subject, I think I now understand. The rating agencies abdicated any ethical or moral responsibility to give an honest opinion on the derivatives because they are paid by the very financial institutions that were issuing them. Unfortunately, investors pay significant heed to these ratings and often pass on doing further due diligence. I could understand that from individuals who are intimidated by understanding financial matters. But these derivatives could never have taken off without significant institutional investor participation. What happened here? Don't these large organizations that hire lots of brainy people actually do their own thinking? Actually, many rely on the opinions of others far more than you might thing, certainly in proxy voting issues, as I learned in writing an article for Corporate Secretary.

So many individual investors, putting their money into money markets, pension funds, and other aggregations of cash might be taking a larger risk than they realize, because they don't always know who's really making the decisions. Where has the financial media been through all this? This story has an Enron-like cast, with lots of people writing in awe of the clever financing and no one pointing out that the Emperor ruled in the buff.