Dodd and AIG Scratch Each Other's Back

The Hartford Currant has documented Connecticut Senator Christopher Dodd's flip-flop on the AIG bonuses, but it seems that there is more going on than he's addressed.

On Tuesday, Dodd said that he was not a member of the conference committee that crafted the final compromise bill and said that the exception had not been in the bill as he drafted it.

But late Wednesday, Dodd admitted in an interview with CNN that he had been involved in the change.

"I agreed reluctantly," Dodd said. "I was changing the amendment because others were insistent."

Don't think that Dodd is at an arm's length relationship with the financial services conglomerate. If you check the record of donations to him, you quickly see that AIG was his fourth largest contributor from 2003 to 2008, with a total of $223,478 donated.

The total money he raised during that time was $8,938,003. That means that AIG was directly responsible for 2.5 percent of all the money he raised during that period. The insurance industry was one of his top five industry donors with a total of $1,440,422, making AIG responsible for 15.5 percent of all insurance company donations to Dodd.

It's not surprising that Dodd has close ties to financial services as he's chair of the Senate's Banking, Housing, and Urban Affairs Committee. This is clearer when you add the total of campaign money received from 2003 to 2008 from securities and investments, insurance, and commercial banks: $6,588,012, or 73.7 percent of all campaign contributions to the senator.

It's not that the money comes directly from the companies, because that would violate election laws. However, 71% of the money comes from individuals; organizations like OpenSecrets.org collect the public information and then cross reference to find the totals. It seems pretty hard to believe that Dodd's own office wouldn't have made the same calculations.

Wired has an article called Recipe for Disaster: The Formula That Killed Wall Street. It's about how a mathematician came up with an idea of how to easily quantify the coupling of risks in individual cases that investors want to know so they can make better decisions. For exmaple, you know that one investment has a given chance of going into default, and that one debt arrangement is bundled with others to make a bigger financial instrument in which you could put money. If one starts going badly, are others also more likely to head south, or are the individual risks really independent of each other? You need to know the answer if you're going to intelligently understand the risk.

The solution was a formula using a technique called a Gaussian copula function. All of Wall Street rejoiced because suddenly it was easy to calculate risk without waiting for historic data:

The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

And then, eventually, the market imploded. But when you look at the approach the mathematician took - examining the historic prices of credit default swaps - you start to see just how stupidly so many in finance acted:

The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford's Duffie and ask him to come in and talk to them about exactly what Li's copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation.

The article focuses on how you cannot count on the correlation of financial securities, because risks that seem out of sync one day can suddenly all manifest at the same time.

I'll put it a little differently than stated in the article becuase I think there's an even more fundamental point that financiers missed. Like any market, CDO purchases largely move on emotion - it's one of those indisputably human activities. When people think they are safe, they will do the most astoundingly stupid things because they simply don't perceive danger.

CDO prices are an accurate historic measurement of what people thought risk was, not of the actual inherent risk of the underlying investment on which the CDO was taken. So all of these investment decisions were made based on looking at people's perception of risk, whether right or wrong, and not the actual risk. No wonder everything blew up. It was like betting on the results of a card game when you weren't one of the players, didn't know their history of success, and couldn't see any of the cards. Here's the scary part: the people who didn't notice the difference are the ones still in charge.

What If Banks Are in Deeper Trouble Than Anyone Realizes?

The Wall Street Journal has a sobering article that starts with a disturbing question: What if nearly half of U.S. banking assets turn out to be bad?

Defaults are rising on every form of debt, which should come as no surprise to anyone. Those who thought that the issue was subprime mortgages need to wake up and realize that no form of debt exists separate from any other. People strapping themselves with mortgages they cannot afford are clearly going to be financially strained elsewhere. But then, people taking out lines of credit against homes, using multiple credit cards, and leasing fancy autos that they wouldn't be able to afford to purchase are also going to be hard-put to manage any untoward financial situation. That will likely add up to a lot of money:

Indeed, Goldman Sachs Group estimates that troubled assets could exceed $5 trillion, if defined as assets that could show a loss rate close to, or above, 10%. To put that in context, $5 trillion is just over 40% of the $12.3 trillion in total assets of U.S. commercial banks.

Granted, actual losses will be much smaller than $5 trillion, and banks won't have to sell every bad asset. Most still can reserve for a good share of their losses. Moreover, the government already is on the hook for losses at Citigroup and Bank of America, with $3.8 trillion of assets between them.

Why take for granted that the losses will be a lot less? This is exactly the type of willful blindness that has led banks to where they are today.

The talk today is of creating a government-owned so-called bad bank, which would buy the bad assets and then liquidate them. The strategy is at least twenty years old and was in use during the 1980s, when many more banks were failing than are failing now.

The problem is that everyone is making things up as they go along. No institution to my knowledge has done risk management planning for such an extreme situation as that much potential default. Not even the U.S. government can take on this level of debt with impugnity. How many years -- how many decades -- will it take to pay off this volume of money?

I don't think anyone in government or the financial community is being straight, either with the public or with themselves. They are likely concerned about inducing panic, but maybe that is exactly what the public needs. Already we're seeing lowered spending and more attention to debt levels, at least by individuals. They are right to react strongly, because they see they are living with choices made over the years. But how long will it be until those who are in charge do the same?

Making Sense of CEO Bonuses

When do you pay a bonus? If you're smart, you sign that check when you've had a clearly-defined goal within the power of the potential recipient to deliver, the behavior you reward strengthens the business, and you watch to see that what you wanted actually occurred. And there's some odd news on this front. At Merrill Lynch, CEO John Thain thinks he deserves a $10 million bonus for 2008. This would be riotously funny if it weren't so tragic and indicative of the problems often found in upper management. Merrill has lost $11.67 billion this year. So far. Thain's view? He deserves a bonus because he helped keep it from getting a lot worse.

It's not that there is no case to be made for Thain. He only took over last December, so literally has been cleaning up the messes of others, and pulled off the acquisition by Bank of America. And yet, the board noted that more successful Wall Street firms - or at least one, Goldman Sachs - aren't giving out bonuses, and that acquiring BofA and the public at large might not sit too calmly with a big payout when so much was lost.

When Mr. Thain landed at Merrill in late 2007, he received a $15 million cash signing bonus and a pay package that was valued from about $50 million to $120 million over a number of years.

Merrill shares were trading above $50 when he was hired, and his pay package was structured heavily toward his ability to increase the price by another $40 or more. Merrill's shares have fallen steadily this year, closing Friday at $13.04 in 4 p.m. New York Stock Exchange composite trading.

As much disaster as he may have averted, he clearly signed on to do something that a more realistic person might have said wasn't possible. If you're going to get big bucks, then you need to deliver big. And if he couldn't see where things were going as recently as a year ago, then maybe he wasn't so insightful after all. Or is the board punishing Thain because it's embarrassed at not having checked the stupidity of his predecessors?

I have a tad more sympathy for Toyota management, which is seeing its bonuses reduced as car sales slide off the road. The company had been doing marvelously well and is clearly caught in forces larger than human decision. But when things go bad, employees are always asked to tighten their belts. Making the same request of management seems only fair.

Bankerss Living in World of Dreams

David Reilly in the Wall Street Journal wrote an interesting analysis of the banking system i which he argues that the institutions need as much of an overhaul as the auto industry.

The crisis, they have argued, is down to an impossible-to-predict perfect storm, predatory hedge funds, panicked investors, unrealistic accounting rules and economic changes that emerged so quickly there was no way to be prepared for them.

If only. The reality is the crisis is due to bad lending and investment decisions.

I agree, but would extend this a bit. Bad decisions caused the problem. The trigger was a series of events that stressed the business model enough that it crumbled.

The problem with the banks' explanation is that it effectively says, "If only things hadn't gone wrong, we'd have been fine." But nothing goes right forever. Bankers rode a long string of wins, and then kept pushing their luck. They didn't test extreme scenarios. That was heinously inept. As I've mentioned before, when you have events that are independent of each other, the probabilities of at least one happening add. Maybe some of these events aren't completely independent, but they're not completely dependent either. As the number of things that can go wrong increases, so are the chances that one of them will.

Executives who cannot grasp this simple fact and who keep telling themselves that everything will be fine are nothing more nor less than addicted gamblers. There is a reason that some financial institutions with a reputation for being overly conservative have lasted hundreds of years. They don't look for the short cut to profit.

We Don't Solve Problems Because We Don't Look At Them

The Wall Street Journal in an article on an upcoming Senate probe into bond-rating firms had what I think is a telling quote:

Sen. Carl Levin (D., Mich.), who heads the investigations subcommittee, has called attention to financial derivatives known as credit-default swaps, which he calls "one of the prime culprits responsible for this financial disaster." Investigators are expected to look into how those derivatives were marketed and used by banks.

Consider that language carefully for a second: one of the "prime culprits" for the current financial debacle is the category of financial derivatives called credit default swaps.

When disaster hits and we as a people look for answers, we tend to point to the simplest and most obvious causes we can cite. These, however, are not causes. They are simply mechanisms that allow individual and collective weaknesses of greed and lying to act with increased effect. Derivatives of any type are nothing more than a legal fiction, a business arrangement between two parties that may or may not be based on quicksand. It is the behavior and willingness to ignore sense on the parts of the people involved that is the problem. You might as well say that cars cause automobile accidents, not their drivers.

I've lately been working on some articles about how executives pull their companies out of difficult economic times and otherwise manage risk. According to the experts I asked, the biggest problem companies have is when top managers refuse to see reality. They pretend that the worst cannot happen. They create one excuse after another for why the company must operate as it does. When bad things happen, they look for people to blame and don't think about the further unintended consequences of their actions. On BNET, I recently covered how high tech lay-offs were generally bad management. That was nothing more than a specific instance of a more general case. The problem is bloated staffing for the business that is here. But who is responsible for that level of hiring? The executives who then lay off the employees with no control over how the business runs. It is those top managers who are responsible - and who execute the innocent.

That's a practical example of finding someone else to blame, and of not noticing the problem as it developed. How long has GM had to see and fix its problems? Instead, management blames the high cost of employees, not the lack of understanding customers and providing what they would want. Until managers overcome the baser parts of their human nature, or at least struggle with them a bit, nothing will change, none of us will learn lessons, and the same behaviors that got us into trouble will shortly restart and then continue as though nothing happened. What a pity.

The Disease That Was Subprime Lending

Those who think that the subprime mess was an unfortunate accident that could not be anticipated by management should read a BusinessWeek story called Sex, Lies, and Subprime Mortgages. Fraud and trading of sexual favors for mortagages that could be bundled into hot securities were supposedly common, and whistle blowers were shut down by managers who didn't want the good times to end. What went on was literally criminal, and I suspect that the major Wall Street institutions simply turned blind eyes to everything in their quest of deals that could yield profits and a quick exit before the players got caught. Unfortunately, the collective moral depravity set off a chain reaction that we will be facing for years. It does make me wonder what similar may have gone on in credit default swaps, credit card-based CDOs, and other such debacles.

Credit Card Derivatives: Facing Reality, One Step at a Time

The amount of single-minded focus that the media has placed on the mortgage market and the collateralized debt obligations surrounding it is nothing more than a fad. I don't mean that the problem is a fad - far from it. This is part of something bigger that is here to stay for many years. But the media pays attention like an industry with ADD. Journalists have grabbed on this because it was big and bright, essentially as it latches onto a story about a celebrity or the murder of a pretty coed.

But the financial crisis is much more than mortgage-based CDOs and the London inter-bank rates. According to whom you ask, the derivatives market has hit between 1 and 1.25 quadrillion dollars. Yes, a thousand trillions. That is so massively beyond the size of the 50 trillion GDP of the entire world as to be stunning and scary.

We've seen two shoes drop in mortgages and credit default swaps (which is continuing to evolve as more defaults happen and more institutions become liable for the "insurance" they offered). Chances are strong for future rounds of stock market plummets as companies continue to need cash to cover their positions and sell securities to get it.

The next one is likely credit card derivatives. As I've mentioned before, there's an entire bond market created in the bundling of credit card and auto loan debt. I have yet to find a good estimate of the total market size. But consider this: a large part of the quarterly $5.29 billion write-off that AIG took in the last quarter of 2007 was for credit card derivatives exposure, possibly through credit default swaps. And around the end of September, Citi said that it "faced up to $10 billion in credit losses, partly because of rising credit card defaults."

Subprime mortgages got into enormous trouble with, what, a ten percent default rate? Last quarter, U.S. banks charged off 5.47 percent of all credit card loans, or about $50 billion. That was up from 3.85 percent in 2007.

To be sure, credit cards don’t represent a huge portion of assets for most banks. For example, they comprise about 14 percent of all consumer loans and leases at Bank of America, the country’s largest credit card issuer. The main problem, Nishikawa said, is that “everyone is so weak after what happened with mortgages that another blow to a consumer product would be hard to handle.”

Consumer groups have long complained that credit card issuers push cards onto people who don’t need them or can’t afford them. They say rising credit card defaults —- just like mortgage defaults —- are largely the fault of banks who lent to risky borrowers.

Innovest estimates about 30 percent of Bank of America’s credit card loans are to subprime borrowers —- second only to the failed Washington Mutual Inc., which had almost half of its credit card loans held by subprime borrowers.

What that story doesn't say is that in the event of a mortgage default, the bank still owns the property -- probably not longer at the value the bank had assumed when writing the mortgage, but still something. Credit cards? Totally unsecured. And when auto loans go bad, the car has lost enormous value once driven off the lot.

Even if the credit card and auto CDOs are smaller than CDOs based at least in part on subprime mortgages, the impact they'll have has the potential to be far larger.

The Inversion of Finance

There's an interivew with FedEx's CEO Fred Smith in the Wall Street Journal online, and he makes one of the most intelligent and perceptive comments about the financial services industry that I've yet to see:

He attributes the financial crisis to "the intersection of four long-term developments." Reckless mortgage lending policies; high energy prices; mark-to-market accounting rules; and national policies that favor what he calls "the financial sector over the industrial sector."

"Rather than in our business where you have to have a dollar of equity for, 10 cents or 15 cents of debt," he explains, "it's exactly the opposite in the financial sector where you have one dollar of equity for 10, 25, 50 times risk." "Things became so flipped upside down," he explains, that "the assets at these banks became the liabilities and the liabilities became the assets. These people were making these fantastic returns -- at places like Fannie Mae and Freddie Mac -- but in reality they weren't adding a lot of value. I have said time and again that there is a fundamental tendency in good times in the financial sector to over-leverage. Our national policies actively encouraged all this debt."

The concept of assets becoming liabilities and liabilities becoming assets is so completely apt as to be startling in its simplicity.

I'm not sure I agree with his appeal to change the tax structure allowing capital purchases to be treated as out-of-pocket expenses. The question is whether you drive accounting rules by tax policy or tax policy by accounting rules. The reason for amortization is to more throughly match up expenses with revenues. At the same time, to be fair, once you've paid for that Boeing 777, you're not getting to return it and the money is gone. But what if it's financed and you're paying over time. It doesn't seem reasonable to allow the immediate expensing of the entire amount.

He mentions that he things the corporate tax rate should be lowered, and that at 38% it's even higher than Germany's 25%. My question would be not what the tax rate is on the books, but what the average realized tax rate is. I have a suspicion that most large corporations are managing to write off enough that the effective tax rate is far lower.

Credit Ratings Firms Spun Tales to Spin Gold

In case you think truth never comes to light in Congress, then look at the Washington Post story about how the credit rating agencies knew for at least a year that they helped fuel the financial meltdown.

In one of the confidential documents obtained by the committee, Raymond W. McDaniel, chief executive of ratings firm Moody's, said analysts and executives are "continually 'pitched' by bankers, issuers, investors . . . whose views can color credit judgment."

"we 'drink the kool-aid,' " he wrote in a Oct. 21, 2007, memo to the board. "Unchecked, competition on this basis can place the entire financial system at risk."

I think this shows that their claims of "getting to the bottom" of programming errors in their risk management systems was so many lies and an attempt to slide a knife in the backs of technicians for what was primiarily an issue of their own greed.

Frankly, this has been true for many years and is exactly the same type of situation as faced the accounting firms that wanted to provide consulting and auditing services at the same time. You can't do it fairly because there's an inherent conflict of interest. Your vast income is the result of kissing the plump rear of those who run the client companies. People will always act in accordance with their personal financial incentives.

In short, I think this means that no one can believe a single word coming from any of the rating agencies. If they are willing to pump up ratings based on rewards, why wouldn't they knock down ratings because of the lack of them. I suspect that will come out at some point because it's part of the same human nature: If you won't look out for me, then screw you.

Now consider the extent of this. You can't trust the ratings on securities. On banks. On insurance carriers. On bonds. On anything. It might be that the ratings are often accurate, but how can you know? The morally reprehensible action of all these executives who knew of the problems and did nothing was that they destroyed any sense of trust in the system. Not blind belief, but the trust that institutions will do more or less what they are supposed to do. When that goes, so does the willingness to invest.

"We have to earn our credibility back," said Deven Sharma, president of Standard & Poor's.

Mr. Sharma, you simply cannot. No one with any sense will ever believe any of you, because you've all proven what you are willing to do to line your pockets. There's no reason to expect that you would be any less willing in the future so long as you thought that you wouldn't be caught. I'd call all of them a pack of swine, but it would be degrading to pigs.

Credit Swaps are Old Friend

Virtually everyone going on in the media about the credit crisis keeps talking about the subprime mortgages, but there's little talk about the credit swaps which were the real force in knocking everything over. At his blog, billionaire investor Mark Cuban pointed out that the crash of 1987 also was triggered by schemes to insure leveraged investments. In each case, the sudden requirement to pay up as things went south was why companies had to "dump everything AND sell stock index futures to raise cash, which in turn lead to a crisis of confidence and deleveraging." And he makes an additional interesting point:

Which is the genesis of our problem in the US. Its not wrong to run with bull markets and leverage to the hilt. That can be a very good thing. But we have to make the upside based on investments, rather than financial engineering. Which is exactly why we have to change our tax code. We want to encourage investment, not financial engineering.

He suggests having zero capital gains tax on selling stocks and bonds bought during an IPO and held for five or more years, and if sold early it would become taxes as regular income. Cuban also would not allow stock to be borrowed against, requiring a sale instead. I understand the impulse, but it's my understanding that there are already types of financial deals that effectively transfer ownership of stock for periods of time. Although I see the impulse, I suspect this would be as easily walked around as other blockades that regulators and legislators have tried to erect. How can you keep legislators from loosening things up over time because they get entirely too much money from the financial services industries?

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.