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26
Aug 10

Artificial Sweeteners Turn Sour

Last week in Artificial Sweeteners we discussed how government intervention has distorted the economy, the stock market and the housing market.  The basic thesis:

Excessive economic stimulus and a misguided zero interest rate policy has created false bottoms in the housing and stock markets.   See Artificial Sweeteners

Dour economic statistics released this past week only confirm that thesis.  While extrapolating from one month’s statistics is dangerous, nevertheless the numerosity and interrelated nature of recent reports raises questions whether there ever was an economic recovery.

Scanning the Headlines

The past week we have been bombarded by negative economic reports from housing to employment to durable goods.  A quick look at the headlines:

The Super Sweetener

The Congressional Budget Office calculates that stimulus added 4.5% to GDP.  Further, these programs created up to 3.3m jobs.   One estimate is that without stimulus, GDP would have been negative 3.5%.   What happens next?

So now that the stimulus is tapering off, America has the following rather unpleasant things to look forward to: a 4.5% reduction in run rate GDP as the direct economic boost disappears, the gradual loss of 1.4 to 3.3 million jobs, and the eventual realization that non-recurring, one time items can not be projected into perpetuity, despite what Keynesian dogma may preach. See CBO Estimates that Stimulus Boosted Q2 GDP by 4.5%, Standalone Number is likely under around -3.5%

Shoveling Money to No Avail

Morton Zuckerman captures the folly of current economic policy:

Tons of money have been shoveled in to rescue reckless banks and fill the huge hole in the economy, but nothing is working the way it normally had in all our previous crises. See End of American Optimism

All we have created is a “new normal” of slow or little growth. Compared to sales growth of 4% in past recessions, sales are increasing at a little over 1%.

…there are at least 14.5 million Americans still searching for work: 1.4 million of them have been jobless for more than 99 weeks, 6.5 million have been jobless for over 27 weeks. This is a stunning reflection of the longer-term unemployment we are coping with.

The unemployment numbers are worse than reported. Last year the Labor Department admitted it over-counted the number of jobs by 1.4 million….

Since April, the Labor Department has counted 550,000 nonexistent jobs under this so-called birth/death series. Without these phantom jobs, the economy this year created virtually no jobs—certainly not the 600,000 the administration has been touting.

The Obama administration projects the unemployment rate will drop to 8.7% by the end of next year and 6.8% by 2013. That is totally unrealistic. See The End of American Optimism.

A policy of artificial sweeteners has misled the American public and merely put off the day of reckoning.  Trillions of stimulus dollars have masked underlying weakness in the American economy.  Instead of these sweeteners, banks should have been forced to write off bad debt, insolvent firms should have gone bankrupt, government interference in the economy should have dwindled,  and programs increasing employment costs should have stopped.

If the economy were permitted to self correct, we would be on our way to recovery rather than be suffering the sour aftertaste of artificial sweeteners.

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16
Aug 10

Bring Back the Robber Barons

Bill Gates and Warren Buffet have encouraged wealthy families to give half their wealth to charities, and many have done so.  One year into the effort, Buffet announced that forty families have agreed to pledge more than half their wealth to charity.   Emblematic of our current age, most of these families have made their money in the finance industry.

A Different Time in America

Once upon a time in America there was an entrepreneurial class that did more than shuffle pieces of paper.  They produced real things.  Historians originally referred to this group as “Robber Barons” because the large fortunes they amassed involved ruthless and sometimes uncompetitive business practices.  While some made their fortunes in finance, the overwhelming majority laid the foundation for America’s 20th century industrial dominance:

  • John Jacob Astor  (real estate, fur)
  • Andrew Carnegie (steel)
  • Jay Cooke (finance)
  • Charles Crocker (railroads)
  • Daniel Drew (finance)
  • James Buchanan Duke (tobacco)
  • James Fisk (finance)
  • Henry Morrison Flagler (railroads, oil, the Standard Oil company)
  • Henry Clay Frick (steel)
  • John Warne Gates (steel)
  • Jay Gould (railroads)
  • Edward Henry Harriman (railroads)
  • Milton S. Hershey (chocolate)
  • Mark Hopkins (railroads)
  • J.P.Morgan (banking, finance, steel, industrial consolidation)
  • Henry B. Plant (railroads)
  • John D. Rockefeller (Standard Oil)
  • John D. Spreckels (San Diego transportation, water, media)
  • Leland Stanford (railroads)
  • Cornelius Vanderbilt (railroads)

These individuals were also the backbone of American philanthropy.  For example, think of:  Carnegie (libraries); Rockefeller (University of Chicago, the Rockefeller Foundation) and Leland Stanford (Stanford University).  The Robber Barons not only focused on industrial wealth creation.  They were equally concrete and focused in charitable giving that provided tangible benefit to American institutions and society.

In contrast, the Gates Foundation focuses on world health concerns, a worthy but certainly more amorphous goal.  As an aside, the Gates-funded vaccination and AIDS treatment programs have received criticism for singular focus on certain diseases to the derogation of comprehensive health care and diversion of important medical resources.  Few of the Gates Foundation initiatives benefit Americans.

The Over Financialized Economy

The wealthy donors signing on to the pledge are one more reminder of the over financialized American economy.   See The Mirage of a Financialized Economy; The People v. Wall Street.  Today’s fortunes were earned at the expense of the industrial economy, rather than in pursuit of its success.   Two recent commentaries support the deleterious effect of an economy over-focused on the financial:

Boston-based asset manager Jeremy Grantham in Summer Essays criticizes his own profession:

“In 1965, 3% of GDP that was made up of financial services [and that] was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%.

This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.”

Professor Steve Keen, an Australian economist and author of Debtwatch believes that the percentage of GDP going to the financial sector should be even lower:

Because of that debt level, bank profits have gone through the roof as a share of GDP. Back before we had a financial crisis—when debt levels were far lower than today—so too were bank profits as a share of GDP. A sustainable level of bank profits appears to be about 1% of GDP.  See Bank Profits a sign of economic weakness, not health

Bring Back the Robber Barons

We need a political and economic re-set button.  The Obama and Bush Administrations have attempted to uncritically favor the financial sector through loan guarantees, TARPs and other artifices.  No one has asked the critical question of why we are favoring this sector that has absorbed a disproportional share of GDP at the expense of a productive reality-based economy that makes real things and employs real people.

No wonder unemployment has remained stubbornly high, and the economy is poised to enter a “double dip” recession.  Perhaps we need a new class of wealthy people focused on creating real wealth and jobs in America.   Maybe it is time for some twenty-first century Robber Barons.

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20
Jul 10

Team Play: How to Lose the Game

Corporations and politicians love to emphasize “team play.”  A whole mythology surrounds the concept.  There are 1,800,000 Google search results under ‘team play.” Websites are devoted to “team building,” “effective team work” and “team play.”  Corporate and political entities adopt sports analogies and metaphors for success: teams that play together as a unit win.  Thus, if we convince independent and sometime maverick executives to sublimate their needs to the “team,” the team will be more successful, that is, win more.

By extension, we obviously must isolate and demonize the non-team players.  Those who have not embraced team play are mavericks, lone wolves, naysayers, whistleblowers or worse.  If we round up these “stray camels” and get them all under the corporate tent, how much better off will we be?

Team Play Sounds Great, Right?

Superficially, ‘team play” sounds like a great concept: everyone on “the same page,” effectively communicating, sublimating individual ego and producing outstanding results.  But there is a more insidious inner lining to team play.  ‘Team play” is a way of quashing independent thought and dissent.  What upper management or senior government officials really want is an employee who will carry out directives from above blindly, without assessing the wisdom or integrity of a particular strategy or project.  This paradigm values adherence to “the program” and loyalty over competence.  Even when some thoughtful criticism can produce a much better result, the team will value mediocre results.

Unfortunately, “team players” get promoted disproportionately, perpetuating the “team play” cycle.  Those not promoted learn an important corporate lesson:  “go along” and “get along” or look for other opportunities elsewhere.

I am not privy to BP succession planning, but I would guess the lead management representative on the Deepwater Horizon rig was the consummate team player.  One has to wonder if common sense came in second place to “team play.”

The Strange Case of Elizabeth Warren

Elizabeth Warren, a Harvard law professor, was named chair of the Congressional Oversight Panel looking into the bank bailout program (“TARP”).   Unfortunately, Prof. Warren had the temerity to grill Secretary Geithner on the AIG bailout and backdoor assistance to Goldman and other banks.  Indeed, by doing this she was questioning the wisdom and integrity of a measure that would ensure that these banks would be paid in full on credit derivative positions with the failed AIG.

Ms. Warren is the champion of establishing a consumer financial protection agency.  The new bill establishes a new Consumer Financial Protection Bureau.  Knowledgeable financial commentators such as Yves Smith and Simon Johnson believe that Prof. Warren would be the right person to head the new bureau.

Warren is the obvious choice to head the otherwise-guaranteed-to-be-a-joke consumer financial services agency due to set up its shingle at the Fed. She has been a tireless consumer advocate, is trusted and well liked by the public at large, an effective communicator and a respected legal scholar, and is willing to stare down political opponents. All those qualities make her hugely threatening. Banksters and their lobbyist allies have been saying loudly and clearly that they are firmly opposed to having Warren head the new consumer agency. So, predictably, Geithner acts as their water-carrier. See Elizabeth Warren in Treasury Crosshairs Again

Mr. Geithner has proved to be a toady for the big banks and Wall Street firms. Of course, he would like to block  Ms. Warren’s appointment.  He instead wishes to install a “team player” such as his pro-bank rubber stamp lieutenant, Michael Barr, Assistant Treasury Secretary.  Mr. Barr’s bona fides are set forth:

This Administration has acted quickly and aggressively to confront the economic challenges facing our economy and the housing market. See Elizabeth Warren or Bust, I’m Drawing the Line

No comment is required.

Afflicting the Comfortable

Humans are tribal. We are comfortable with our own tribe and team.  Along comes an individual of integrity, conviction and unquestioned competence like Elizabeth Warren.  Those individuals attack “group think,” upset the powers that be and make some  a little uneasy.  Suddenly, the name calling comes out and Prof. Warren is called a “commie” or a “weirdo” because she questioned the overly cozy relationship between the Administration and the banks.   Moreover, perhaps hidden in the discomfort is the fact that she is a female in the largely male world of banking and the Treasury.

Undercutting the maverick in a corporation is a little more subtle:  is the person sound, can we rely on him in a pinch, or isn’t he a little different from us?

For the sake of the country, we need more more mavericks like Prof. Warren.   Sometimes it is good to afflict the comfortable.

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14
Jul 10

Distortions

One theme we have explored in past posts is the negative role government has played in the economy.  See e.g., Let it Be and Can You Invest in the US Equity Markets? Government intervention in a capitalist economy distorts economic behavior.  Further, government anoints winners and losers without subjecting market participants to the rigors of a free marketplace.  See Government Intervention and Bowmar Brains.  Interventions occur on both state and federal levels.  Let’s examine some of the recently reported inevitable distortions.

Federal Employment

Andrew Briggs and Jason Wine examine the disparity between federal employee and private sector pay.  Federal employees with the same experience and education as private sector employees make 24% more.  Federal employees also receive generous health and pension benefits.   See The Government Pay Bonus.

In addition to compensation and benefit advantages, federal workers are shielded from layoffs and terminations.  Finally, I have extensive experience working with federal employees.  Do not expect that your phone call will be returned after 5 PM.

State Contractors

Illinois, like many other states, has out of control budget deficits and massive pension underfunding.  Michael Shedlock highlights the overweening sense of entitlement displayed by highway construction workers whose pay scale is determined by the state prevailing wage laws for public projects.  While making $50-$68 per hour, these workers are threatening to strike to increase their wages 5% per year to offset increased health care costs.  In contrast, hundreds of unemployed applicants have besieged Walmart to obtain $9.50 per hour positions in newly opened stores in the Chicago area.

Saving the Favored Banks

Amazingly, the top six banks’ holding companies made $51b in 2009 while the other 980 banks lost money:

Focus hard on this shocking Wall Street reality: The top six bank holding companies earned an aggregate of $51 billion in pretax income in 2009. We’re talking about JPMorgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, Citigroup and Wells Fargo.

All of this pretax income can be attributed to their trading revenues of $59.7 billion. The proprietary trading operations of an oligopoly of banks, saved from disaster by Uncle Sam’s largesse and subsidized with cheap money from the central bank, was the single driving force behind the restoration of their fortunes and the renewed surge in their stock prices.

For those willing to go long when the outlook was the bleakest, they’ve banked a double in JPMorgan Chase, scored a quadruple in Citigroup and nearly a quintuple in BofA.

Some of the other 980 bank holding companies–like Bank of New York Mellon, PNC Financial Services, U.S. Bancorp and M&T Bank–lost an aggregate of $19 billion for the 2009 year. Bank of New York Mellon had the seventh-largest trading revenue–it was just 1.6% of the total. By comparison, Goldman Sachs had 36.2%, Bank of America 18.8%, JPMorgan Chase 15.4%, Morgan Stanley 11.3%, Citigroup 6.9% and Wells Fargo 4.2%. See Six Giant Banks Made $51 Billion Last Year; The Other 980 Lost Money

I suspect that much of the vaunted trading revenue came from Federal Reserve borrowing at 0-.25% interest rates, and then buying higher yielding treasury securities.  Would you call that investing or just “shooting fish in a barrel” courtesy of the US taxpayer?

Government Intervention and Economic Recovery

Distorting economic incentives is one factor retarding economic recovery.  Crony banks are guaranteed profits while eschewing Main Street lending.  Private sector employees face insecurity in the workplace;  that does not translate into robust discretionary spending.  Further, while not currently a problem, and with abundant surplus labor, private sector employers ultimately will compete with government compensation packages 24% higher than the private sector.

This is a smattering of the distorted economic incentives in the world of Obama, Geithner and Bernanke and their state counterparts.   Their constant meddling and direct interference in the private sector guarantees that we will have plenty of distortions  in the future.

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8
Jul 10

The Tragedy of the Commons Part II: Modern Finance and BP

In Part I, we discussed the “tragedy of the commons” paradigm.   Financial excess in the housing market was a major factor leading us into the current financial crisis.  Finance is not the only area of concern.  Let’s turn our attention to BP.

BP, the Gulf of Mexico and the Eastern Seaboard

We are now approaching 80 days after the BP Deepwater Horizon oil rig spill.  Up to 100,000 barrels of oil are still spilling into the Gulf of Mexico.   The government now believes that by August 2010 there is an 80% chance that the spill will reach Miami coastal waters.  Once the oil slick starts moving up the Atlantic coast, some experts believe it will damage the fishing industries as far away as the Chesapeake Bay and even the Grand Banks off Newfoundland. See BP’s Crude Politics and the Looming Environmental Mega-Disaster

A dynamic tension exists among private profit, America’s need for oil, especially domestic oil, the government’s need for lease and tax revenue from the industry, and environmental concerns.  Despite campaigning against lax Bush Administration enforcement of oil drilling limits the Obama Administration ignored an environmental warning contained in a DC Court of Appeals decision.  Citing financial necessity, the Administration was able to overturn the ruling:

Less than four months after President Barack Obama took office, his new administration received a forceful warning about the dangers of offshore oil drilling.

The alarm was rung by a federal appeals court in Washington, D.C., which found that the government was unprepared for a major spill at sea, relying on an “irrational” environmental analysis of the risks of offshore drilling.

The April 2009 ruling stunned both the administration and the oil industry, and threatened to delay or cancel dozens of offshore projects in Alaska and the Gulf of Mexico.

Despite its pro-environment pledges, the Obama administration urged the court to revisit the decision. Politically, it needed to push ahead with conventional oil production while it expanded support for renewable energy. Obama Decried, Then Used Some Bush Drilling Policies.

The Risk of a Pro-Drilling Policy

A pro-drilling policy with minimal governmental supervision set the stage for the Deepwater Horizon tragedy.  Macondo History Before the Blowout provides a full analysis of the mistakes made at Deepwater Horizon.  First, Congressional investigators documented that BP took numerous short cuts: a cement log was not run, a lockdown sleeve was not used, they failed to circulate a sufficient quantity of mud, instead of a more sturdy liner they used a weaker production casing, and 6 rather than the recommended 21 centralizers were used.   While these shortcuts most likely contributed to the problem, the author focuses on human error.  The BP drilling engineer in charge ignored four major well events, referred to as “kicks” in the industry.  These are warning events.  One can surmise the engineer was trying to complete an over budget drilling project, quickly.  Drilling engineers are trained in mandatory safety courses to recognize “kicks” and take appropriate action.  Perhaps in a desire to expedite the project, he chose or was pressured to disregard obvious safety warnings.

Blowouts are a strong possibility when drilling. They are not rare events.  The author goes on to state “it is inexcusable that BP should have been so completely unprepared for the aftermath. BP should have had the containment built and tested ahead of time.”  By contrast, the Shell Corporation had a system on standby.

In pursuing its private interest in increasing shareholder value, BP despoiled a very large “commons.”  Avoiding an obvious extra expense, BP did not have a containment system on standby.  If the worst happens, BP will have fouled fishing grounds as far north as Newfoundland, and part of the Gulf region will become uninhabitable.  Of course, if BP goes bankrupt,taxpayers again will be asked to shoulder the clean up expense.

Private Interests, Public Policy and Protection of the Commons

The message and lesson of the Tragedy of the Commons is that there are dangerous activities requiring strict, intelligent and active regulation.  Neo liberal economists believe that regulation should not hinder the free market.  They assert that the free market will always self correct.  But in a technologically advanced and interconnected world, the stakes are far higher.  Unfettered capitalism can literally collapse the financial system as demonstrated by the recent financial crisis, or the eco system as demonstrated by the ongoing BP oil spill.

No one would question the right to limit private profit made through the sale of anthrax or nuclear materials.   We know that some activities are so inherently dangerous that the state should intervene and carefully control usage.   We are now learning that previously deemed “safe activities” can now have horrendous and unacceptable societal cost.

Nothing would please me more than for the financial industry to pursue whatever risky schemes they wish to engage in.  Just be prepared to bear your own losses.  Unfortunately, we learned that when it all explodes, we deem it a national crisis requiring domestic intervention to save the banks, insurance companies and industrial companies with finance arms (GE and GM).   In a parallel analogy, we have learned that an oil spill could paralyze an entire region of the country and perhaps the entire eastern seaboard.

We cannot afford too many more tragedies in our commons.  If we find ourselves privatizing profits and socializing losses, proactive and aggressive government regulation and intervention is going to be required.  At issue now is the viability of society itself, and that outweighs private gain anytime.

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6
May 10

Endangered Icons

Although the economy appears to be improving, we have to wonder whether we can sustain economic growth.  I believe that you cannot extrapolate from the last 25 years of experience to project future economic growth.  And if that is true, then we have to reevaluate some of our most basic financial and personal assumptions and expectations.

Disappearing Icons

McMansions – With reduced income prospects, rising energy costs, smaller projected family size, restriction on credit, higher down payments, and rising taxes, McMansions will become difficult to maintain or altogether unaffordable.

High Salaries - America has been a high wage economy.  With global competition and improved expert software, high paying jobs in law, finance, medicine and accounting will become scarce.

Regular Public Services – Garbage and trash pickup two or three times a week, six day per week mail delivery, and extended library hours are all possible future relics.   Furloughs due to state budget cuts will presage these cutbacks.  There is also cognitive recognition that perhaps many of these service levels were unnecessary in the first place.

Guaranteed Public Sector Job Security, Wage Increases and Pensions -   Shrinking municipal budgets (Harrisburg PA, Oakland CA, Detroit MI and others near bankruptcy) coupled with declining household incomes imperil the automatic public sector union collective bargaining escalator.  More likely, these jobs will be privatized and outsourced as property and income taxpayers who pay for these jobs will revolt.

Cheap Travel –The conquering of space (not the extraterrestrial kind) always seemed to be an American right.  Work commutes of fifty miles and more remind us that we are used to traveling for what we want, be it a home or job.  The current Gulf of Mexico oil rig explosion is one more reminder that oil extraction is costly and environmentally dangerous. We are facing Peak Oil with cheap gasoline a distant memory.     Our transportation options are bound to be affected.

Medicine on Demand – Current health care reform merely highlights an existing trend: medical care rationing. We have created great demand for medical services. At the same time young people are waking up to the prohibitive cost of medical education and the meager lifetime income return on this massive personal investment. Today there is a lengthy wait to see medical specialists.  The wait will only get longer.

Vacation Homes for the Masses – The economic problems associated with McMansions, falling incomes, rising taxes, insurance and maintenance and constricted credit have an even greater effect on the second home sales market.  When Americans are having a difficult time affording one home, a second home is rapidly becoming pure fantasy for most. See Vacation Homes – Not the Investment to Have When You are Having More than One.

Four Year College Educations – The four year college degree not only seemed to be an American birthright, but also a ticket to the good life.  But now these costs are rising faster than the CPI, and job prospects are unsure for graduates no matter where they go or what they study.  Perhaps the whole paradigm of formal study after high school should return to the world of the privileged or the extraordinarily talented.

Shopping Malls – Shopping malls have proliferated.  But malls were not developed to be discount centers.  And they presuppose cheap gas, easy credit and lots of disposable income for their ideal customer.  Current economics favor the opposite on all these counts.

The Welfare State – European sovereign debt is in crisis. This is not an abstract economic battle between government and evil short sellers.  Rather it is a wakeup call that the European social welfare state model is unsustainable.  The Obama administration’s efforts to emulate this crumbling model will fail in a new world order of falling national income, declining tax receipts and loss of credit.

At the Moment the Trend is Not Your Friend

Keynesian attempts to inject public funds into the private sector through large deficits will ultimately founder.  These efforts are fighting dominant trends: globalization with the impact of wage competition, Peak Oil, profligate public sector wages and pensions, and declining incomes.   Maybe it would be better to be realistic, adjust expectations and steer clear of these endangered species.  How did that old song go?   The best things in life are free?  And that is probably a good thing.

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29
Apr 10

Some Random Thoughts on Goldman

Tuesday’s Senate hearings on Goldman raised as many issues as they answered.  Today’s thoughts on the status of Goldman Sachs’ current folly and the US financial industry:

-          Goldman executives have no idea how angry the average American is at Wall Street in general and Goldman in particular.

-          Nobody likes Ivy-league trained, arrogant, wise-cracking executives, least of all those who wear great suits and have great haircuts.

-          In a work-related email, lack of discretion and caution can really return to haunt the writer.  Thus, characterizing a deal as “shitty,” calling the securities “monstrosities,” doubting the sale of your product to “widows and orphans,” and not understanding the complexities of these products guarantees later problems to both writer and firm.

-          When pressed on the use of the word “shitty” in the email, the correct response is not that it was an unfortunate use of words.  Rather, explain whether or not it was a good or bad deal for the investors.

-          To the average American, trying to justify a $9 million cash compensation package as “modest” will never work.

-          If indeed the customer comes first at Goldman, it is impossible to duck questions on fiduciary duty to your customer.

-           “I did nothing legally wrong” will only antagonize the SEC and other prosecutors.  The court will decide what is lawful.

-          As a corollary point, isn’t Goldman smart enough to stop its ongoing public relations releases attacking the SEC and proclaiming innocence?  Nobody believes them.

I have made much of Wall Street’s casino atmosphere.   The Senate should now focus on the following:

  • Why are these types of securities even  legal?
  • What societal or economic good do they promote?
  • How did Goldman and other firms prosper through the short-selling of their competitors’ securities (e.g. AIG, Bear Stearns, Lehman)
  • Even if a security is marginally legal, is it ethical to sell it to customers without detailed and comprehensive disclosures?
  • Since Goldman does not write mortgages, commercial loans or engage in other aspects of retail banking, why should it have a national bank charter?
  • Since it is really a disguised hedge fund, why should it be able to borrow at the Federal Reserve’s discount window at zero percent interest?
  • What is Goldman’s current level of leverage compared to leverage employed just prior to the financial crisis?
  • How could overuse of leverage cause a second more serious financial crisis?
  • Does Goldman (or any other firm) expect to be bailed out again if the crisis reappears?
  • What has Goldman done or approved to assure the public of no more tainted securities and no second bailout?   Personnel changes, managements controls, ethical standards, external oversight?

The press has given much coverage to these hearings.  It is now time for some thoughtful reflection on  Wall Street’s behavior: Is there excessive leverage? Favoring of certain financial institutions? Are we investing or gambling?  Have we learned any lessons? Where are the regulators?

For a public with a short attention span and a Senate looking for quick financial reform, it is handy to target Goldman.   Unfortunately, flogging their executives is merely peeling back one layer of the very large, smelly onion that Wall Street has become.

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22
Apr 10

Watershed Event in the Financial Crisis – SEC v. Goldman

There is an old saying on Wall Street: “no one rings a bell at the top.”  The same metaphor can apply to financial crises.  Plus, these aphorisms can lead to epiphanies: things are never going to be the same again.

In February 2007, HSBC issued a loss warning related to subprime lending, the first such announcement in its 142-year history.  See HSBC’s First Profit Warning Ushered in the Crunch.  CNBC tried to minimize the development pointing out this was only one bank and HSBC was responding to the problem by signaling a $10b write-off.  One month later, Ben Bernanke testified before Congress that “problems in the subprime markets seem likely to be contained.”  At the time I believed that this was a warning shot ushering in the financial crisis. In my own portfolio I acted accordingly, sold my stocks, and urged  family members to do the same.

The SEC v. Goldman lawsuit appears to be another watershed moment.

The Surprise Complaint

SEC v. Goldman is something other than business as usual.  Pertinent points:

  • Announcement of the complaint caught Goldman by surprise.
  • Wells Notice – The SEC sometimes issues a Wells Notice to inform a company that they may be the subject of an enforcement proceeding.  Companies usually disclose receipt of such a notice in a public 8-k filing.  Goldman did not do so, perhaps believing that it was not material or that they had defenses to the charge.  See Goldman Sachs Said to Have Been Warned of SEC Lawsuit.
  • Past SEC practice is to negotiate with the company and announce the action and the settlement simultaneously. It appears there were no serious settlement discussions.
  • This week Congress seriously moves financial reform legislation into law. Filing the fraud suit is a way to galvanize public support for reform.
  • Morgan Stanley was selected over the politically connected Goldman to underwrite the sale of the government’s position in Citicorp.
  • The German and UK governments have opened inquiries into Goldman’s CDO practices and have contemplated lawsuits to recover losses. See German,UK Demand Goldman Sachs Probe.
  • Special Inspector General for TARP, Neal Barofsky, is working with the Department of Justice to examine whether securities sold by Goldman to AIG constituted a fraud on US taxpayers.
  • Congresswoman Marcy Kaptur has written to US Attorney General Eric Holder  demanding a DOJ investigation of Goldman

Supporters and Detractors

Dick Bove, a bank analyst at Rochdale Securities, felt the lawsuit would be settled with a manageable fine and reiterated his buy recommendation on Goldman’s stock.  Unfortunately for Goldman, Mr. Bove was amazingly wrong on bank stocks throughout the financial crisis.  What Mr. Bove is not considering is the potential Pandora’s Box of lawsuits by defrauded investors.  It is too early to calculate the reputational damage to Goldman.  Perhaps the selection of Morgan Stanley to handle the Citicorp offering is a harbinger of other future Goldman underwriting losses. Also Mr. Bove did not consider a newly emboldened SEC.   Stung by public criticism   as a lapdog of the industry, the SEC may use this lawsuit to conduct further discovery implicating more senior executives at Goldman and other firms.

Goldman Was Not Alone

Unemployment remains high and credit remains limited for small business and individuals.   Wall Street continues to ignore the rising public mood of anger: Jamie Dimon lectures the German government on over regulating banks and blithely predicts bank crises every 5-7 years; Lloyd Blankfein  informs the public that  Goldman does the Lord’s work; CEO’s continue to receive record Wall Street bonuses, Wall Street still opposes financial reform legislation.

This is the wrong time in financial history to be tone deaf to the public.  Despite the pundit’s attempt to minimize the SEC complaint as a relatively minor matter, there is something more going on.  And come November, this public anger could very well threaten Democratic Congressional majorities and all incumbents.

The financial industry which has caused so much damage to the economy may have just met its match. None too soon.

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11
Apr 10

A Prince of a Fellow

Being Chief Executive Officer (“CEO”) of a Fortune 50 company is not an easy job.  CEOs get paid a lot of money.  How do they earn that money?  To assert that outsized CEO compensation bears any relationship to the position, the person must demonstrate extraordinary leadership skills, in depth business knowledge and foresight.  Thursday, Charles Prince, former CEO of Citigroup testified before the Financial Crisis Inquiry Commission.  He fell far short of these measures of excellence.

A Prince’s Testimony

Peggy Noonan, in the Weekend Wall Street Journal dismissed Mr. Prince’s testimony as bland. See After the Crash, A Crashing Bore.  I found the testimony fascinating for what he said and did NOT say:

-          The financial crisis occurred because interest rates remained too low for too long and “investors were reaching for yield.”

-          To satisfy demand for higher yielding instruments investors turned to securitized mortgage investments.

-          We were also satisfying the political agenda of encouraging home ownership.

-          We relied on statistical models and rating agencies.

-          Too many subprime mortgages were written and securitized

-          We had to announce an estimated $8-$11 billion write off

-          I resigned

-          The biggest problems were in the “super senior” mortgage tranches which my senior traders held in Citigroup’s portfolio. These caused some of the largest losses.

-          I was not aware of decisions made at our trading desk. I cannot fault our traders.

-          When I became CEO, I named a sophisticated chief risk officer who also missed the problem with the senior tranches.

-          We became aware of these problems in the fall of 2007 and held many high level management and special Board meetings. We were not able to avert this problem.

-          I am sorry for the damage Citigroup caused to homeowners, investors and others.

-          Citigroup is not “Too Big to Manage.” See Prince Testimony.

According to Mr. Prince, Citigroup “still had to keep dancing” as the subprime crisis worsened or it would lose business and employees to competitors.

The Banality of a Prince

Hannah Arendt, author of books on the Holocaust, coined the phrase the “banality of evil.” The phrase referred to great evil perpetrated by ordinary people who accepted  rules of the system, no matter how wrong or ill advised  Whether Mr. Prince is evil is for moral philosophers and historians to decide, but he is surely banal.  He looked like he was scripted for the hearings to be as bland and apologetic as possible.  What was missing from this performance was any personal responsibility.

Four themes pervaded Prince’s testimony:

  1. I had very smart traders and a sophisticated risk officer surrounding me, so how could you expect me to anticipate the problem when those on the front line were unaware of the problem?
  2. We were passive and ineffectual observers of external events such as low interest rates, greedy investors, federal housing policy, ineffective rating agencies and others.
  3. These actors conspired (woe is me!) to cause this problem and
  4. Everybody was in the same securitization business so it would have been unfair to our shareholders and our employees to exit the business; hence we had “to keep dancing.”

The Role of the CEO

In exchange for hefty pay a CEO needs to “see around corners.”  By his own admission, Mr. Prince saw nothing.  While the extremely well paid Mr. Prince received a $40 million severance package, he obviously did not fulfill his part of the contract.

In conjunction with attorneys, speech writers and public relations specialists we can now identify the “confluence” of factors that caused the crisis.  Where was Mr. Prince’s foresight to analyze these factors in advance and avoid the pitfalls?

Mr. Prince argues that the bank is not too big to manage. I would differ.  Mr. Prince either lacked the time, interest or acuity to grill his chief risk officer and senior traders on what could go wrong in subprime securitizations.  I was a senior executive of a corporation and an attorney by training. The first question I would always ask was: what could go wrong? What events and circumstances could close down the business?

Was Mr. Prince asking these questions?

Everyone Was Doing It

Finally, Mr. Prince brings us the classic defense used by generations of teenagers: “Mom, everyone is doing it, so why can’t I?”  His unarticulated motivation is apparent anyway: “if I had the moral and intellectual courage to exit the subprime business, my competitors would remain in, might make a lot of money and I would lose face before my senior management, Board and shareholders.  I might even lose my job!”

In the end Mr. Prince lacked the intellectual honesty, moral courage and leadership skills to be a CEO.  A Prince turned his shareholders and the American taxpayer into paupers.

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9
Apr 10

Above the Law: Too Big to Jail

By and large compliance with the law is voluntary.  Every crime cannot be prosecuted.  In an ethical business culture companies and individuals believe compliance is the right thing to do.  For those who lack a moral compass, the fear factor of imprisonment, fines and social obloquy do the trick.  But now companies display a disturbing cynicism toward legal compliance.

The notion of “Too Big to Fail” is no longer new.  Unfortunately, we are creating a new concept: “Too Big to Jail.”

Pfizer

  • CNN reports in Feds Find Pfizer too Big to Nail that Pfizer illegally marketed Bextra, a painkiller. The FBI conducted a criminal investigation and with much fanfare announced the appropriateness of a Pfizer indictment; i.e., fully prosecuting Pfizer would send a clear directive for tough law enforcement.  But the government did not try Pfizer, and instead settled.  The company agreed to pay a large fine, $1.2 billion dollars, and entered into a special reporting and compliance program.  The government did not seek the ultimate penalty of prohibiting (debarring) Pfizer from participating in Medicare and Medicaid programs.  Prosecutors reasoned:

that excluding Pfizer would most likely lead to Pfizer’s collapse, with collateral consequences: disrupting the flow of Pfizer products to Medicare and Medicaid recipients, causing the loss of jobs including those of Pfizer employees who were not involved in the fraud, and causing significant losses for Pfizer shareholders.

Thus, to avoid debarment, an agreement was reached between a shell subsidiary of Pfizer, which was created for the sole purpose of paying fines and the government.  One federal prosecutor questioned whether even a $1.2b penalty was enough to punish Pfizer.

JP Morgan Chase

To finance a sewer upgrade project Jefferson County (Birmingham), Alabama, entered into a series of financial transactions with a division of JP Morgan Chase.  JP Morgan advised the county to move from a fixed rate mortgage to a variable rate mortgage. JPMC then created complex synthetic derivative rate swaps to match cash flows between payments to bondholders and payments it was to receive from the bank for the interest rate swaps.  In 2008, these deals blew up. The county was then required to pay a major part of the project in 4 years instead of 40 years, and a $647m one time penalty fee. The county’s annual payments jumped from $53m to $636m.

In addition to the poor financial advice which has nearly bankrupted the county, federal bribery convictions were obtained against twenty officials and businessmen.  However, so far, JP Morgan Chase has not been indicted. Rather, it has faced an SEC action and been required to forgo collecting the $647m one time penalty. See Mike Taibbi’s excellent article and chronology Looting Main Street.

As with Pfizer, JPMC avoided indictment for reasons that are clearly expedient rather than ethical.  Karl Denninger on Market Ticker explains:

JP Morgan is the firm that handles the Federal Government’s food stamp program – by creating debit accounts so that there is no “stigma” associated with public assistance.  They issue what look like generic debit cards and of course collect a fee when they’re used, as well as a maintenance charge….

JP Morgan would have a hell of a time justifying the retention of their lucrative food stamp business were they to be charged and convicted of criminal fraud in the Jefferson County case.  See Greenspan’s Delusions Deepen

Reeling in the Small Fish

The government seems to be allergic to indicting and fully prosecuting the worst perpetrators of financial fraud.  For over two years Angelo Mozilo of Countrywide, the ground zero of shoddy mortgage practices, has been investigated without an indictment.

Instead we have been treated to insider trading cases involving Martha Stewart and Samuel Waksal in the Imclone insider trading case and Robert Moffat, an ex-IBM executive who fed inside information to the Galleon Group hedge fund.  Bernie Madoff was convicted only because he confessed to the crimes.  The SEC ignored evidence of his criminal fraud and indeed has been embarrassed by the revelations brought to light in the case.

The Unbalanced Criminal Justice System

A standard not written into the law is the preservation of a corporation deemed systemically important to the society as a whole.  As a result, the criminal justice system has treated the large corporate offender with kid gloves.  However, we now know that fraud was part and parcel of the current financial crisis.  And as Karl Denninger has opined, the system will not recover until we clear it of corporate corruption.  So, how to approach this ethical Catch 22 that may keep us in crisis for the foreseeable future?

President Obama is an attorney who is well aware of the disproportionate sentences meted out to accused and convicted minorities.  He was also a constitutional law professor who understood the need for equality under the law.  Yet more than two years into the financial crisis we have yet to indict, try and convict any “too big to jail” institutions.  Continuing this inequity will only convince Americans that there are two sets of laws, one for favored institutions and individuals and another for the rest of us.

No one should be above the law.

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