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16
Mar 10

The Failure of Extrapolation

The human mind loves linear extrapolation over time.  We build 5-year plans.  Graphically, five-year plans look like hockey sticks: first, slow and minuscule income, revenue growth in the first year, and then spectacular growth by the fifth year.  I have sat through a dizzying number of presentations for start up businesses which rarely, if ever, achieve their predicted spectacular growth.  For every Apple or Google there is a Pets.com and bankruptcy. ­­­ However, hope springs eternal.

Rosy Scenario and Her Evil Twin

Investment analysts, CEOs and government officials constantly project questionable positivity.  Prosperity is always around the corner, green shoots of recovery are everywhere, and a chicken will appear in every pot.  We pillory realistic if negative analysts as pessimistic naysayers, prophets of doom or worse.  But we ignore reality at our peril. More often than not Rosy Scenario often clashes with her evil twin Dashed Expectation.  The results are often calamitous.

Ignoring Reality

The last decade has brought ignoring reality to a high art form.  Linear extrapolation has brought the following prophesies:

  • Dow 36,000
  • Internet businesses with no customers and unrealistic business plans worth several times the value of established companies (IBM, DuPont)
  • Ever-rising housing prices
  • The FIRE economy (Financial, Insurance, Real Estate) supporting the entire American economy
  • Sustained non-problematic leverage ratios of 30 and 40:1
  • Debt growth several standard deviations greater than GDP
  • Counterparties to derivative contracts always making good
  • Never defaulting on sovereign debt
  • Pension fund assets always earning between 7-9%
  • Federal debt growing faster than tax receipts
  • Public sector wages growing faster than GDP and tax receipts
  • Aggressive accounting (Enron, Lehman) considered good financial engineering
  • Zero interest rates restoring economic prosperity.

Past is Not Always Prologue

We are prisoners of our past experiences.  We expect the Federal Reserve to cut interest rates and the economy to magically recover.  We are surprised when the nominal unemployment rate is at 9.7% and the actual is 17%.   We are surprised when Wall Street bonuses soar and Main Street suffers.  We are surprised when Moody’s threatens to downgrade US debt from AAA rating. See Moody’s Says U.S. Debt Could Test Triple-A Rating

Rarely do we say that this time is different.   As a society, we have incurred debt far exceeding our capacity to repay.  Balance sheet recessions/depressions are far worse than previous inventory recessions.  Just as the Vietnamese fooled our World War II trained generals, the Federal Reserve and Administration are intent on fighting an outdated economic war.

It is time for some nonlinear thinking.  Instead of posturing, Congress should be asking Ben Bernanke for a Plan B.  Averting financial Armageddon is not enough.  JP Morgan CEO, Jamie Dimon, projected a banking crisis every five to seven years.  See Elizabeth Warren Exposes Jamie Dimon. As a society we can ill afford another year like 2008.  Reality is gaining on us.

How well did the five-year plans work out for the brittle Soviet system?   Is it time to ditch Rosy Scenario and deal with reality?

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1
Mar 10

Labor and Employment Laws: The Hidden Job Killer

When we ignore government sleight of hand, the real number of unemployed Americans is a staggering 26.9 million.  In For 15 Million Unemployed any Job is a Good Job; Questions for Pollyannas; Wishes Aren’t Fishes, Michael Shedlock (“Mish”) continues his excellent analysis of the unemployment situation.  Contrary to Bernanke and Obama Administration rosy projections, Mish predicts that official unemployment will remain greater than 9 % through 2015.  In a quote from Allen Sinai, chief global economist for Decision Economics, Mish describes corporate hiring behavior:

American business is about maximizing shareholder value…You basically don’t want workers. You hire less, and you try to find capital equipment to replace them.

Workers are expensive. Federal, state and local employment laws make them more so.

New Deal Labor Legislation

In the late 19th and early 20th century, rapid industrialization resulted in powerful owner/capitalists, virtually powerless workers, and deplorable working conditions.   Upton Sinclair’s The Jungle dramatized the deplorable state of affairs in the meatpacking industry.  In reaction, in 1935, Congress passed the Wagner Act to permit union organizing. Then it enacted the Fair Labor Standards Act to establish minimum pay, limitations on hours and pay for overtime work.  Perhaps labor legislation should have stopped at that point.

Nothing Succeeds Like Excess

New Deal labor legislation was just a springboard for greater federal control over the workplace.   Since 1964, there has been a flood of labor and employment legislation and Executive Orders.

  • The Civil Rights Act prohibits race, color, religion, sex or national origin and pregnancy discrimination.
  • The Age Discrimination in Employment Act prohibits age discrimination.
  • One Executive Order prohibits all forms of discrimination and requires affirmative action.  This includes training and outreach programs and other positive steps which must be incorporated in written personnel policies and a plan which must be updated annually.
  • The Equal Pay Act requires that men and women in the same workplace be given equal pay for equal work.
  • The Americans with Disabilities Act prohibits disability discrimination. The Rehabilitation Act requires most federal contractors and subcontractors to take extra measures to hire and promote qualified disabled individuals.
  • The Occupational Safety and Health Act requires employers to meet legal health and safety standards.
  • The Employment Retirement and Income Security Act (“ERISA”) sets uniform minimum standards to assure that employee benefit plans are established and maintained in a fair and financially sound manner.
  • The Workers Adjustment and Retraining Notification Act requires that covered employers provide notification sixty days before a plant closing or a mass layoff.
  • The Family and Medical Leave Act provides covered employees with entitlement to up to 12 weeks of job-protected, unpaid leave during any 12 months for the following reasons:

-Birth and care of the employee’s newborn or adoption or foster care of a child

-Care of an immediate family member (spouse, child, parent) who has a serious health condition

- The employee’s own serious health condition

These are the major pieces of federal labor and employment legislation, but there are additional enactments regulating the employment relationship.

Since we live in a federal system, state and even municipalities impose additional employment, benefit and labor obligations.  Moreover, the courts have intervened to create doctrines such as wrongful discharge to limit an employer’s right to dismiss an employee at will.

Real World Consequences

Much of the above legislation is grounded in noble sentiment: workplace fairness and employee protection.  But there are real world consequences: a loose definition of “serious health condition” allows employees to take large unpredictable amounts of time off, harming production schedules.  Affirmative action programs require lots of staff and recordkeeping, extra recruitment and training, and slower hiring.  ERISA imposes fiduciary liability on plan sponsors. With virtually every workplace sector protected, firing an employee is difficult, with the ever present danger of a discrimination or retaliation charge. And so the American workplace is now one of the most regulated areas of our economy.

Laws are often a hidden tax. See Ask Your Congressional Representative to Do Nothing.   Allen Sinai has reached the correct conclusion: why hire expensive workers who have a host of protections and entitlements when you can substitute cheaper capital (automated machinery, robots, computers, etc)?  In a globalized economy where a highly motivated, well-trained Chinese worker makes about $1 per hour, the over protected American worker may have priced himself out.

If the Obama Administration is serious about reducing the unemployment rate, it should be thinking about shelving expensive health care initiatives and the Employee Free Choice Act.  More employer cost will equal less American employment.

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16
Feb 10

Where Are We Now?

“Where Are We Now?” is my fiftieth blog post.  The purpose of a political and economic blog is to “connect the dots” looking for coherent patterns.  This post will attempt to do just that, warning you that the emerging pattern is disturbing.

Slow Motion Depressions

Policy makers in Washington and other western capitals are recently smug. They proclaim that, through coordinated monetary and fiscal response, we have averted the Second Great Depression.  More bluntly, all we have done is throw a lot of money at the problem through unprecedented monetary easing and a fiscal policy of bailouts and stimulus bills.  The core financial issue remains:  western countries and the US in particular have too much debt and insufficient income to service that debt.  Depressions have their own timetable. In my opinion, government intervention has only slowed the timetable, but definitely has not averted the event.

The Magic Act

Politicians and central bankers are a bit like magicians.  While an observer is firmly focused on the right hand we miss the left hand’s activities, which are hiding in plain sight.   Just look at current economic and financial trends:

  • Increasing Risk of Sovereign Debt Default – In late 2009 a problem arose with the financial solvency of Dubai.  Much like the subprime crisis in the US, financial pundits assured the public that the Dubai default was minor and self contained.  Yesterday, credit protection for Dubai rose to a record high exceeding the November peak. See Dubai CDS Hits 652, Ploughs Through November Highs As Gold Jumps.   Greece too is on the verge of sovereign debt default and is seeking a European Union bailout.  Portugal, Ireland, Italy and Spain are reportedly in dire financial trouble as well.  The United States, Japan and United Kingdom are not immune from talk of default.
  • Crisis at the State Level – The Center for Budget and Politics has projected 48 of 50 states will have budget deficits.  Cumulatively, the Center estimates an $180b shortfall for this fiscal year.  All states with the exception of Vermont have a balanced budget requirement.  Some assistance to the states has been proffered through the American Recovery and Reinvestment Act, but it is questionable whether this aid can continue. See Recession Continues to Batter State Budgets; State Responses Could Slow Recovery. It is more likely that states will follow the lead of newly elected Republican Governor Chris Christie.  Recognizing that the state is on the edge of bankruptcy, Christie has declared a fiscal “state of emergency” and intends to slash $2.2b from the budget. See Chris Christie Declares Fiscal ‘State of Emergency,’ Paving Way for NJ Spending Cuts. The crisis in municipal finance portends trouble in the municipal bond markets.  The unsuspecting public has purchased municipals in search of yield and instead may receive an unpleasant surprise.
  • National Fiscal Irresponsibility – President Obama signed into law a $1.9t increase in the debt ceiling, raising it to $14.2t. As the administration has predicted deficits out to 2020, this ceiling will rise each and every year. Also, it does not include the Christmas Eve bailout of Fannie Mae and Freddie Mac which provided “unlimited financial assistance” to these two entities. We will likely exceed our previous limit of $400b on financial assistance under emergency bailout provisions.  See US Promises Unlimited Financial Assistance to Fannie Mae and Freddie Mac.  Moreover, how can we continue to finance these deficits without an increase in interest rates?  However, such an increase in interest rates could put the US in a “doom loop,” as interest payments become the dominant budget line item crowding out other federal spending programs.
  • China – Recently China has made a number of financial moves that do not bode well for the US and world economy. First, China has ordered its currency managers to withdraw from any US dollar denominated risk assets, such as corporate bonds, equities and only invest in US guaranteed assets.  Second, it has raised its reserve requirements on its own banks to dampen an over-inflated domestic real estate market.   Speculation in Chinese real estate has reached the point that Jim Chanos, a respected investor, predicts an economic collapse.  See Jim Chanos: China Bubble Ready to Burst. Given the size of our deficits, the US desperately needs China to continue purchasing US government securities. The world needs China as a growth engine to continue world trade and prevent a second leg of the recession.

Harbingers of the Economic Unraveling

Before the next phase of an economic crisis there are often clues to impending problems. Some harbingers to consider:

  • Junk Bonds – The Greek crisis has spurred investors to sell junk bonds, highly risky assets, at the fastest rate since 2005.  As a result credit spreads are widening between treasury and higher risk corporate bonds. See Junk Bond Spreads Widening: A Canary in the Coal Mine.
  • Problems in a Treasury Auction – Last week’s US 30-year Treasury bond auction was considered a failure.  Indirect bids, that is, foreign buyers, dried up and the government had to offer a yield of 4.72% compared to an expected yield of 4.687%.  See Dismal $16b 30 Year Auction
  • Credit Card Problems – Capital One, a major credit card issuer, reports that in January delinquencies rose and that expected unrecoverable loans have risen to 10.41% from 10.14% in December. See Capital One: Credit -Card Delinquencies Rose in January.
  • State and Municipal Finance –In its upcoming July 1 fiscal year budget, California expects a $20b shortfall.  Illinois has a $61b pension shortfall, and is borrowing to make contributions.   Harrisburg, Pennsylvania, is contemplating a March 1 bankruptcy filing.  These stories are the proverbial tip of the municipal finance debt iceberg. See Illinois Pension Fund $61b Underwater; State Borrows Money for 2010 Contribution; California $20b in the Hole Again.

Reality

Till now the policy direction of the Obama administration and other western leaders has been to “extend and pretend:”  we will ignore economic realities by permitting banks to suspend “mark to market accounting” and we will send various administration spokesmen to spread the fairy dust of “green shoots” to pacify an anxious public.  Essentially, we have an economic policy of faith and hope that willfully ignores reality.  Economics does respond to the laws of mathematics.  Like a termite that silently eats away the wooden supports of a house, excessive debt has eaten away the structure of the world economy.  There will be more troubled countries like Dubai and states like California before this Depression has run its course.

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5
Feb 10

It is All a Derivative of Productive Enterprise

The bulls on CNBC touted the increase in health care employment in the most recent Non-Manufacturing Institute for Supply Management Report on Business. Similarly, Fox Business News trumpeted growth in health care employment, but did point out these jobs paid substantially less than jobs in the manufacturing sector.  What both news outlets missed was that these jobs were derivative.  These positions are substantially funded by the productive sectors of the economy.

Economic Illiteracy

Michael Shedlock this week focused on a major theme plaguing America, economic illiteracy. See Are Teachers to Blame for Economic Illiteracy? Nowhere is this lack of economic literacy more evident than in the service sector in general and health care in particular.  If polled, most Americans would most likely answer that the government or insurance companies provide health care in the United States.  Medicare and the current debate on health care reform only add to this misperception.

Thank Goodness for the Private Sector

Health care money comes from the support of the private sector which directs a portion of a workers’ compensation to paying health insurance premiums for their employees.  Public sector employers also pay health insurance premiums for their employees.  However, in the case of the public sector, that employer is recycling tax receipts, real money, received from private sector activities.  In short, without a productive private sector there would be no health care support.

Restoring Economic Literacy

Americans have come to expect a “free lunch” from the government. Of course, this is fantasy; there is no free lunch.  Health care is paid for by our productive enterprises and manufacturing was the lynchpin.   Further, other service industries such as law, insurance, travel, leisure, entertainment, and others are derivatives of productive manufacturing enterprises.  When the economy turned down law firms were among the first to layoff partners and associates.  Without a vibrant private economy legal activity declined, with fewer contracts real estate transactions, mergers, acquisitions and frivolous lawsuits.  Corporations reduced their legal budgets.  Similarly, other service businesses contracted.

Outsourcing lucrative manufacturing jobs and global wage arbitrage have only worsened the unemployment situation in the United States.  Reliance on a service economy and public sector employment has been false bedrock for our system.  If we want first class health care, we must bolster the private manufacturing sector and reduce the public sector.  Government dominance of our health care system and other service sectors (think banking) only ensures larger deficits, continued recession, higher unemployment and an inadequate, underfunded, cheap, quick and dirty, band aid solutions health care system.

That is not a good prescription for anyone’s health.

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2
Feb 10

Timothy Geithner and Plausible Deniability

Congressional hearings often make wonderful theater.  Last week at the House Oversight and Government Reform Committee, the American public heard testimony from Timothy Geithner, former head of the Federal Reserve Bank of New York and now US Treasury Secretary and Henry Paulson, former US Treasury Secretary.  Both men’s testimony relied on one premise: if we did not bail out AIG and pay its counterparties 100 cents on the dollar, the financial world as we know it would have ended,  i.e., the US would have plunged into a second Great Depression.  By written statement, Fed Reserve chair Ben Bernanke informed the Committee of his full support for this decision.  In person, Henry Paulson agreed.  However, both men said they had nothing to do with the decision.  Further, Mr. Geithner testified that he had relied on his staff or details of the bailout.  And even further than that, he later distanced himself from the decision whether nor not to disclose the details of the bailout. America was treated to the concept of “plausible deniability.”

Plausible Deniability

Working in a corporation one gets a firsthand look at the concept of “plausible deniability.”  Plausible deniability works something like this: a crisis starts; an important decision must be made; a senior executive is charged with making a decision; the senior executive delegates much of the preparatory work to  staff or a trusted lieutenant; the staff or trusted lieutenant ultimately makes a recommendation which later becomes “The Decision. “  If or when something goes wrong in the future, the senior executive denies involvement and places the blame on the staff or the trusted lieutenant.  Almost every time, the superiors of the senior executive accept this scenario.  The senior executive survives.

Let’s Get Real

Harry Truman said “the buck stops here,” meaning that the most senior executive has ultimate responsibility for a decision.  Perhaps with President Clinton or at some time it became fashionable for the senior person to distance himself from the decision so that he would have plausible deniability.  Further, it was expected that subordinates would “throw themselves on their swords” to preserve their boss.

It stretches credulity that the three most senior financial executives in government, The Chairman of the Federal Reserve, the President of the New York Federal Reserve and the Treasury Secretary did not know the intimate details of the AIG bailout.  At stake at the time was $62b of taxpayer money to effect this phase of the bailout.  All three men agree that if the bailout did not take place financial Armageddon would have ensued.

More is expected of our public servants. We appointed these individuals because of their unique skills, judgment and character. Apparently, these individuals were unavailable in the AIG crisis to make critical decisions.  Based on these stated actions, I deplore the confirmation of Ben Bernanke.  Moreover, I would ask for the resignation of Timothy Geithner.

It is time that high level government officials took responsibility and become the watchdog of the public purse. Trying to blame subordinates should elicit the response from the public: “that dog won’t hunt!”

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27
Jan 10

We Can Handle the Truth

“You can’t handle the truth!” Col. Nathan R.Jessep in A Few Good Men

After his election President Obama had the opportunity to educate the public on the causes of the financial crisis and the necessary steps to help us emerge from it.  Over this past year, he has squandered this chance, and in so doing has created the political backlash that is occurring today.

Policy Making and the Truth

With great fanfare, we inaugurated President Obama against the backdrop of the greatest financial crisis since the Great Depression.  In any new Administration, policy making is never easy and advisors at times seem to operate in virtual echo chambers, hearing only themselves.  They presented Obama with a range of options: nationalize the banks; let them fail and let the bankruptcy courts sort it all out; continue the Bush/Paulson bailout policies.  From the beginning, Obama advisors took the middle of the road policy to continue the bailouts.  As voters and participants in a democracy, we can now see the missing piece in this scenario. President Obama owed the public an explanation of this policy choice.  My guess is that his advisers warned against candor.  I would further conjecture these advisers felt that candor would have made the crisis worse.  Elites always worry about scaring the masses. This was confirmed at today’s Congressional hearings on AIG.  AIG was viewed by both Timothy Geithner and Henry Paulson, as the “end of the financial world as we knew it.”  The Administration and we are now suffering the consequences of this subterfuge.

Back to the Future

President Obama could have made a few simple points that would have educated the public, built a consensus for his policy choice and left open future policy options if the bailout approach failed.

President Obama could have made these simple and direct points:

  • We are facing the greatest financial crisis since the Great Depression
  • We got into this problem by borrowing too much, and producing and saving too little
  • At the center of this crisis are the large money center banks and Wall Street investment firms
  • Using inappropriate levels of borrowing and creating non-transparent products, derivatives, which could not be accurately valued or traded, these banks and firms gambled with our money.
  • Banks, however, are the transmission mechanism for getting money into the economy through check clearing, making loans and other services.
  • We are going to provide enough support for the banks to continue their necessary and transparent functions.
  • There will be a consequence to any bank for needing this ad hoc and unusual government support.
  • Shareholders and creditors of the banks must share in some of the losses.
  • Bank employee bonuses will be severely limited or eliminated until the banks recover.
  • The government will take part ownership in the banks until they return to financial health.
  • I have asked my Attorney General to investigate whether these institutions committed any crimes.  I will ask him to hold indictments in abeyance until we are on our way to recovery.
  • Let me assure you that the government will punish wrongdoing.

We Build Prisons of our Own Making

We know this fictional address to the public did not take place.  The Obama Administration now owns the policies of failed bailouts.  The recovery is precarious and now the government asserts that the health of the stock market hinges on re-appointing Ben Bernanke as Federal Reserve Chairman.  The Massachusetts senatorial election was a wakeup call that the middle class is “mad as hell and isn’t going to take it anymore.” See The President Wakes Up and Smells the Election Results.

In tonight’s State of the Union Address, President Obama scratched the surface of candor. He stated that he hated helping the banks, but that failure to do so would have led to greater unemployment, business closure and lost homes.  President Obama, it is not too late for complete candor. It is not too late to commence investigations and prosecutions.

Col. Jessep was wrong: the American public can handle the truth!

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25
Jan 10

Freedom to Fail

In his 1941 State of the Union address, President Franklin Roosevelt articulated four iconic freedoms:

  • Freedom of speech
  • Freedom of religion
  • Freedom from want
  • Freedom from fear

In our current situation, capitalism needs a fifth freedom, the freedom to fail

The Systematic Destruction of the Freedom to Fail

In the 1950’s, Dr. Benjamin Spock’s child rearing advice focused on a child’s self-esteem rather than discipline, performance, success or accomplishment.  This emphasis correlated to a new and pervasive permissiveness which sought to prevent failure as a childhood experience rather than process it for personal growth when it inevitably occurs.  And so the advent of the “Lake Wobegon effect:”

where ‘all the women are strong, all the men are good looking, and all the children are above average,’ … used to describe a real and pervasive human tendency to overestimate one’s achievements and capabilities in relation to others. The Lake Wobegon effect, where all or nearly all of a group claim to be above average, has been observed among drivers, CEOs, stock market analysts, college students, parents, and state education officials, among others.

And so we coddled the Baby Boom Generation.  If our child failed a course, get a tutor.  If College Board scores were not high enough, enroll the child in a review course.  Everyone was entitled to a college education, a house and a good paying job. Originally, affirmative action was designed to overcome discrimination.  It morphed from its original intent, equality of opportunity, to equality of outcome.   In the corporate environment, one’s status (that is, minority, female, disabled among others) many times trumped one’s accomplishments. I am in favor of the original purpose of affirmative action, but not its wrong-headed incarnation.

The Financial Crisis and the Freedom to Fail

The government stepped into the breach to prevent major institutions– AIG, GE, American Express, Capital One, GM, Chrysler, Fannie Mae and Freddie Mac– from failing.  In an economic analogy to Dr. Spock parenting, the Fed reacted as a permissive and nonjudgmental parent to a child eminently deserving of a failure experience from which to learn something.  By not permitting these institutions to fail, we may have exposed ourselves to much larger systemic failure with a default or devaluation of our currency.

Failure is Integral to Success

We should think about our own personal life paths.  Did we learn more from success or failure?  If we are honest with ourselves, we would admit that we learn much more from failure.  It builds resilience, humility and,  if we absorb the lessons, a path to success.  It is almost immoral to take away the ability to fail and learn.

Joseph Schumpeter, an Austrian economist, in Capitalism, Socialism and Democracy, theorized that “creative destruction” was integral to capitalism:

the same process of industrial mutation–if I may use that biological term–that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. . . .

Failure is an excellent teacher.  Permitting smaller failures after the internet boom would have saved the country the anguish of millions of people losing their houses, the near destruction of our banking system and the collapse of the stock market.

Now the government would be prudent to permit business failures regardless of business size or political connections.  Sparing the rod of failure only spoils the childlike business with more reckless behavior.  Without the “hell” of failure, there can be no “heaven” of success.

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19
Jan 10

Citigroup, Branch Rickey and the Theater of the Absurd

In 1951, Pittsburgh Pirate Ralph Kiner led the National League in home runs, but his team lost 112 games and finished last.  In response to Kiner’s request for more money, legendary general manager Branch Rickey said: “We finished last with you; we can finish last without you.”

Where is Branch Rickey when you need him?

Citigroup 2009 Earnings

This morning Citigroup announced that it lost $7.6b in the fourth quarter of 2009 and $1.6b for the full year. The Wall Street Journal pointed out the positives: better than last year’s fourth quarter; narrowing losses in the consumer credit area; greater efficiencies and financial stabilization.

The main stream media seems determined to make poor performance sound better than it is. I guess we don’t want to ruin the self esteem of executives, who are trying really really hard.

What the media fails to point out is that Citigroup has been given every financial advantage.  The government has given it TARP funds, participates in its capital structure with a 34% ownership stake, and has permitted the bank to mint money with a zero interest rate policy.

Citigroup Bonuses

Citigroup announced a bonus pool of $24b and the media again has obfuscated the real story.   The headline in the Times Online (London) is: “Citigroup Cuts Compensation by 20% as Losses Fall.”  Dig into the story a little further and there is virtually no reduction in compensation.  Because of layoffs the compensation pool of eligible executives has been reduced by 18%.  Thus, the compensation pool is virtually flat year over year.  The company has lost $1.6b this year and $29.2b over two years.

The CNBC corporate apologists attempted to justify the bonuses: there was improvement, Citicorp needs to retain executives to remain competitive, and the bonus will be paid in stock.  One commentator did point out that the stock was immediately vested, and therefore indistinguishable from a cash bonus.

There was a Different Time

I have written about disconnecting effort and reward. See What Went Wrong? Disconnecting Effort and Reward. Citigroup results have made me think that we have also disconnected results and rewards.

In a different time, I worked for a company that one year paid no bonuses.  That year we had poor financial results, but did not lose money.  Based on the poor results, the Chairman and CEO engaged in no handwringing, no excuses, no attenuated intellectual justifications nor elaborate proofs. He merely reached the conclusion that poor performance equaled no bonus – amazing in its simplicity.  As a result, very few executives voluntarily left the company, the world did not end, we all worked harder, and did better the next year.

Maybe Mr. Pandit, Citigroup CEO, should channel his inner Branch Rickey and eliminate all bonuses for 2009.  His reply to whining executives who threaten to quit: “we lost $29.2b with you; we probably could have lost $29.2b without you.”

Branch Rickey applied one other perfect aphorism to a non- producing, disruptive ballplayer:

“It was addition by subtraction.”

Too bad Mr. Rickey is not around to advise Citigroup.

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4
Jan 10

What Went Wrong? Disconnecting Effort and Reward

A decade of financial frustration has just ended with US equity returns negative for the entire period.  This is the first time this has occurred, and that includes the 1930’s America’s Great Depression.  A grim statistic indeed; what went wrong?

The United States began and thrived as a nation of ideas, imagination, hard work and grit.  Its hallmark has been a population that saved and produced.  Contrary to these admirable national character traits, Alan Greenspan and his protégé Ben Bernanke utilized low interest rates and a “fire hose” of liquidity to solve financial crises. From this folly, we now suffer negative consequences detrimental to the very fabric of American Society. See Shredding the Social Fabric.

The Age of Get Rich Quick Schemes

America has always had a history of “get rich quick schemes:” the California Gold Rush, the Florida land boom and the “roaring”1920’s stock market.  These booms and inevitable busts were damaging, but did not change America’s basic character.  Even the Great Depression did not change our basic values of thrift and hard work.  But the toxic combination of Greenspan’s easy money, and ubiquitous information and spin disseminated via the internet and financial television elevated “get rich quick schemes” to national obsessions.

  • The Internet Boom – A poster child and pitiful example for the boom and bust was MicroStrategy.  From its initial offering in June 1998 it rose to a market cap of $26b.  The founder was found guilty of numerous SEC violations.  Still in business 11 years later the company has a market cap of $1.1b.See Search for Redemption.
  • Day Trading – Closely allied to the internet boom was the wave of day traders who quit their jobs to spend full time trading stocks.  Many achieved temporary riches only to suffer huge losses after the internet boom turned to bust. See Downfall of a Day Trader.
  • House Flipping – To offset the internet stock market crash, the Fed adopted a policy of ultra low interest rates.  In the ensuing housing frenzy from 2002-2007, speculators flipped houses and even raw land.  The disastrous results are now obvious.
  • Credit Derivatives – Experts from Myron Scholes, the Nobel Prize winner for his work on valuing credit derivatives (Black-Scholes model) to Warren Buffet view credit derivatives as financial weapons of mass destruction. These esoteric instruments were key factors in the recent financial crisis and many believe the problem has not been fixed. Indeed derivatives became a source of large profits for Wall Street firms, often at the expense of their own clients.  See Banks Bundled Debt, Bet Against It and Won.
  • Ponzi Schemes – Disregarding obvious warning signs, sophisticated investors lured by consistent above market returns were ultimately defrauded by Ponzi schemers like Bernie Madoff, Allen Stanford and others.
  • Wall Street Bonuses – Instead of holding capital in reserve in anticipation of the next financial crisis, Wall Street firms are paying record bonuses this year equal to fifty percent or more of revenue.  This easy money is even more galling as we used taxpayer money to stave off bankruptcy in these same firms.  The lure of easy money trumped prudent financial strategy. See Wall Street on Track to Award Record Pay.

Disconnecting Effort and Reward

The last decade has made fools out of the average working person.  Why work at a $50,000 a year job, stay out of debt and try to save 10% of your income while others reap outsized rewards with seemingly little effort?   Low cost, virtually unlimited lending enticed many to “day trade”, “house flip” and engage in a consumer orgy.

I have chronicled the obvious problems of too much debt.  We will take a long time, if ever, to work our way out of this morass.  More damaging was the disconnect between effort and reward.  Financial schemes replaced production.  We invested scarce societal savings in these get rich schemes which make economic recovery even more difficult.

And too, our precious human capital has been compromised, as resources were diverted from teaching, engineering and management programs into MBA’s in finance.  A prestigious job on Wall Street became way more attractive than teaching, engineering, entry into a manufacturing company or even law or medicine.  This was not just a financial crisis, but a crisis of American character.  I hope it does not take ten years to return to fundamentals and our core national values.

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28
Dec 09

Trust Once Lost

My college history professor had an astute observation: “trust once lost cannot be easily regained.”  Naked Capitalism has two excellent posts today: “Is Blaming AAA Investors Wall Street Serving PR?” and “Has Obama Been a Success despite Suspicions of Crony Capitalism?” A common theme that both articles fail to fully articulate is– trust.  Trust is a commodity everyone now sells short.

Wall Street’s Treatment of Investors

In “Is Blaming AAA Investors Serving Wall Street PR?” Thomas Adams argues that Goldman Sachs and other clever bankers are pinning the blame on institutional investors who bought AAA-rated, collateralized debt obligations. Many of these securities turned out to be worthless. The investment banking community argues “caveat emptor,” but Adams convincingly rebuts:

The argument that the CDO market blew up because it was so complex and speculative is fundamentally flawed. Believe it or not, the bonds that caused the damage to AIG, the bond insurers, and banks were not highly speculative, high risk bonds. They were AAA securities and were supposed to be virtually free of credit risk. In many cases, they were “super senior” bonds – meaning they had another layer of protection above the AAA level to make them even safer than regular AAA bonds.

AAA securities were meant to be easily understood by any investor.  These products should not have required sophisticated analyses as Goldman and others now argue.

Adams cuts to the heart of the investment banker’s sin:

The problem with the CDO market, and a good chunk of the financial crisis, is that the participants took complex, highly volatile, highly risky and highly leveraged assets and passed a magic wand over them to turn them into AAA. Unfortunately, this process did nothing to remove the volatility, risk, complexity or leverage (in fact, the CDO made all of these worse). From the very start, the market for AAA CDO bonds backed by ABS collateral was a fraud….

Most telling is that the same investment banks selling these investments as AAA securities were simultaneously shorting the same securities to profit from their eventual default. See Banks that Bundled Bad Debt Also Bet Against It.

This is the new age of investment banking.  Would Sidney Weinberg the legendary head of Goldman Sachs bet against his own clients? I suspect not. Mr. Weinberg understood the basic value of trust.

What Price Success?

The Obama administration is extremely proud of stabilizing the economy.  In “Has Obama Been a Success Despite Suspicions of Crony Capitalism?” Edward Harrison addresses the large gap between the President’s words and deeds. Harrison bypasses Obama labels — liberal, a closet republican, technocrat — and instead examines the evidence:

The evidence, therefore, tends to demonstrate that we have witnessed an orchestrated campaign by the Bush and Obama Administrations to recapitalize too big to fail institutions by hook or by crook, bypassing Congressional approval if necessary. And when it comes to healthcare, both Congress and the White House have bent over backwards to keep the lobbyists onside. As I see it, our government has favored special interests in the past year of Obama’s tenure to our detriment.

Thus, banks or pseudo-banks are guaranteed survival (e.g. American Express, GE, Goldman Sachs and others) while Main Street (small businesses and community banks) is pushed to the back of the economic assistance line.

And consider other erosions of public trust by the Obama Administration:  an alphabet soup of federal guarantee programs, sham bank stress tests, suspended accounting rules, and favoritism toward health insurance companies and big pharmaceuticals in the current health care debate.

The Age of Cynicism

We live in an age of flawed short term thinking.  How do we make our numbers for the next quarter? How do we get through this financial crisis? How do we get a health care bill passed so we can claim victory? How do we win the 2010 elections?  Each “success” comes at a very high price.  America is a carefully woven social contract with trust as its bedrock.  But increasingly, cracks now appear in this bedrock of trust just when it is most needed.  Will public trust be completely gone when the inevitable next crisis occurs?

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