Regulation

American Society / Consulting / Corporate Behavior / Political / Regulation / Tax Policy — 0 Comments
21
Jun 11

Corporations: The Good and the Bad

In Are Corporations Really the Devil? we examined the concept of corporate profit maximization.  Corporations are essentially amoral in nature, pursuing economic efficiency for the benefit of shareholders. In this pursuit they exhibit both good and bad behaviors.  Since Charles Hugh Smith conflates corporations with the “work of the devil,” let’s begin with his thesis of the evil corporation.

The Bad

Having worked for thirty-plus years within the bellies of these beasts I can indeed report lots of bad stuff:

Greed – Executive compensation often dominates the corporate agenda.  It is a costly diversion, consuming the efforts of attorneys, consultants, accountants and senior management.  Management is often diverted from the more important job of running the business.  In the end neither shareholders nor the executives are satisfied.  The result of the process is that there are too many overpaid executives.  Few if any executives demonstrate the management acumen justifying such overly generous compensation packages.

Lack of Foresight – I could excuse large pay packages, if a senior executive had true foresight and talent in matters relating to the business of the corporation itself.  The record of too many CEOs?   They stayed in businesses which should have been sold, missed investing in and deploying new technologies, made horrendous hiring decisions, laid off employees when they should have been hiring, and were late in removing poorly performing executives.   A corollary truth to this realization:  many executives can competently perform their jobs, but few are visionary.  Few executives can follow hockey great Wayne Gretzky’s advice: “…skate to where the puck is going to be, not to where it has been.”

Careerism and Promotions – Many executives put their own career advancement over the good of their employees, fellow executives and the corporation.   And worse, business ethics and simple interpersonal courtesy and manners were routinely and very sadly lacking.   Bad corporate behavior includes:  withholding of critical information, undercutting colleagues’ efforts, and wasteful projects for self aggrandizement.  Many times bad behavior leads to ethical lapses and legal shortcuts that subject the company to expensive liability.

Many times the wrong person is promoted into a higher level job for all the wrong reasons.  The tireless self-promotion and undercutting of colleagues that some executives made their modus operandi sent terrible messages to good performing employees when these behaviors were rewarded with inappropriate promotion and aggrandizement.

Abnegation of Responsibility - When something in a corporation goes wrong, executives who accept blame and responsibility are few and far between.   It is the rare executive who accepts blame for a decision gone awry and takes responsibility for the cleanup.

Job Insecurity – When I began my professional life in 1977, there was excellent job security in corporate America.  Starting in 1981 and each and every year thereafter until I retired in 2009, my corporate employers and many others had work force reductions either through early retirement or layoffs.  It was a fact of life.  Accepting this fact, my belief is that one is paid up to date, and the corporation does not owe the employee lifetime employment.

Bureaucracy – A corporate hierarchy by definition is a bureaucracy. Myriad layers of corporate approval always slow innovation.  In the wrong environment, bureaucracy is a sure condition for good ideas to go nowhere.

The Good

Wealth Accumulation – Given the current state of our tax laws, corporations provide the average employee with a means for wealth accumulation.   Many companies have 401k savings plans, often with generous matching contributions, health spending accounts, defined benefit pension plans, employee stock purchase plans, and medical, dental, vision and life insurance plans.  In my experience a frugal secretary who took advantage of stock purchase and savings plans would be able to accumulate substantial wealth, often times in excess of a million dollars.

Freedom from Discrimination – With our wide range of equal employment and anti discrimination laws, employees of big corporations are largely free of discrimination.   Although much maligned, the human resources department does ensure that employees are treated in accordance with the law and that the workplace is essentially fair.

Training and Promotions – Corporations provide their employees valuable formal and informal training.  Further, many large employers pay for college and advanced courses, thus enhancing resumes and promotional opportunities, notably promotion from within, which increases seniority while maintaining job stability for an employee.    I worked with many secretaries and paralegals who completed college and master’s programs, and then were promoted into management.

Ethical Conduct – Corporations promulgate codes of conduct.  Corporations are serious about enforcing these codes of conduct, as ethical infractions could lead to criminal penalties and fines.  While everyone can point to Enron and WorldCom as counter examples, by and large corporations are ethical bastions with numerous controls in place (internal and external auditors, compliance and legal departments) to deal harshly with violators.

Balancing It All Out

Regulators – Mr. Smith believes that large corporations can bend compliant regulators to their will.   And yes, corporations are profit maximizers in any way they can be.  They are going to try everything within the law to shape the regulatory environment in their favor.   Mr. Smith fails to realize that this is not a one-handed game.  Industry competitors, consumer groups and other activists are also lobbying regulators to bend the rules in their favor.  One corporation cannot entirely shape a regulatory agenda.

Taxes – Commentators lambasted GE for investing in a huge tax department to avoid paying any US income tax.  In law school one of the strongest mantras is:  no taxpayer has an obligation to pay one cent more than is due.  If one does not like GE’s tax avoidance, change the tax laws.

Technology – Much has been made of layoffs, outsourcing and the dispensable employee.  Little thought has been given to the role of technology which has eliminated the need for many jobs. High speed communication innovations and faster, larger modes of transportation have made outsourcing of manufacturing and other jobs feasible.  Are corporations supposed to retain employees when the job no longer exists or is uneconomical to perform in the US?

Man versus Machine

Corporations are a legal construct.  They are created by humans and are flawed like humans.  On balance, they probably do more good than bad.  To particularize the current state of affairs, we live in a highly competitive, financially short sighted world. And knowing that means that the days of guaranteed employment, lush compensation and benefit packages, and benevolent corporations will not be returning in our lifetimes.  In the end I guess no one likes to contemplate the thought that we are all dispensable.

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American Society / Financial / Nuclear Energy / Regulation — 0 Comments
30
Mar 11

Meltdowns

New York Times financial columnist Floyd Norris compares the global financial crisis to the Japanese nuclear accident.  Mr. Norris found that “overconfidence born of experience led to increased risks once a disaster unfolded.”  Japan’s Meltdown and the Global Economy’s

  • The Financial Crisis – “In the world of finance, there was a general acceptance of the idea that banks and their regulators had developed sophisticated risk models to prevent a disaster. As lending grew more reckless, there was confidence that no real risks were being taken. “…In the world of finance, the assumption that safeguards would prevent disaster led people to believe it was safe to borrow heavily. There had, after all, been a prolonged period in which markets were not turbulent and there were only profits, not losses, to be realized from taking on the additional risk of leverage.” Japan’s Meltdown and the Global Economy’s
  • Japan - “[T]he risks of earthquake and tsunami were well known, and believed to have been dealt with. An earthquake could damage a nuclear plant and its vital cooling process if power to the reactor were cut off. So backup generators were built and batteries installed to provide power even if the generator did not immediately kick in. A tsunami could cause flooding. So huge sea walls were built to prevent floods.” Japan’s Meltdown and the Global Economy’s

- All the precautions had worked in previous earthquakes, a reassuring history.

Unfortunately, the nuclear plant builders assumed that tsunami risk had been eliminated by the precautions of others. Backup generators were behind the flood walls, but were not on high ground. The generators flooded and the cooling systems broke down, with consequent radiation release. Whether this situation will lead to something much worse is still not known.

Mr. Norris then sprinkles journalistic “fairy dust:”

“Fortunately, there is reason to hope that the worst fears will not be realized. When — let us hope it is not ”if” — the radiation releases are controlled, Japan can begin to rebuild and the worst economic fears could prove to be as exaggerated as the depression fears that paralyzed financial markets two years ago.” Japan’s Meltdown and the Global Economy’s

“Hope” is not analysis. Mr. Norris misses the big culprit of these tragedies; i.e., that we live in an over financialized world with weak regulation.   We have decreased society’s margin of safety, in the former case financial, in the latter nuclear.

Taking Risks

Years ago, prior to commencing bargaining negotiations, manufacturers would routinely hold extra inventory, for two reasons.  One, this strategy warned the unions that they were serious about their position and willing to endure a strike.  Two, during any strike customer deliveries (and hopefully loyalty) would continue.   Many times I recommended such an inventory increase.  As time progressed, management replied that the finance organization would not allow it: “too costly.”  Here was an early warning that finance would come to dominate many business decisions, and not to the company’s long-term benefit.

Financialized behavior became so prevalent that corporate financial executives viewed the cash flow from real operations as fodder for financial engineering schemes: company owned life insurance, leveraged ESOPs, share buy backs and others. While these schemes are harmless enough (except for their effect on the US Treasury), they have more dire consequences when it comes to nuclear reactor design.

A Japanese engineer, Mitsuhiko Tanaka, worked on Fukushima Dai-Ichi No. 4, one of the array of six reactors.  At the time of the March 11 earthquake and tsunami, No.4 was closed for maintenance.  Mr. Tanaka confessed that:

-          The reactor pressure vessel inside Fukushima’s unit No. 4 was damaged at a Babcock-Hitachi foundry in Kure City, in Hiroshima prefecture, during the last step of its manufacturing process. If the mistake had been discovered, the foundry might have been bankrupted.  There was no disclosure.

-          During the last phase of heat and pressure testing a reactor vessel wall warped. Proper procedure should have been to scrap it.

-          The engineer was ordered to reshape the reactor vessel to hide the damage.

-          The company saved billions of yen and the engineer received a sizeable bonus.

See Fukushima Engineer Says He Helped Cover Up Flaw at Dai-Ichi Reactor No. 4 (BLOOMBERG)

Dangers of an Over-Financialized World

Why are we surprised when multi-billion dollar, high profile, long-term projects like nuclear reactor construction have management and finance executives who try to cut every expense?

Consequently, the aftermath of the Japanese earthquake demonstrates the direct and indirect dangers of this over financialized world:

-          Lack of backup power supply – The backup power supply for the Fukushima reactors was placed in the flood area near the reactor and failed after the tsunami.  At greater expense the backups could have been placed on elevated ground away from the reactor. See Chinese Nuke Plant Safer than Fukushima

-          Manufacturing components supply interruption – Since US manufacturing has shriveled we have become mere assemblers of goods.  We rely on international supply chains thousands of miles long.   It probably sounded like a great idea to the CFOs of the world, but we now face supply disruptions from Japan for key auto and electronic components.  Concepts of a margin of safety, second source domestic suppliers or stockpiling are anathema to maximizing financial returns. See Global High-Tech Supply Chain Shaken by Japan Crisis

-          Energy supply disruption – Electric supply in Japan is approaching critically low levels.  There will either be plant closings or rolling blackouts which cut consumer electric power.  This is due to years of underinvestment in conventional power plants.   See Japan Electricity Losses: Summer with Air Conditioning???

-          Foolish recommendations to buy Japanese stocks – Investment banking firms say that the crisis is overstated, the Japanese are a resourceful, determined people, and the selloff in the Japanese stock market is overdone. Inexplicably, they predict only a minor impact on global growth.  See, e.g., Goldman’s Magnum Opus on the Economic Impact from Japan’s Earthquake.  I would suggest financial speculation is the last thing we should be involved in.   Has Wall Street turned every crisis into a stock buying opportunity, foolish or not?

Regulation

It is too soon to determine whether or not there was devastating nuclear regulatory failure in Japan.   The Bloomberg article on the Fukushima nuclear engineering cover up highlights some frightening probabilities on this issue.

Whether in finance or nuclear regulation, watchdogs have been too willing to let industry have their way.  As a legal advocate, many times I made the case to regulators that they were not considering the industry viewpoint.  With the laissez-faire regulatory environments fostered by Greenspan and the Bush Administration, the message to regulatory employees was clear:  “the less government regulation and interference in the free market place the better.”  Industry can always make a statistical case that the chance of a financial or safety catastrophe is extremely low.  But in these cases, industry profits trumped overall societal welfare.  Disinterested, intelligent regulators free of political and industry pressure should have been centurions guarding the public welfare.

With issues like financial speculation, leverage and fraudulent mortgages, derivatives, mortgage backed securities or nuclear power plants, the stakes are great.   When dealing with the public good and survival, laissez faire regulation is downright dangerous. We came within a hair’s breadth of destroying the financial system.  Now, we have physical destruction looming as well.  Nuclear power plant accidents have the potential to make large parts of Japan uninhabitable and increase death rates in Japan and worldwide.

Another “tragedy of the commons” is staring us down yet again, when individuals pursue economic self interest to the detriment of the overall society. See Tragedy of the Commons: Modern Finance and BP Parts I and II. Just as no one would question that anthrax should be tightly regulated, so should we guarantee the same stringent  regulation in the current dangerous environment.   Given near destruction of the financial system and negative health consequences from radioactive releases and waste, government should be imposing the strictest regulations in these two areas as if they were regulating anthrax.

Hubris Needs to Go

Overconfidence is but a symptom of the overall malady.   I am all for risk taking, private profit and entrepreneurial spirit, but not at the expense of the entire welfare of our society.   The emphasis on things solely financial needs to be diminished.   Some would argue we are impinging on free enterprise through tight regulation.   Alas, with government bailouts of the financial industry and backdoor Fed subsidies, finance is already more a ward of the state than true free enterprise.  Similarly, the nuclear industry survives through federal loan assistance and limitation of liability. (See Price-Anderson Nuclear Industries Indemnity Act)  Regulators need to step in, tightly but fairly, and advocate for the public interest. They can no longer be handmaidens of these two industries.  Finally, from a societal viewpoint we need to think less about short-term profit maximization and more about establishing a margin of safety.

 

 

 

 

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American Society / Banking / Business / Financial / Political / Regulation / The Federal Reserve — 0 Comments
1
Feb 11

Many Answers, No Solutions

Why do we never get an answer, When we’re knocking at the door…With a thousand million questions, About hate and death and war…’Cause when we stop and look around us, There is nothing that we need…In a world of persecution, that is burning in its greed.

Question, Justin Hayward (The Moody Blues)

The Financial Crisis Inquiry Commission (FCIC) issued its 576 page report analyzing the 2008 financial crisis.   Some of the findings:

  • The crisis was both foreseeable and avoidable.
  • Widespread failures in financial regulation and supervision proved devastating to the stability of financial markets.
  • Dramatic failures in corporate governance and risk management practices in systemically important companies such as AIG, Citicorp, Merrill Lynch and Fannie Mae were a key cause of the crisis.
  • A combination of excessive borrowing, risky investment and lack of transparency put the financial system on a collision course with the crisis.  Both households and companies borrow too much and save too little.  Risks were hidden from the public.
  • Government regulators (Treasury, the Federal Reserve, etc.) were ill-prepared to deal with the crisis and their responses were late and inconsistent.
  • There was a systemic breakdown in ethics and accountability.  Households lied to get mortgages and financial institutions knowingly underwrote bad loans.
  • Collapsing mortgage lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis.
  • Unregulated derivatives were a major contributing force to system instability.
  • The credit rating agencies charged with properly evaluating securities were a major contributor to financial destruction.

Even the public and political leaders were to blame for not reigning in excesses.

Republican members dissented from the report, and instead focused on the government encouraging home ownership and the roles of Fannie Mae and Freddie Mac and the majority’s over-focusing on lax regulation and greed.  See Financial Crisis Inquiry Commission’s 10 Major Findings

Some Observations

-          When everyone is to blame, no one is to blame.   The FCIC report focuses on ten areas, including the roles of the public and our political leaders.  Blame is so diffuse there is essentially no blame.  The uninformed average citizen will simply breathe a sigh of relief and hope that this does not happen again.

-          The FCIC report states that there was mortgage fraud, SEC violations and ethical lapses.  Where are the prosecutions?

-          The FCIC report misses an obvious culprit.  Easy money in the form of excessively low interest rates was the Federal Reserve response to the bursting of the internet stock market bubble in 2000.  Interest rates were kept too low for too long and stoked the housing boom. Easy money is misdirected into speculation and economically dubious projects.

-          The FCIC report reacts in horror to the Lehman bankruptcy.  The report implies that bankruptcies of large financial institutions are not acceptable.  Preventative regulation is not enough.  Instead of more regulation, wouldn’t fear of bankruptcy encourage more financial prudence?

Where Are We Today?

The public and our leaders should be asking whether or not we are in a better position today to avoid a new financial crisis.  We have punished savers, pension funds, insurance companies and retirees with zero percent interest rates.  We have run over $4 trillion in deficits and supplied $23 trillion in financial guarantees. We have stubbornly high unemployment and meager economic growth. Through outright money printing (QE2), we have triggered new bubbles in commodity and equity markets.  Both markets appear overpriced.  To show their true financial picture, banks are cheering another delay of the Financial Accounting Standards Board attempt to reinstate mark to market accounting.  We operate in a perpetual state of economic emergency.

Interestingly, we rushed to pass the Dodd-Frank financial reform bill even before the completion of the FCIC report.  We prescribed medicine before a diagnosis.

We applaud ourselves for avoiding financial Armageddon, and we are making many of the same pre-2008 mistakes.

Some Modest Proposals

We could do better.  Some obvious and necessary changes we could implement immediately:

§  End zero interest rate policies and quantitative easing (money printing).  Saving and investment will return and business will expand again.

§  End guarantees to our “too big to fail” financial institutions (and others as well).  Financial prudence will return without excessive new regulation.

§  Permit the imprudent to go bankrupt.

§  For two reasons, aggressively prosecute the guilty: 1.) our democracy is based on the principle that no person or institution should be above the law, and 2.) prosecution will chasten and deter the reckless.

§  Remove Bernanke and Geithner.  The Federal Reserve under Bernanke could not foresee the crisis. It failed to regulate the mortgage lending practices of the banks.  As head of the Federal Reserve Bank of New York, Geithner failed to control the reckless practices of Citicorp and other banks under his jurisdiction.

§ Impose claw back provisions on bank bonuses.  In exchange for providing deposit insurance, TARP, below market interest rates for bank, the public has a right to demand that bank bonuses be “at risk.” This means that in good years bankers get to keep their bonuses, but in bad or abusive years those bonuses can be reclaimed by shareholders, creditors or the government.

According to Einstein, insanity is “doing the same thing over and over again and expecting different results.”  We continue to repeat past behaviors.  With QE2 we introduced nuttier behavior to prop up our too big to fail banks. The FCIC report raised a million questions and too few solutions.  Thus, we are truly facing a world that is “burning in its greed.”

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American Society / Economics / Political / Public Sector Unions / Regulation / The Federal Reserve — 0 Comments
4
Jan 11

From Under-Reaction to Over-Reaction

DC Beltway insiders, abetted by their friends in academia, are expert at identifying and recommending political curatives for the ills of society. At the most sophisticated and effective level, punditry has a predictable genesis and trajectory.  First, from the chaos of all manner of the environment’s input, whether in universities or “think tanks” academics identify a societal problem that needs correction.  Many times, what follows is often widespread agreement that a problem exists and needs correction.  When that occurs, the process gains momentum, traction, attention and support from different constituencies.  Politicians whip up widespread public support.  Pundits produce inspirational articles and editorials in support of the corrective action.  Myriad examples emerge of the consequences of the unsolved problem.  Some examples may emerge of solutions to the problem, albeit solved on a finite, boutique, scale.  Soon we have groundswell support to “do something.”  We lobby, pass legislation, establish agencies and write regulations.  At the beginning all goes well, but soon problems arise. We experience administrative overreach, which is often worse than the original problem.  So what has begun as a good idea becomes misshapen beyond recognition and becomes its own societal problem. Some examples:

-          The problem: discrimination on the basis of race or sex.  The solution: Passage of the Civil Rights Act of 1964.  Starting with a simple corrective of ending discrimination we have built an administrative Rube Goldberg empire: the Equal Employment Opportunity Commission, the Office of Federal Contract Compliance, state anti-discrimination agencies. Soon class action and affirmative action programs were introduced as mandates.  Further, the Obama Administration now desires to expand the scope of anti-discrimination laws regarding the concept of equal pay for equal work to a new more troubling concept of “comparable worth.”  Employers are now beset with charges of discrimination and class actions. See ‘Comparable Worth’ Rears Ugly Head in Age of Obama

-          The problem: America lacks universal health care coverage.  The solution: The passage of Obamacare.  The law is byzantine beyond explication:

…the health system is complex, yes, but also ornate. The new law creates 68 grant programs, 47 bureaucratic entities, 29 demonstration or pilot programs, six regulatory systems, six compliance standards and two entitlements.

Getting that massive enterprise up and running will be next to impossible. So Democrats streamlined the process by granting Health and Human Services Secretary Kathleen Sebelius the authority to make judgments that can’t be challenged either administratively or through the courts.  See Obamacare Only Looks Worse on Further Review

The law has other consequences: 117 million current health care plan participants may need to change plans in 2013; 16 million new participants may be forced into Medicaid: Medicare benefits will be reduced to pay for the program; a 3.8% additional tax will be imposed on investment income; a 40% excise tax on “Cadillac” health plans and a $2100 increase for families buying private insurance plans.

-          The problem: Public employees need employment workplace protections. The solution: In 1962, President Kennedy extended collective bargaining rights to federal employees.  While federal employees could only bargain over working conditions, not salary and benefits, this precedent set the stage for widespread collective bargaining rights for public unions.  At the state and local level bargaining occurs over all issues.  Politicians have recognized the efficacy of acceding to union demands.

Thus, we have had an explosion in public sector salaries and benefits, especially lucrative pension plans.  As states and municipalities face huge budget deficits and massive pension plan underfunding, these entities are considering benefit cutbacks, bankruptcy and large tax increases.  The public, facing job insecurity or unemployment are revolting against increased taxes.  See Strained States Turning Laws to Curb Unions; Cash-Strapped States Seeks Laws to Curb Labor Union Power

-          The problem: The financial crisis threatens the solvency of US banks. The solution: The government ignores its own advice to the troubled Japanese financial system.  Instead of forcing the banks to write down bad assets, the government undertakes a costly and legally and economically dubious program of buying trouble assets.  It has  forced $700b dollars of funds on troubled banks, and continued to guarantee bankrupt Fannie Mae and Freddie Mac, and maintain a zero interest rate policy for over two years.   The economic consequences have been enormous:  unemployment near 10%; savers and retirees punished;  oil and other commodity prices exploded and the dollar substantially lower.

Taking it to the Limit it Too Many Times

We have lost the ability to identify a societal problem and implement a measured and thoughtful solution.  We have also lost the ability to forebear, take no action and let the problem work itself out.  We move from under-reacting to over-reacting.  Over-reacting imposes enormous costs on society.  Thus, we have backlashes against affirmative action, a move to repeal Obamacare, tax revolts against the privileged financial protections afforded to public employees, and simmering resentment toward Treasury and Federal Reserve policies which favor Wall Street over Main Street.

Perhaps in matters of important policy, more thoughtfulness, realism and humility, rather than brash hubris and impulsiveness, would restore confidence in both our government and our economy.

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29
Oct 10

Is the US Economy an Impaired Asset? Part II

In Part I we defined impaired assets and posited that the United States could be compared to a corporation so burdened.   Has ill-advised investment in multiple critical areas led US INC to be over-indebted with too limited income to repay that debt?   If the answer is yes, it also leads to other impediments to a genuine economic recovery.

Impediments to Economic Recovery

-          Discouraging savings – Productive enterprise springs from investment. Investment is predicated on a pool of savings to tap.  Zero interest rates and high taxes impede savings and investment.

-          Workplace regulations – We have overregulated the workplace.  Worker protections have been taken to an extreme.  We protect workers against a myriad of discriminatory behaviors: race, age, sex, national origin, pregnancy, gender, disability, union membership, marital status, veteran’s status and others.  While all noble goals, fearing expensive litigation, companies build costly compliance complexes and hesitate to discipline or discharge a poorly performing employee because of their protected status.

-          Environmental regulations – While initially a worthy goal, the overlapping state and federal (EPA) enforcement regimes and expensive compliance impose significant costs on American companies.   Foreign competitors face little pressure in this area and thus enjoy a competitive advantage.

-          Unionization – Through a myriad of seniority and work rules, breaks, and generous wage and benefit demands, unions impose a significant employer expense. These limit employer flexibility to respond to changed economic conditions.  The Administration has an avowed policy of trying to make unionization easier.

-          Litigation – Besides employment, environmental and labor litigation, employers face significant litigation risk in product liability and securities areas.  States with pro-plaintiff orientations have encouraged expensive and prolonged class action litigation.

-          Public Sector – Expanded public sector employment creates a dual problem.  First, the private sector is at a competitive disadvantage competing for talent against the higher paid, secure employment in the public sector.   Second, an expanded public sector imposes greater tax burdens across all levels of government, all of which costs are ultimately levied against private enterprise.

-          A Culture of Entitlements – Public policy over the past seventy years has built an expensive safety net of personal entitlements: social security, Medicare, Medicaid, unemployment, disability insurance, family leave, medical leave and others.  The Obama health care initiative only adds to these burdens.

The US is much like the mid-1990s telecom environment.   We are burdened by too many legacy costs.  We have too much debt, overvalued assets and insufficient income to pay back our debts or support our regime of entitlements and regulatory burdens.

Solutions

Technology and poor economic policy have earned US INC the dubious status of impaired asset.   One way the markets have been expressing this concern is through the decline of the dollar.  Moving up the economic chain, the next move would be for foreign governments to refuse to purchase US Treasury securities.

Looking at government attempts to export our way out of this problem through depreciating the dollar, Doug Noland of Prudent Bear comments:

Having de-industrialized and failed to invest sufficiently in productive capacity during our prolonged Credit Bubble, there will be no near-term exporting our way out of trade deficits.  And there is little evidence that help is on the way from the current elixir of massive non-productive government debt expansion and ultra-ultra-loose monetary policy.  While extreme government stimulus has stabilized incomes, consumption and imports, it has done little to promote the type of productive investment necessary to rebalance our maladjusted economy. See Rebalancing the World

It is time to end extend and pretend.  If US INC was subject to private business accounting rules, the banks would be forced to write down their “assets” (loans) to fair market value.  Yes, this would involve hardship upon the equity and bond holders of banks.  But failure to remedy this problem will only prolong the economic agony.

Further, any good business person would look at the cost side of the enterprise and try to reduce expenses.  We probably have gone as far as we can in cutting employment expense through layoffs.  We need to move up the chain to look at societal costs being imposed on business.  We are not about to throw out all environmental, workplace and other protections  However, we need to see how a more sensible regulatory scheme could reduce costs and minimize employer litigation costs.    Further, public policy needs to reduce public sector employment numbers and cut back entitlements.

We need to take these steps before our foreign investors and competitors impose them upon us.

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17
Oct 10

Millions for Design, Not One Cent for Administration

Shortly after the American Revolution, France began seizing Americans ships and demanding payment for their return.  CC Pinckney, one of three members of the American delegation to France, memorably replied:  “Millions for defense sir, but not one cent for tribute.” XYZ Affair

In the modern world of corporations, let’s modify this quote to: “millions for design, but not one cent for administration.”

Brilliant Wall Street “masters of the universe” have designed elegant and sophisticated mortgage backed securities.  Exactly what are these financial instruments?  The designers instructed that a mortgage be underwritten, conveyed to a trust (REMBIC), and then placed in a mortgage backed security to be sold to investors.  Even more appealing to investors is that they could select various tranches (levels of risk) of the final product to invest with higher or lower expected default rates.

As we now learn, mortgage notes may never have been actually conveyed to the trusts.  Further, the banks are having difficulty locating the original mortgage notes. To muddy the water further, we have allegations of fraud, faked documents, mass notarizations, and false affidavits. See This Magic Moment

How did we get to this current state of affairs?

After the Big Launch

It is intriguing to imagine being the star chef, the center ring performer, the creator of something special.   Far less interesting is the job of cleaning the kitchen, sweeping out that center ring, or making the complicated creation actually work.  Somehow the follow up has less, or little, dignity.

Corporations operate the same way, and corporate behavior reflects all human behavior.  When a company launches a new financial product, service or program, the accolades go to the designers: the star lawyer, finance official, actuary or business executive who originates and sells the idea to high level management.  The designers get big bonuses, exposure to the CEO or board, and promotions to the inner sanctum. They give scant thought to how a new financial product or service will be administered.  And corporations allocate few budget resources to administration.

The Tragic Stepchild:  Administration

How do corporations or banks repetitively get to this state of affairs?  Some probable reasons:

  • Greed – Rewards flow to the designers, not the administrators.
  • Elitism – The designers tend to be from elite schools and hold fancy sounding titles in the corporation. Administrators, on the contrary, hold high school diplomas and maybe some college courses from somewhere.
  • Lack of Funding – Once the thrill of design has worn off, management wants to control costs so the administration function, a/k/a overhead, gets short shrift.
  • Program or Product Complexity – Many programs are devilishly complex, yet need to be flexible.  The combination is expensive and requires well trained personnel.  And complexity is an excellent way to hide cost and pricing.
  • Poor Training – Closely allied with lack of funding and complexity is poor training.  Designers may prepare rote scripts for administrators, but they are inadequately trained to exercise judgment or handle non-standard questions or errors.
  • Fear – Job insecurity and low corporate status make program administrators reluctant to report problems or errors to their superiors.  They are even more fearful of being “whistleblowers” and reporting actual malfeasance.
  • Neglect – Corporate headquarters are in or near tonier places like New York, Los Angeles or Chicago.  Administrative operations are either in rural areas or overseas.  Other than brief flyovers, headquarters management has little time or interest in being where the administrators and their problems are.

Clean Hands and Dirty Programs

Previously, I have written about the reluctance of our elite college graduates to seek jobs in manufacturing. See Clean Hands and a Weak Economy. Administration is a close analog.  It is populated by non-elite individuals, in remote locations with little promise of promotion for a job well done.

We are now seeing the fallout from this corporate disdain and distaste for administration.  Reports are now legion of hairdressers and Wal-Mart employees with little or no training being pressed into service working for foreclosure mills.  They have no idea what a mortgage note or affidavit is, much less what to do with it. See Meet the Foreclosure Experts

America 2010:  millions for design, not one cent for administration.  Where were the regulators? We should never have been in this mess.

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Business / Financial / Pensions / Regulation — 0 Comments
15
Jul 10

Pension Insecurity

Substantial recent financial media focus has been lavished on subprime mortgages, credit derivative bets on a decline in the residential housing market, flash crashes in the stock market, bank insolvencies, major corporate bankruptcies, and sovereign debt defaults. They have paid less attention and provided less insight into the perilous state of pension funds.

Both public and private pension funds face an emerging crisis.  We need to examine some disturbing trends in both sectors.

New Jersey Pension Fund Crisis

In No Garden-Variety Pension Crisis, Andrew Briggs asks hard questions about the funding of New Jersey’s public pension plans.  If the state used private sector pension accounting, the underfunding would rise from an already horrendous $46b to a mindboggling $170b.  This deficit is more than five times the 2011 $29.4b state budget.

The real question is, when will the plan run out of money?  Assuming the plan can earn 8%, which may be an aggressive assumption in the current environment, the plan would run out of money in 2019.  However, NJ has increased its risk profile for the fund.  The state has moved 60% of its pension assets into riskier alternative investments, such as hedge funds and private equity.  Thus, there is a 25% chance the fund can run out of money as early as 2017.

The article concludes that NJ is not alone.  Connecticut, Indiana, Illinois and other states are due to run out of money before the end of the decade.  (See Bailout Nation Lives: Revisited, a Short Update).

Diageo

And while we are worried about risky funding strategies utilizing hedge funds and private equity, pension funding creativity reaches new heights with a plan by the Diageo Corporation. This beverage conglomerate intends to “fund” its plan with more than 2 million barrels of scotch whiskey.

Diageo said … it would transfer ownership of £430 million, or $645 million, worth of whiskey to a pension funding partnership. Diageo employees would not receive their pensions in whiskey rather than cash, but the move does give them a guarantee that they would not walk away empty-handed should the company default.

“A pension funding partnership will be formed, which will hold maturing whiskey spirit as assets,” ….

As part of the deal, Diageo agreed to pay the pension partnership £25 million a year as it sells the recently distilled whiskey once it matures after three years and replaces it with new stock. The agreement would expire after 15 years, at which point Diageo would buy back the whiskey, which comes from distilleries such [as] sic Oban on the west coast of Scotland. See Diageo Uses Scotch to Plug Gap in Pension Plan.

I personally love Diageo products.  Talisker, Lagavulin, Oban and others are some of the finest whiskies in the world.  See Tis’ the Season for Deflation and Update on Deflation. In my prior posts on Diageo, I pointed out that some of their premium products were in dramatic price decline.  Now it becomes clear that weak pricing power and pension underfunding for Diageo are connected.  If Diageo had pricing power, it would have sufficient profits to fund its pension plan with cash.  In a deflationary world, should their pension plan beneficiaries hope to count on the future price of scotch whiskey in order to receive their benefits?

GM, A Cautionary Tale

We have seen innovate funding techniques before.  In 1993, GM asked federal pension regulators to approve an innovative plan to meet a $24b pension deficit.

Under the plan announced today, GM would contribute shares of its class E common stock to the pension plan. The value of that stock is tied to the performance of a wholly owned subsidiary, Electronic Data Systems. Its closing price today on the New York Stock Exchange was $31; based on that price, the total value of the contribution would be $5.7 billion.  See G.M.Acts to Secure Pension Using Stock.

Regulators acceded to the GM request.  The rest is economic history:   GM recently went bankrupt, and the plans remain massively underfunded.

Poverty Follows Financial Innovation

In its time of pension deficit, Diageo is not the only creative funder. The UK is rife with new schemes:

The British supermarket chain J Sainsbury said earlier this year it would transfer property into a pension vehicle, while Whitbread agreed to hand over a share in its portfolio of restaurants and hotels. The investment firm Man Group moved some hedge fund assets into a trust as a security for its British pension plan in March.

“We’re seeing a huge growth in the use of non-cash funding,” Marc Hommel, leader of the pensions practice at PricewaterhouseCoopers in London, said. “There are big pension deficits and sponsors are cash-strapped. These mechanisms provide security for the pension plans in exchange for less cash.”  See Diageo Uses Scotch to Plug Gap in Pension Plan.

Mr. Hommel probably did not intend to be humorous, but one must ask whether these new methods of providing  “security” make the funds more or less secure.  I would submit that when one has to innovate and pull financial “rabbits out of the hat” both equity holders and pensioners of these companies face a lot more risk.  And so do we, the taxpayers and funders of our enormous public pension funds and guarantors of private pensions through the Pension Benefit Guaranty Corporation.

In this current age of funding gimmicks, maybe we should refer to pensions as a social insecurity system.

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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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7
Jul 10

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

“Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”
Alan Greenspan,  Senate Agriculture Committee testimony – July 30, 1998.

BP’s Hayward conceded that his giant oil company had been unprepared for this disaster.  “What is undoubtedly true,” he said, “is that we didn’t have the tools you would want in your toolkit.”  Tony Hayward, June 4, 2010 interview with the Financial Times

A powerful and controversial precept in economics is the “Tragedy of the Commons.”  University of California biology professor Garret Hardin introduced the concept in a 1968 paper published in Science:

The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy.

As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?”

The tragedy is overgrazing:

…the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another…. But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

We do not have a problem with herdsman.  Unfortunately, we have evolved to deadlier pursuits which threaten us all.  Let us examine the cases of the post-1999 financial world and the BP Deepwater Horizon tragedy.

The World of Modern Finance

Modern finance was born in 1999 with the passage of the Gramm Leach Bliley bill, ironically named the Financial Service Modernization Act, which repealed the Glass Steagall Act of 1933.  Glass Steagall among other reforms required a separation of commercial and investment banking activities.   Further, a commercial bank could not hold a brokerage firm.  With the passage of the Gramm bill the line between traditional and investment banking was obliterated and permitted  the merger of commercial and investment banks, brokerage and insurance firms.   The financial “commons” was now open for all to graze in.  The result:

-          Excessive use of leverage.

-          Large scale subprime lending.

-          Exotic mortgage products such as interest only, adjustable rates, and ALT-A.

-          Securitization of everything from mortgages to car loans to credit card debt.

-          Expansion of consumer lending facilities such as home equity line of credit, automobile leasing and mass issuance of credit cards to anyone who could fog a mirror.

-          Predatory private equity corporate takeovers amplifying leverage with “pick or pay” payment options.

-          Conflicts of interest between credit rating agencies and issuers and the ultimate purchasers of securities.

-          Credit derivatives wherein firms could bet on and simultaneously attempt to engineer the demise of other firms.

Before being distorted beyond their original purpose, these practices started from a rational base.  Take for example housing.   The reigning ideology supporting aggressive lending practices was that housing prices would always rise and homeowners would do everything possible to avoid foreclosure of their homes.  Banks armed with AAA ratings from the credit rating agencies and sophisticated models predicting default rates could bundle mortgages, create securities and sell them to “confident” investors.

The tragedy of this commons was that loose credit increased both real estate prices and supply to the point where incomes could not support repayment.  In turn, the packaged securitized mortgages did what no one unpredicted, failing at an alarming rate in excess of mathematical projections.  Soon the “housing commons” was littered with foreclosed homes, plunging prices, impaired bank balance sheets and the ultimate failures of Bear Stearns and Lehman.

Each participant: banker, builder, lender, appraiser, credit agency, and homeowner was merely pursuing his own economic interest.  If this was merely private participants losing money, it would create economic difficulties but not a financial crisis.  Unfortunately, two of the major players in the mortgage market were Fannie Mae and Freddie Mac, government sponsored enterprises with an implicit guarantee from the Treasury.  These entities are sporting losses which will exceed $1 trillion or more.  We the taxpayers through TARP and government guarantee programs are subsidizing these losses.  See Shredding the Social Fabric. We are still paying the price for this disaster with 8 million unemployed and countless millions more underemployed.

Part II will examine BP’s ill-fated sojourn into a “common” otherwise known as the Gulf of Mexico.

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27
Jun 10

Safety and Profits: Oil and Water?

Last Thursday was another opportunity to watch a corporate executive, Tony Hayward, BP CEO,  grilled before Congress.  Suddenly, our previously silent representatives sprang into action and demonstrated their new-found expertise in off shore drilling, cementing protocols, drill logs, blow out preventers and other esoteric elements of drilling and exploration.

How do these mishaps occur? Are other corporations really any better? What are the CEO’s like in these mammoth enterprises?

Risky Business

Industrial accidents occur in corporations.  It is a fact of corporate life.  People die at work every day, and the number is probably under reported.  A significant corporate mishap that reaches the popular press always shocks the public.   If there is a large enough loss of life or damage to the environment or economy, Congress jumps in to demonstrate that they are “on top” of events and protecting the public.

Some accidents are preventable, some are not.  Much of the outcome depends on corporate culture.

Safety, Environmental Compliance, and Corporate Culture

Enactment of Corporate Sentencing Guidelines drove corporations to compliance and ethic programs. Safety and environmental compliance were major parts of these programs. The first programs focused on formulaic policies and procedures and appointment of a chief compliance officer.  Understandably, prosecutors wanted managements to take compliance seriously.  Thus, in addition to compliance manuals, programs evolved to incorporate in-depth training, comprehensive investigations of wrongdoing, self disclosure and discipline of offenders.

Safety and environmental compliance are two particularly sensitive areas, as literally they can involve life and death.  Despite the best efforts of the corporation to establish robust compliance programs in these two critical areas, success still depends on corporate culture.   Does the corporation take compliance seriously? Are employees provided extensive training?  Does the compensation system support good practices? How will whistleblowers be treated?  How much of corporate resources are devoted to compliance?  Are violators punished?

Life in the Trenches

No one goes to work thinking that there is going to be a mishap.   Things happen in the trenches.  This is where corporate culture really plays the key role.

I am not an oil expert but we can imagine how a BP disaster could occur.  On June 14th, the House Committee sent a letter to Tony Hayward, CEO of British Petroleum, querying five areas of concern:

(1) the decision to use a well design with few barriers to gas flow; (2)  failure to use a sufficient number of “centralizers” to prevent channeling during the cement process; (3)  failure to run a cement bond log to evaluate the effectiveness of the cement job; (4)  failure to circulate potentially gas-bearing drilling mud out of the well; and (5)  failure to secure the wellhead with a lockdown sleeve before allowing pressure on the seal from below. The common feature of these five decisions is that every one was a trade-off between cost and safety.

The House focused on these areas, as each represented a trade off between cost and well safety.

A dynamic tension exists within corporate environments between cost and safest practice. The rig was 43 days overdue, meaning that BP was incurring $500,000 per day of incremental rental cost.   The project manager was under enormous pressure to bring the project in as close as possible to budget.  It does not take much creativity to conjure the conversations or attitudes at play on the rig when employees or contractors discussed safety issues:

Is (whatever) change really necessary?

-          How much is this going to cost?

-          Is everyone being a “team player?”

-          Are the contractors recommending this course of action so they can charge us more?

-          “Who wants to call London and explain a delay to top management?

-          Didn’t X Company do this safely without any problems?

-          Why a design change?

-          Do we really need to involve the government?

Each of these is a subtle intimidation intending to silence any naysayers standing in the way of “progress” and “profits.”

In most cases, the CEO of a mammoth corporation is detached from day to day operations.  Often, a CEO seeks plausible deniability. See Timothy Geithner and Plausible Deniability. While Mr. Hayward proclaimed that safety was a major BP concern, how did the rank and file personnel operationalize that concern?  CEO’s often send mixed messages and employees may have heard that while safety is important, the company is in the business of making profits for shareholders.  The true litmus test is behavior on the oil rig. From all accounts it appears that cost shortcuts trumped safety.

BP is Not Alone

Every day in corporate America companies make tradeoffs.  It is naïve to think that only BP is doing it.  Safety, compliance, and environmental controls are cost, not profit centers.  On the contrary, lots of companies exert subtle and not so subtle pressure on employees, subcontractors and even government officials.

If we are truly interested in preventing future avoidable accidents, we need to raise and enforce penalties on corporations and individuals.  The Corporate Sentencing Guidelines already provide a template.  Further, the government needs to intelligently enforce regulations on the books and promulgate new regulations when necessary.   Finally, corporate and environmental compliance needs to rise to the top of the corporate governance checklist.

Perhaps then we can avoid the “show” of the House of Representatives examining problems after the event.  We need to give prior thought to preventing calamities before they happen.  On so many levels, the cost of the aftermath is simply too great.

We have learned the hard way that balancing profits, safety and environmental concerns are like mixing oil and water.

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